Student Loan Interest and Taxes
The federal government recognizes the financial burden that higher education and related student loans can place on borrowers. To address this, the IRS offers certain tax benefits to those who are in the middle of student loan repayment, which you can include in your tax preparations for clients.
Anyone who has used student loan funds to finance their education is allowed to deduct eligible interest from your income tax each year that you made on qualifying loan payments. Therefore, it’s essential to ask your clients about any student loan and interest payments they have made as you prepare their tax returns.
Due to COVID-19 and the ensuing impact on the job market and income prospects for millions of borrowers, U.S. lawmakers implemented an automatic forbearance for student loan borrowers. This will impact tax preparation for those borrowers who had qualifying loans throughout the pandemic.
In 2020, Congress passed new legislation enabling student loan borrowers to temporarily pause all student loan payments, and any accrual of interest on those loan balances. This loan forbearance period provided relief to borrowers for the following loan types:
- Federal Direct Loans
- FFEL Loans not owned by the Department of Education
- FFEL loans in default, but not owned by the Department of Education
- Defaulted HEAL Loans
The relief on interest charges is currently set to end on January 31, 2022, so borrowers should prepare to resume payments beginning February 1, 2022.
Who’s eligible for student loan interest tax deductions?
In order for you to apply tax deductions on student loan interest, your client must fulfill several requirements. First, they must have paid interest on qualified student loans during the specific tax year, and that student loan interest must have been a legal obligation for them to pay.
Their tax filing status can’t be “married, filing separately” for the student loan interest deduction. Additionally, the client’s modified adjusted gross income (MAGI) can’t exceed a preset limit, which is set each year.
For the tax year 2020, the maximum adjusted gross income to receive any tax deduction for student loan interest is $85,000 for single filers. For married couples, filing jointly, the maximum income limit is $170,000. The tax credit phases out gradually between $70,000 and $85,000 for single filers. For those who are married, filing jointly, the tax credit phases out between $140,000 and $170,000.
You won’t be able to deduct student loan interest on behalf of a client if someone else can claim them on their tax returns. They are also ineligible for the student loan interest deduction if anyone else claims the client’s spouse, in the case of couples who are married and file jointly.
Other requirements for eligibility: the student loan itself must have been used to pay for qualified educational expenses including tuition, mandatory fees, textbooks, and equipment.
Who isn’t eligible for deductions of student loan interest payments?
If you’re preparing a client’s tax returns and they don’t meet the requirements set forth by the IRS, they cannot claim the taxable income deduction from student loan interest payments.
The following types of borrowers are ineligible to claim a student loan tax deduction:
- Those who didn’t attend a qualified educational institution with student loan funds.
- Private student loan borrowers.
- Borrowers who took out loans that weren’t for themselves, a spouse, or their dependent.
- Borrowers who are dependent on someone else’s tax returns.
- Those who aren’t legally obligated to pay student loan interest.
- Tax filers whose status is “married, filing separately”.
- A parent of a student, when the student is the legally obligated borrower.
- Those whose adjusted gross income is $85,000 or more (single) or $170,000 or more (filing jointly).
How much is the deduction for student loan interest?
Even if your client paid a massive amount in interest alone on their student loans (which is unlikely during the pandemic pause on student loan payments and interest), the entire amount isn’t necessarily deductible from income taxes.
According to the IRS, the amount borrowers are allowed to deduct from their taxable income is either $2,500 or the exact actual amount they paid during that particular year, whichever figure is less.
For example, if the client paid a total of $1,800 in student loan interest throughout the year, the maximum deduction to be claimed as an adjustment in income would be $1,800. However, if the total interest paid was $3,200, since that’s above $2,500, only the maximum of $2,500 is deductible.
It is also worth noting that if a taxpayer’s employer pays a portion of the employee’s student loan, the interest on the amount of debt paid by the employer is not deductible by the taxpayer/borrower (IRC §127(c)(7).
Forms to complete to claim the student loan interest deduction
For someone who does qualify for the student loan interest tax deduction, they don’t have to itemize deductions. Instead, the deduction works as an adjustment to income and is entered on Form 1040, Schedule 1.
To report any student loan interest payments on tax returns, the client will need Form 1098-E. This form should be automatically supplied to the borrower by the loan servicer as long as the client paid a minimum of at least $600 in student loan interest during the previous year.
Form 1098-E provides the exact amount the client paid in interest on applicable student loans. If the borrower paid less than $600 overall, which is certainly possible due to the coronavirus forbearance, then they can contact the loan servicing company to get the correct interest amount.
Tax credits for students
In addition to deductions for student loan interest payments, some of your clients might still be in school programs and therefore could benefit from educational tax credits.
The following two tax credits aren’t related to student loans, but they offer similar tax benefits to students enrolled in qualified higher education institutions. A client who wants to take either the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Credit (LLC) will need to complete Form 8863 for the IRS.
As you already know, these are tax credits rather than tax deductions. The tax deduction based on student loan interest reduces the number of income clients pay taxes on. The AOTC and LLC are tax credits, which means they directly reduce the person’s tax bill itself.
The American Opportunity Tax Credit
The American Opportunity Tax Credit offers a maximum of $2,500 annually for students in their first four years of higher education. Tuition payments, as well as schoolbooks and supplies, are costs that qualify for the AOTC.
The first $2,000 a student spends on these qualified costs provides a $2,000 tax credit, and of the next $2,000 spent on qualified educational expenses, you can receive a 25% tax credit, or $500.
The Lifetime Learning Credit
A Lifetime Learning Credit may be a benefit for older students who have already completed the initial four years of post-secondary schooling. Twenty percent of tuition and payments of up to $10,000 is available as a tax credit for students. That’s a maximum tax credit of $2,000 for qualifying students.
Your client might be eligible for both the AOTC and the LLC credits in the same year, but they can only claim one credit per filing.
Since student loan forbearance, along with the pause on interest accrual, is slated to expire on January 31, 2022, borrowers should be prepared to start making payments on both the principal and interest in February 2022. A free student loan calculator can help them plan for calculating payoff timelines once the federal forbearance ends.
Once loan payments resume for all federal borrowers, you can expect to return to calculating student loan interest deductions for clients as usual.
By Travis Hornsby
“Coronavirus Info For Students, Borrowers, and Parents.” Studentaid.gov.
“Publication 970 (2020), Tax Benefits for Education,” IRS.gov.
“Topic No. 456 Student Loan Interest Deduction,” IRS.gov.
About the Author:
Travis Hornsby, CFA, is the Founder and CEO of Student Loan Planner. He lives with his wife and baby daughter in Chapel Hill, NC, where he loves thinking up new student loan repayment strategies, kayaking, fishing, and hiking. As one of the nation’s leading student loan experts, he has consulted on close to $700 million of student debt personally.