There are several ways your student loans can help you save money on your federal income tax return. A few of these student loan tax breaks have changed recently, some due to pandemic relief legislation, so a fresh review is in order.
Current tax breaks include the following:
- Student loan interest deduction
- Tax-free student loan forgiveness
- Tax-free employer-paid student loan repayment
- Qualified distributions from 529 plans to repay
Student Loan Interest Deduction
The student loan interest deduction provides an above-the-line exclusion from income for up to $2,500 in interest paid on federal and private student loans. This tax deduction can save you a few hundred dollars on your federal income tax return.
But, the word “paid” is the key to getting this tax break.
If you qualified for the student loan payment pause and interest waiver on your federal student loans, you cannot qualify for the student loan interest deduction on those loans because you didn’t pay any interest on those loans during the payment pause.
Even if you opted to continue making payments on your eligible loans, your payments would have been applied entirely to the principal balance of the loan, since no new interest was accruing.
You might nevertheless be able to claim this tax break on some student loan interest:
- You may have paid 2-3 months of interest prior to the start of the payment pause and interest waiver in March 2020
- You may have paid interest on private student loans and commercially-held FFELP loans that were not eligible for the payment pause and interest waiver
So, your student loan interest deduction for 2020 (and 2021) may be lower than in previous years. But, not having to pay any interest yields greater savings than being able to deduct the interest on your taxes.
For 2020, the student loan interest deduction is phased out for modified adjusted gross incomes between $70,000 and $85,000 ($140,00 and $170,000 if filing jointly).
Tax-Free Student Loan Forgiveness
Some types of student loan forgiveness is tax-free. This includes loan forgiveness for working in particular occupations, such as Teacher Loan Forgiveness and Public Service Loan Forgiveness.
Student loan discharges may also be tax-free. This includes closed school discharges, false certification discharges, unpaid refund discharges and defense to repayment discharges.
The Tax Cuts and Jobs Act of 2017 made death and disability discharges of student loans tax-free, but only through the end of 2025. It is likely that this benefit will be extended after 2025, maybe even permanently.
The forgiveness of federal student loans after 20 or 25 years in an income-driven repayment plan is taxable under current law. The IRS treats the cancelation of debt like income to the borrower, who will receive a 1099-C. However, a borrower who is in an income-driven repayment plan for two decades is probably insolvent, with total debt exceeding total assets. Student loan borrowers who are insolvent can file IRS Form 982 to forgive the tax debt that results from the cancellation of student loan debt. Read IRS Publication 4681 for more information.
During the COVID-19 pandemic, a payment pause and interest waiver suspended the repayment obligation on federal education loans held by the U.S. Department of Education. The suspended payments are treated as though they were made for the purpose of federal student loan forgiveness and loan rehabilitation programs. In a way, this provides borrowers who are pursuing public service loan forgiveness with partial loan forgiveness, since the suspended payments effectively increase the amount of forgiveness the borrower will eventually receive.
Everybody is wondering whether President Joe Biden will forgive some or all student loans, and whether this loan forgiveness will be tax-free. President Biden has reaffirmed his campaign promise to forgive up to $10,000 in student loans, but will ask Congress to pass legislation to implement his proposal. He used executive action to extend the payment pause and interest waiver, but questioned whether the executive branch has the legal authority to forgive student loans. No details have been provided as of yet, including whether this loan forgiveness will be tax-free or not.
President Biden has also proposed a new version of income-driven repayment which will provide tax-free student loan forgiveness of the remaining balance after 20 years of payments.
Tax-Free Employer-Paid Student Loan Repayment Assistance Programs
The CARES Act made employer-paid student loan repayment assistance programs, or LRAPs, temporarily tax-free in 2020. Subsequent legislation extended the tax-free status through the end of 2025.
Up to $5,250 in employer-paid educational assistance, including tuition and LRAPs, is tax-free.
Ask your employer to consider offering an LRAP if they don’t already. Not only do LRAPs provide a great recruiting and retention incentive for employees, but they also provide the employer with some tax savings, not just the employee.
Using a 529 Plan to Repay Student Loans
The Setting Every Community Up for Retirement Enhancement Act, or SECURE Act, expanded 529 college savings plans by allowing up to $10,000 per borrower in tax-free student loan repayment as a qualified expense.
This benefit is available to the 529 plan’s beneficiary and the beneficiary’s siblings. With a change in beneficiary, parents can also benefit from this student loan tax break.
The $10,000 cap is a lifetime limit per borrower.
Note that not every state conforms with federal law. So, some states will treat student loan repayment as a non-qualified distribution for state income tax purposes even though it is tax free for federal income tax purposes. In these states, the income portion of a non-qualified distribution is subject to ordinary state income taxes, plus possible recapture of state income tax credits or tax deductions attributable to the distribution.
The SECURE Act became law on December 20, 2019. Although the legislation was retroactive for all of 2019, most borrowers who use qualified distributions from 529 plans to repay student loans will do so in 2020 or a subsequent year.