How Student Loans Impact Your Taxes and Other Tax Advantages for Education Expenses
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Summary:
If you’re a recipient of private student loans or federal student loans, you may be eligible for certain tax deductions or other tax breaks on your federal income tax return. Some tax credits can be taken advantage of while a student is still in school or after graduation. Some tax breaks include the student loan interest deduction, the American opportunity tax credit, and the lifetime learning credit.
Getting a degree can be incredibly expensive, even with student loans. Student loans are a way for many people to access higher education that they otherwise couldn’t afford. However, student loan debt can also become a big problem for graduates who suddenly realize that repaying student loans is a large burden to bear.
That said, there are some tax reduction options that can help alleviate some of the expense of student loans. Read on to learn more about how student loans affect your tax returns and other tax situations that impact student loan borrowers or those who pay for educational expenses.
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Tax breaks for student loan borrowers
If you have student loan debt and pay taxes, it’s worthwhile to be aware of the potential tax implications that can affect student loan borrowers.
Student loan interest deduction
Part of your student loan payments are applied to the principal of the loan — the amount of money you borrowed in the first place — and the rest of your payment goes toward paying interest on the student loans.
And while your total student loan payments aren’t tax deductible, the Internal Revenue Service (IRS) will allow borrowers to claim a tax deduction on the interest payments. This is known as the student loan interest deduction and it lowers your taxable income and may lower how much you have to pay at tax time.
The student loan interest deduction allows you to claim up to $2,500 in interest paid in the tax year or how much you’ve actually paid in interest, whichever is less. For example, if you paid interest of $1,000 for the year, that’s the maximum deduction you can claim on your return. If you’ve paid $3,000 in interest, you can only deduct $2,500 from your taxable income.
It’s important to be aware that there are tax filing and income requirements that limit your ability to take the deduction. In 2022, the income limits are as follows.
- If you’re single, head of household, or a qualified widow or widower, the deduction begins to phase out when your modified adjusted gross income (MAGI) reaches $70,000. Once your income goes above $85,000, you can’t take the deduction at all.
- If you’re married and filing jointly, the deduction is reduced starting at a combined income of $145,000. Once you and your spouse’s income reaches a total of $175,000, you are no longer eligible for the deduction.
- If you’re married and filing separately, you’re not eligible for the student loan interest deduction at all. This means if you want to take the deduction, you’ll need to file a joint return.
Pro Tip
Keep in mind that tax filers who normally take the standard deduction, rather than itemizing each deduction, can still take advantage of this tax break, says Caitlynn Eldridge, Owner at Eldridge CPA LLC.
“You can take it even if you take the standard deduction because it is actually an adjustment to your income and reflected on line 10 of your 1040,” explains Eldridge.
Who can claim the loan interest deduction
All of the following criteria must apply in order to be eligible for the interest deduction.
- You paid interest on a qualified student loan in the tax year.
- You’re legally obligated to pay interest on a qualified student loan.
- Your filing status isn’t spouses filing separate returns.
- Your MAGI is less than a specified amount, which is set each year.
- Neither you nor your spouse, if filing jointly, can be claimed as dependents on someone else’s return.
How to claim the student loan interest deduction
By January 31, if you’ve paid interest of $600 or more in the past year, your loan servicer will send you IRS Form 1098-E Student Loan Interest Statement. You can use the form to see how much interest you paid so you can deduct interest from your taxable income.
If you don’t receive Form 1098-E, you may have paid less than $600 in interest. Contact your loan servicer or look up your online account to see how much interest you paid for the year. You could also calculate how much interest you’ve paid by looking at your past student loan bills.
IMPORTANT! If you’re not sure if you have a qualified student loan (such as private student loans versus federal loans, use this form created by the IRS to determine if you’re eligible to deduct student loan interest.
Student loan forgiveness or debt cancellation may not be taxed
Normally debt forgiveness, often known as debt settlement, is considered taxable income by the IRS. For example, if you settle a medical debt for less than you owe, the money saved is taxed as income. So if your bill was for $2,000 and you negotiated to settle the debt for $1,000, you would have to pay federal income taxes on that $1,000.
Student loans are treated differently though, especially since President Biden’s American Rescue Plan Act of 2021. It used to be that only certain student loan forgiveness went untaxed on the federal level, like public service loan forgiveness.
However, because of the Act, federal student loans that are forgiven, canceled, or discharged are not subject to federal taxes through the year 2025. For example, an income-driven repayment plan, where the remaining loan balance could be forgiven after 20 or 25 years of payments, is no longer subject to federal income tax until after 2025.
However, borrowers should be aware that student loans forgiven or canceled may be considered taxable income by the state you live in, Eldridge says.
“The forgiveness of the student loans — if related to the Biden executive order — would not be taxable at the federal level. However, it could be taxed by the states if they do not follow federal tax rules (which is within the right of the state for this). Forgiveness of loans actually appears on a 1099-C as canceled debt.”
Other tax benefits for students and parents of students
Even if you don’t have student loan debt, there are education tax breaks that can help students or parents with dependent students save money on their federal income taxes.
American opportunity tax credit
The American opportunity tax credit (AOTC) is worth up to $2,500 per student, per year (for a max of four years), for taxpaying students or parents of students. Because the AOTC is a tax credit and not a deduction, you could potentially knock $2,500 off of your tax bill. Or, alternatively, you could even receive a refund if the credit exceeds what you owe. However, the eligibility requirements are fairly strict.
To be eligible for the AOTC, a student must:
- Be pursuing a degree or other recognized education credential
- Be enrolled at least half-time for at least one academic period (semester, trimester, summer session, etc.) beginning in the tax year
- Not have finished the first four years of higher education at the beginning of the tax year
- Not have claimed the AOTC (or the former Hope credit) for more than four tax years
- Not have a felony drug conviction at the end of the tax year
Income and tax filing status requirements also apply to AOTC. In 2022, a single filer’s AOTC credit begins phasing out between $80,000 and $90,000 in income. After making $90,000, borrowers are no longer eligible for the credit.
For those who are married filing jointly, the phase-out begins at a combined modified adjusted gross income of $160,000. Once your MAGI reaches $180,000, the credit is no longer available. Similar to the loan interest deduction, if you’re married filing separately, you can’t take the credit at all.
The forgiveness of the student loans — if related to the Biden executive order — ...could be taxed by the states if they do not follow federal tax rules. — Caitlynn Eldridge, owner of Eldridge CPA LLCClick to Tweet
Lifetime learning credit
The lifetime learning credit (LLC) is for qualified tuition and related education expenses paid for eligible students attending school at a qualified educational institution. The tax credit can be used to pay for undergraduate or graduate degrees, a career school to earn professional certification, or courses taken to learn new job skills or improve upon existing skills.
The LLC is worth up to $2,000 per year, per student, and there is no limit to the number of years that you can take the tax credit. There is also no minimum number of hours a student must be enrolled, as long as it’s at least one class in an academic period.
Filing status and income requirements are the same as they are for the AOTC. The credits start gradually reducing at an income of $80,000 for single filers and $160,000 for spouses filing together. The credits are phased out completely once your MAGI reaches $90,000 for singles and $180,000 for married couples who file jointly.
Unlike the AOTC, if the LLC has a remaining balance — as in, you’ve used the credit to pay your tax bill and there’s still money left over — you don’t receive the rest of the money as a tax refund. Finally, you can’t take advantage of both the AOTC and LLC in the same year. Because of this, you may want to consult with a tax professional to see which credit is most beneficial for your personal finance situation.
| Criteria | AOTC | LLC |
|---|---|---|
| Maximum benefit | Up to $2,500 credit per eligible student | Up to $2,000 credit per return |
| Refundable or nonrefundable | 40% of credit (refundable) | Not refundable |
| Limit on MAGI for married filing jointly | $180,000 | $180,000 |
| Limit on MAGI for single, head of household, or qualifying widow(er) | $90,000 | $90,000 |
| If married can you file a separate return? | No | No |
| Dependent status | Cannot claim benefit if someone else can claim you as a dependent on their return | |
| Can you or your spouse be a nonresident alien? | No, unless nonresident alien is treated as resident alien for tax purposes (see Publication 519 for information on nonresident alien status) | |
| Number of years of post-secondary education available | Only if student hasn't completed 4 years of post-secondary education before 2022 | All years of post-secondary education and for courses to acquire or improve job skills |
| Number of tax years benefit available | 4 tax years per eligible student (includes any years former Hope credit claimed) | Unlimited |
| Type of program required | Student must be pursuing a degree or other recognized education credential | Student does not need to be pursuing a degree or other recognized education credential |
| Number of courses | Student must be enrolled at least half time for at least one academic period beginning in 2022 | Available for one or more courses |
| Felony drug conviction | Students must have no felony drug convictions as of the end of 2022 | Does not apply |
| Qualified expenses | Tuition, required enrollment fees and course materials needed for course of study | Tuition and fees required for enrollment or attendance |
| For whom can you claim the benefit? |
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| Who must pay the qualified expenses? |
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| Payments for academic periods | Made in 2022 for academic periods beginning in 2022 or the first 3 months of 2023 | |
| Do I need to claim the benefit on a schedule or form? | Yes, Schedule 3 of Form 1040 and Form 8863, Education Credits | |
| Source: IRS |
Taxes and education savings accounts
Parents (or other interested parties) saving for children’s future college expenses can benefit from a 529 plan, which is a type of savings and investment account much like a 401(k). The primary difference is that a 529 plan is expressly meant to pay for education.
The tax benefits to a 529 plan are two-fold — the money grows tax-free, and as long as the funds are used for qualified education expenses, withdrawals are not taxed. Qualified education expenses can include tuition and fees and other college costs like room and board or books.
There may also be tax benefits for contributions made to the plan, but state laws vary, so you’ll want to check with your local laws to find out. (If the money is not used for education expenses, the funds are subject to penalty fees and state and federal taxes.)
Difference between tax credits and tax deductions
It can be easy to get the two terms confused, but they actually mean very different things when you’re filing a tax return. A tax deduction reduces your taxable income before calculating how much tax you owe.
A tax credit, on the other hand, gives you a tax break by either reducing your tax bill or increasing your tax refund. A credit can actually make you eligible for a refund even if you don’t owe any taxes that year.
Pro Tip
The ins and out of tax deductions and credits can be tricky to figure out on your own. If you have any questions it might be a smart move to talk to a tax professional or certified financial planner to determine your eligibility for various tax-advantaged programs.
Alternatively, you can also use tax preparation software, which can help you prep your taxes and get you the highest refund possible.
Tax implications for defaulting on a student loan
If you default on a student loan, meaning you fail to repay the loan under the terms of your agreement with the loan servicer, you may be subject to wage garnishment. On the other hand, your tax refund may be reduced or taken by the Treasury Offset Program (TOP).
TOP collects past-due debts from people (such as child support payments or federal student loans) owed to state and federal agencies. The U.S. Department of Education should give you 60 days’ notice before that happens, to give you an opportunity to set up a payment plan or to apply for a hardship program such as a deferment or forbearance.
If at all possible, try not to default on your student loans. Not only will you be subject to possible wage garnishment and loss of tax refunds, but it’s also very bad for your credit report and score. This can make it difficult to get approved for other loans or lines of credit for years to come.
Key Takeaways
- People with qualified student loans can take a tax deduction on interest paid each year through the student loan interest deduction as long as they meet income and tax filing requirements.
- Because of the American Rescue Plan Act of 2021, student loans that are forgiven, canceled, or discharged do not count as taxable income and don’t need to be reported on your federal income tax return through 2025.
- Some states who don’t follow federal tax laws may require student loan borrowers to pay taxes on loans that were forgiven, canceled, or discharged.
- Students, parents, or others who pay for college expenses may be able to get a tax break from either the American opportunity tax credit (AOTC) or the lifetime learning credit (LLC) programs.
- If you default on a student loan, the government may seize your tax refund under the Treasury Offset Program (TOP).
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