Mitchell Fox is a Tax Nerd and the Co-Founder of GoodApril, a site that provides consumers with online tax planning and tax advice services and offers a free “Tax Checkup” to help you identify actions you can take to reduce your taxes. You can follow Mitch on Twitter at @mitchellwfox or @goodapriltax.
There are a lot of benefits to paying down your debt – psychological and financial alike – but one of the less known perks for paying down student loan debt is that it can help lower your taxes.
Here’s how it works
If your income is within the permitted range (see below), you can deduct up to $2,500 in student loan interest payments annually – it goes right onto line 33 of your form 1040. Unlike other tax breaks for education, your student loan may have been used not only for the basics (tuition, fees, books, etc), but also room and board (if you lived in university housing).
Like all tax rules there are a lot of caveats, but luckily, in this case they’re all pretty mundane:
- The debt has to be in your name (the IRS says that “you [must be] legally obligated to pay interest”) – not in the name of your parents or someone else (they get to claim the deduction for themselves)
- You (and your spouse, if married) cannot be claimed as a dependent on someone else’s return
- You are not filing as “Married Filing Separately” (the IRS really doesn’t like that)
- The loan had to be used solely to pay qualified higher education expenses, for a degree-awarding institution in which you were enrolled at least half-time
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A Little Tax Planning Can Go a Long Way
Because the ability to deduct student loan interest payments is limited to people earning less than $75,000 per year (if single) or less than $155,000 (if married), higher-paid graduates have a narrow window within-which they can take advantage of the deduction: the year when they graduate.
Here’s what you should think about: will you have enough disposable income from that first job after graduating to be able to make some big interest payments? Perhaps all the way up to $2,500? If so, is your income going to be below the phaseout range (e.g. $60,000 for singles in 2012)? If yes, great. Make those payments!
If, however, your income is going to be between $60,000 and $75,000 (or close), then you can still benefit from the deduction, but you should consider some active tax planning. When you’re in the phaseout or close to the cutoff, reducing your taxable income not only lowers your tax bill for the year, but also enables you to take this deduction. So how do you do that? Contribute more to your 401K. If you don’t have one, make contributions to a Traditional IRA. Harvest some of the losses in your brokerage account – you know, that tech stock you lost money on but is still wallowing in your portfolio?
To help you understand this concept, consider Benny. He’s just finished his MBA and is going to earn about $70,000 between his summer internship, signing bonus, and first few months of work. Let’s say he’s able to pay off the full $2,500 of interest that he can deduct from his taxes. Because he’s earning $10,000 over the limit (at the 66% cut-off on the phaseout), he would only be able to deduct $850 of those payments. If, however, he contributed 10% to his 401K, and realized a $3,000 loss in his investment portfolio (sold his money-losing stock investments), he would be able to increase his deduction by $1,650.
Look ahead, not behind
If you didn’t make your student loan payments in 2012, you won’t be able to take the tax break this year. But don’t let that get you down! Start looking ahead to 2013, and take advantage of ReadyForZero’s tools to help you manage and pay down your student debt this year!
Student Loan Deduction Thresholds
Here are the income thresholds for the student loan interest deduction:
Filing Single and Head of Household:
$60,000 and below – full benefit
$60,000-$75,000 – partial benefit (take the amount of income over $60,000 as a percent of $15,000, and multiply it by $2,500 to determine your reduced benefit)
Married Filing Jointly:
$125,000 and below – full benefit
$125,000-$155,000 – partial benefit (take the amount of income over $125,000 as a percent of $30,000, and multiply it by $2,500 to determine your reduced benefit)
Married Filing Separately:
We hope this information will help you make the best decision when it comes to paying off your student loans and getting the maximum tax benefit for doing so. If you have any questions about student loan interest deductions, let us know in the comments below.
Image credit: Jordanhill School D&T Dept