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?

Oh man, the IRS is getting creative these days! They’ve noticed that MMORPGs (Massively Multi-player Online Role Playing Games) have extremely intricate monetary systems, and they’re thinking of taxing those systems. Um… what?

I can somewhat understand the move to tax Linden dollars, the currency in the game Second Life, which is the main topic of the CNN Money article. Linden dollars actually have a conversion into cold, hard, American currency. But what bothers me is the mention of taxing the money in World of Warcraft. The logic being that because there’s an exchange of goods, there should be a tax (just as you can tax bartering in the real world). From the article:

Tax law is murky, however, when it comes to dealings that occur solely within Second Life or other computer-simulated environments. For instance, is a transaction that occurs only in Linden dollars and doesn’t involve any real-world, dollar exchange taxable?

and

But there is a valid argument that even profits that come from, and stay in, the virtual world are taxable, according to Bryan Camp, a professor at Texas Tech University School of Law. “As soon as you start looking at what’s going on in these worlds, they look a lot like real economic transactions,” he said.

Even if profit isn’t realized in real dollars, there’s still an exchange of items of economic value. In the real world, if someone trades goods or services without the exchange of real money – also known as bartering – that’s a taxable event, Camp noted.

Now, I’ve never played World of Warcraft (although many people have tried to convince me!), but I have played Everquest and Guild Wars (oh man, my geek is showing!), so I feel qualified enough to comment on this.

Basically, it’s a giant crock. Sure, you’re exchanging goods and services… in the game. And yeah, some people do sell game money on eBay. But you have to, have to, have to remember that it’s still a game. Unless the IRS is prepared to tax my Monopoly winnings, they should really stay out of this.

That is, of course, unless they’re going to allow you to pay your entire tax bill in game money. After all, if they’re taxing you for both your day job income and your game income, you should be able to pay your taxes entirely in either currency.

And I’m really not that opposed to paying my taxes entirely in Guild Wars gold. You know, provided I can still get my refund checks in gold ole American dollars! ;o)

I guess I can lightly glow with some amount of pride- I just finished my 2006 tax returns.

I would have liked to do my taxes for free, and I probably could have, by e-filing my federal return, and then doing my state returns by hand and mailing them in. But I was a tad worried about doing my state taxes right, because I worked in two states during 2006. Also, I’m lazy. So I paid for the whole she-bang.

Last year with TurboTax*, my taxes (one federal and one state) cost me $48.05 to e-file. Did I manage to do any better this year? Yes, yes, I did. The big thing this year is “free federal filing!” but then everybody catches you by making you pay for your state returns. Fooey! Like I said, I didn’t actually manage to work around this – I just shelled out my money and grimaced.

On a tip from Flexo, I checked out TaxACT. I was drawn in by their Online Deluxe + State deal for $15.95. What I really liked about this was that it offered to give me a nice worksheet to use when I fill out my financial aid paperwork. I didn’t bother to look at how much it would cost me for the second state’s return, which ended up being $12.95.

So…

I Could Have:
Used TaxACT’s Standard edition and done my federal return for free.
Paid $12.95 for each state return.
For a total of: $25.90

But Instead, I:
Used TaxACT’s Deluxe + State edition for federal and one state: $15.95
Paid $12.95 to file the other state’s return.
For a total of $28.90

So was the financial aid worksheet worth the extra $3? In hindsight, no, not really. It won’t save me more than a few minutes on my paperwork, especially considering my mother likely won’t use TaxACT, so I won’t get a nice worksheet like it for her half of the paperwork.

The good news? I’m done with my taxes, and it cost me over $20 less than last year. I call that a win!

*Affiliate link. Because I can.