Each December, people get themselves into a tizzy, making some last minute moves to reduce their upcoming tax bill or increase their refund. This little game is called “tax avoidance” and it is the legal, wholesome brother of “tax evasion.” (Avoidance good! Evasion bad!)
But those of us that are young and bright-eyed don’t have a lot we can do in the name of tax avoidance. There’s the time-honored idea of throwing money at our favorite charity, which I definitely recommend. But if you’ve got student loans, 
they provide you another opportunity to (legally) hack your tax bill.
(Apologies to my readers outside the United States – this article’s probably not for you.)
Why It’s Legal
Before I get started, there’s always someone who jumps at the idea of tax avoidance and claiming deductions on tax returns. Taxes can be tricky business, and some people avoid claiming anything at all, just to make doubly-sure that they’re on the up-and-up.
Don’t be that guy. Tax avoidance is legal, or there wouldn’t be a section for deductions on your tax forms. It’s all about incentives – there are certain actions that the government wants us to take (such as buying houses, paying off student loans, and giving to charity), so the government puts a little cash-back program into the tax system to reward us. Hurray!
It would seem that Uncle Sam wants us to go to school, even if we can’t quite afford it, so there’s a deduction for student loan interest built into the taxes. You don’t even have to do that crazy “itemizing” thing to take advantage of it.
What’s a deduction? Tax deductions and tax credits are easy to mix up. It goes like this: a deduction reduces the amount of income that counts for tax purposes. A tax credit actually takes money straight out of your tax bill (or adds it directly to your refund). Credits are much more rare than deductions, so it’s no surprise that this is a deduction, not a credit.
Student Loan Interest
Some things to pay attention to when trying to harvest your student loan interest tax deduction:
Interest, Interest, Interest! Be careful! This is a tax deduction on interest paid off only, not principal. If your loans aren’t in repayment yet, and you don’t have any loans that build up interest while you’re in school (unsubsidized loans), you don’t have any interest to pay off!
If your loans aren’t in repayment yet, check to make sure you actually have interest before you make payments toward it.
Who gets it? Oh, hey, are you still being claimed as a dependent on someone else’s taxes? Sorry, you don’t get to claim the deduction, the person claiming you does. Apparently the government assumes that if you’re a dependent, you’re not paying your own student loan interest yet. If you want to use this to your advantage, you can try asking your parents/whoever to pay something toward your student loans in order to get the deduction. It’s worth asking! – [Update: According to IRS.gov, it looks like if you are a dependent, no one gets to claim the deduction. I was wrong about this piece of information originally.]
What year to do it in? This relates to the last bit, for some people. If you’re in your senior year, you might be claimed as a dependent this year, and not next year. So it may be to your advantage to wait to do it.
Limits. The amount you can deduct will be reduced if you make too much money. From the IRS website:
For 2008, the amount of the student loan interest deduction is phased out (gradually reduced) if your filing status is married filing jointly and your modified adjusted gross income (MAGI) is between $115,000 and $145,000. You cannot take the deduction if your MAGI is $145,000 or more.
For all other filing statuses, your student loan interest deduction is phased out if MAGI is between $55,000 and $70,000. You cannot take a deduction if your MAGI is $70,000 or more.
Also, you can only deduct up to $2,500, even if you pay more interest than that. Thanks to reader Angie for the info on limits!
Tax Avoidance In Action!
If this has been at all confusing, or if you just like to see how this stuff actually works, here’s how I did it:
I have a combination of subsidized and unsubsidized federal student loans, so some of my loans have been building up interest while I’ve been in school. There are some complications because of the fact that I dropped out of school and went back nine months later, but what it basically boils down to is that we’re only dealing with the interest that’s accumulated since the time I went back to school, in September of 2007.
Because I’m a senior, I’ll be a dependent on my mom’s 2008 taxes, and I’ll likely be independent when it comes to 2009 taxes. I’ve been building up money to pay off my accumulated student loan interest, so the only question was:
Pay it now, and give my mom the tax deduction [not possible, only I didn’t know it at the time this was written], or wait until January 1st and save the tax deduction for myself?
After some debating and asking people what they think, I decided to make the payment last week, and give the deduction to my mom. Here’s why [the reasons why I did it based on the information I had, which would make sense if I were right]:
- She has more income, so the deduction will probably have more impact for her.
- I’ll have the opportunity to pay lots (and lots) of student loan interest for many years to come, and get the deduction for myself. This is the last year I could possibly give it to her.
- I’m a wonderful, sweet daughter. And I’m counting this as part of her Christmas present.
- I got itchy fingers and couldn’t wait to pay off that damn money any longer!
So, I sent $1,323.69 to my student loans – all the money I had saved up. $1,157.88 of it paid off all my accumulated interest, and the rest of it went toward the principal. That last bit didn’t give my mom any tax advantage – I just wanted to pay down my principal a bit before graduation.
Depending on my mom’s tax bracket, this will save her between $165 and $275 on her taxes [Again, not true, but I acted with the information I had at the time.]. Nice Christmas present, don’t you think?
I wish I could claim this, you’ve forgot to mention the limit on income (55k-65k single, 110k married). I’ve probably paid well over 3,000 on interest on my student loans this year alone but make “too much money” to deduct it.
You’ve also forgot to mention that the deduction is limited to $2,400 in interest. So anything you’ve paid above that amount isn’t tax free.
In order to get this on private loans call your provider to make sure you have a 1098? Form. Or else you can’t deduct them. YOU MUST DO THIS BEFORE JANUARY.
My fiance didn’t have this form last year and missed out on $600 back from his taxes.
@Angie: Thanks for taking the time to point those out! I knew about those things in the back of mind, but they didn’t surface while I was writing since they didn’t come into play in my personal situation. I’m going to add them to the post.
About the 1098, that seems like it would be a concern more if you have private student loans. (Which, of course, a lot of people do!) Also, I’m not sure why you would have to do this before January, since most places don’t send out things like 1098s until around January 30th? Also, I would advise people to check the website, if they have any kind of online service for their loans. I know I can actually download a PDF of one of my 1098s!
I’m sorry I was too lazy at first to look up the form #. I meant you need to send your private loan company IRS form W9S. To show the loan is qualified for the deduction. Its basically registering for them to send you a 1098. The W9S is what needs to be done before year end.
Off Citibank website:
“Private Loans do not automatically qualify. However, if the borrower provides a completed W-9S form, the interest paid on their Private Loans could then qualify for the deduction. A W-9S is an IRS form that serves as the borrower’s certification that the funds were used solely for education expenses. It can be found at http://www.irs.gov.”
Ok, so I’ve never understood what the point of being all concerned about tax avoidance is. You spend $X on something and get $Y (usually less than $X) back on your taxes. Is it just me or are you spending money to get an equal or lesser amount back?
@Slinky: Well, not really. For most things involved with tax avoidance, it’s not about spending X to get Y back, it’s more like “I have to spend X, and which year I do it in determines when I get Y back.” Look at my example from the post – it was never a question of “should I pay this interest off, or not?” it was simply a question of when. It’s the same things as making an extra mortgage payment in December to get a little extra back on your taxes (mortgage interest is also tax deductible).
About the only thing this isn’t true for is charity – although for a lot of people, they were going to give the money to the charity, they’re just deciding whether to do it in December or wait until next year. (A note on that – if you want to really help a charity, give in March. That’s when all the money they were donated over the holidays usually begins to dry up, and they need more donations.)
I see. So in the end….it doesn’t really matter. It’s just helpful if you need the extra cash back, or want to spread out owing the government money over a few years. I still think people spend way too much time and energy thinking about it. 🙂
Even though I come from Germany, I think their report is very interesting.
I get very serious about reducing ,my taxes every year. It is the easiest way to make money. Just keep more of what you make and you have given yourself a 3 to 6 percent raise !!
Nice article. I think they should have higher limits on the phase out. To start phasing it out at 55k really isnt all that much money.
-Dale
What it boils down to is whether money comes into your pocket or you find yourself paying out to the government. I don’t know about you but I don’t mind doing a little research to help me save/receive a decent amount of money. Due to the fact that I am a student I always get back some money when I file my taxes.
That is great news for the students! Always thought tax evasion was illegal; but is that really liked by the government? Does the Government support such tax evasion techniques?
@Fence: Remember it’s not tax evasion (that’s when you just don’t pay, or you lie on your return).
This is tax avoidance, which is actually designed by the government. It’s very important to know the difference! A good rule of thumb: never, ever lie on your taxes, and make sure you follow the directions as carefully as possible. If you have any trouble or questions, consult a tax professional.
I followed a link over from a more recent post on your student loans. I am not sure your parents can take the deduction for you. I actually thought that you couldn’t take it until loans were in repayment, but that doesn’t seem to be the case anymore.
Anyway…
“Example 2.
During 2008, Jo paid $1,100 interest on her qualified student loan. Only she is legally obligated to make the payments. Jo’s parents claimed an exemption for her on their 2008 tax return. In this case, neither Jo nor her parents may deduct the student loan interest Jo paid in 2008. ”
from irs: http://www.irs.gov/publications/p970/ch04.html#en_US_publink100020876
@SP – Interesting. We’ll have to see how it plays out when taxes are filed next month – then I’ll know for sure how it works.
I am still a little confused about claiming my student loan interest. I went to the irs website to find out more about pub 970 when I got form 1098-E from my lender but I was wondering, do I still have to be a student or would I have to have been one during the 2008 tax year to claim this deduction?
@Sara – no, you do not need to have been a student in 2008 to claim this deduction, as long as you meet all of the other requirements. Good luck!
I am a junior and have taken out a $10,000 private student loan and a $3,900 subsidized Stafford loan. All interest is deferred until after graduation. I have never filed before because my actual earned income has never been over $2,500. I don’t know if I have to file or if I could get some money if I did. I’ve been on the IRS web page but can’t find an answer. Any input on the subject would be greatly appreciated.
@Joy – check out this post I just wrote about doing your taxes while in college: https://poorerthanyou.com/2009/01/23/college-money-tip-6-do-your-own-taxes/
As I said in that post, you can do your taxes with any of the three major companies, and you don’t have to pay until you actually file. So you can put in all of your information and see whether it will actually result in you getting a refund or not – for free. Good luck!
CONFUSED!!! So here it is all I want to know is if its worth it to me to do this deduction I am not so good with all this tax crap?? So if i made around 27,000 and paid 650.00 in student loan interest is it worth it for me to file this. I think its going to take me actually paying someone to do my taxes in order to get it becuase I am seroiusly confused on trying to figure it out HELP!!! if anyone knows how much I “might” save?? Thanks
Shannon – using just the numbers you gave me, and knowing nothing else about your situation, here’s what it looks like:
If you made around $27,000 in 2008, that money is taxed in the 15% tax bracket. Which means if you claim the student loan interest, you will get back about 15% of what you paid, or $650 x .15, which equals $97.50. It is fairly easy to claim this – all you need is the tax form from your student loan.
so I’m confused….if my unsubsidized loans are gaining interest while they are in deferrment, can I still claim the student interest tax credit since I have to pay that interest back ($3,276.10) eventhough I haven’t paid anything yet??
@John – No, sorry. The tax deduction is for interest paid, not interest that’s accrued. You’ll get to claim it when you make payments – so either pay the interest while it’s in deferment (a good idea, since it will keep the interest from capitalizing), or just wait until you start making payments. However, as far as I understand it, you may not get a tax break for paying that interest once it capitalizes, so if you wait until the loan goes into repayment, you’ll only get the tax break on new interest.
Actually, the way it is worded it seems that capitalized interest does not count. But my forms received from my loan companies has infact added the capitalized interest as “interest paid”. In short, I wouldn’t count it if its not on the form at the end of the year. But I would expect it to be there. As with my experience 3 different loan companies have all included it.
Let me clear that up, once you PAY the interest that was capitalized it counts. Not accrued interest that hasn’t been paid.
Thanks Stehpanie very helpful. Im just having trouble getting the math and the right lines on my tax form. I need to do a 1040A right?? Also I have heard that you only get to claim this deduction for 5 years, is that correct if so perhaps its more of an advantage to claim it when you have been paying for a full year and not half a year like i was?? Any thoughts on that. Thanks again for being so helpful.
@Shannon – According to the literature, you can use either the 1040A or the 1040 form, and claim this deduction – use whichever works for you based on your other circumstances. I don’t see anything at all in the literature about a limit on how many years you can claim this deduction.
Source: http://www.irs.gov/publications/p970/ch04.html
Steph,
I was looking into the student loan deduction worksheet and that is a bit confusing. It pretty much comes up with the original amount? Or am I doing it wrong? We tried to run numbers tonight and it looked like I was getting all of the Federal taxes I paid in back, which I know isn’t right. If anyone has some advice, please let me know.
Thanks..
@Shannon – I really don’t know. I do all of my taxes using TurboTax or another online service – I have never done them by hand. If you’re having difficulty, you may want to see a tax professional, or try calling the IRS hotline.
If you aren’t itemizing your deductions. Which is a pure guess assuming you seem confused about this whole tax thing. I suggest using the free efile of TurboTax or similar. It figures it out for you.
so stupid question where do you get the free efile or Turbotax I see them at like costco but they are quit spendy.. Your so right I think I am beyond my means with understanding my deducation at this point LOL!! Thanks for all the insight though I need to get some seroius help lol..
@Shannon: my other article, detailing how college students should do their taxes, has links for the free or discounted online versions of TurboTax, TaxCut, and TaxAct: https://poorerthanyou.com/2009/01/23/college-money-tip-6-do-your-own-taxes/
First off, I really find the picture of a man who seemed to faint because of his student loan or maybe he fainted because of tax evasion quite funny. Second off, it is not really funny as it is happening. The interest in student loans are really incredible and may somehow take you the rest of your life to pay it off.
Funny About Money – My understanding is the gov’t will subsidize but it could be more of a reimbursement for employers too. Not sure though.
Stephanie
I am doing my daughter’s boyfriends taxes and he has an adjusted gross income of about 7200. He had 204 federal income tax withheld and is getting the 400 credit. His refund is 604, however he also paid 640 in student loan interest in 2009 but turbo tax software isn’t giving him any credit for it. Can you help explain why?
Thanks
Hi Kim,
The reason, from what I can understand based on what you’ve told me, that he is not getting anything for it is that he’s already getting all of the tax he paid back, and then some. Student loan interest is a deduction, not a credit, so it reduces your taxable income. If he’s getting back all of the $204 that he paid, his taxable income is already at $0, which means it cannot be reduced any further by deductions.
I was thinking it was something like that, but couldnlt really tell in the pub explaining student loan interest.
Thank you very much!
Okay I’m asking a while after this post was made, but I have been trying to find this kind of info for a while! My question is about the legal obligation to pay the interest. The loans I have are in my name so it’s me (versus a relative etc) that is responsible for their payment. However, my loans are in deferment since I entered grad school right after graduating. So does my loans being in deferment mean I’m not technically obligated to pay it at this time and therefore am not eligible for the deduction, or does it just refer to the person who’s legally bound to pay off the loans?
Johnny,
I’m not 100% sure I understand your question, but I’m going to take a crack at answering it anyway. Let me know if I’ve got your question right, here: you want to know if you can claim the deduction for interest paid this year, even though you’re not obligated to make any payments because your loans are in deferment, right? (Let me know if I’m correct!)
The answer to that is, yes. If you pay off some (or all!) of the accrued interest on your student loans, you can claim the deduction for the amount of interest paid on your 2012 taxes. The only reason you wouldn’t be able to claim that is if (as in the example of my original post) you are being claimed as a dependent on someone else’s 2012 taxes. Then no one gets to claim the deduction.