Chasing a Student Loan Tax Deduction isn’t Worth it
We have written quite a few articles and posts about student loan repayment, covering everything from the best way to pay off student loans to the repayment and forgiveness programs that are available to those facing a hardship or dealing with limited income. And believe it or not, one of the most common questions and debates that has come up time and time again in the blog comments is whether the student loan interest tax deduction should play a role in the repayment strategy. While we are hesitant to give a blanket answer that covers all situations, the short answer is “no.” Let’s take a closer look.
How the Student Loan Interest Deduction Works
You probably know this already, but a tax deduction allows you to subtract an amount from your “taxable income.” So, if you have $1000 to deduct and you make $30,000, then your taxable income will be reduced to $29,000. It’s fairly simple.
The student loan interest you pay over the course of a year is reported to you by each student loan servicer who handles one of your accounts. They report this on Form 1098-E and either mail it to you or post it to your online account. When you do your taxes, you will add up the totals and subtract them from your taxable income.
Why the Deduction should not affect your Repayment Strategy
Like we said, we don’t want to give a blanket answer, but in most cases if you go out of your way to claim a larger tax deduction, you might be sacrificing efficiency. In other words, this approach might lead to a longer payoff time for your loans and a more expensive total repayment. You see, doing it this way will force you to deviate from the best way to pay off student loans. If it’s going to cost you more time and more money—it probably isn’t worth it.
Let’s explain why this is true in theoretical terms, and then will take a look at a concrete example (math included).
We have established that the best way to pay off student loans is to pay off the account with the highest interest rate first. By doing this, you limit how much the loans will grow, and this leads to a cheaper and faster total payoff. If you have loans with the same interest rate, you pay off the smallest one first because there is no mathematical difference and you can close individual accounts more quickly. This can boost your credit and create stability.
Chasing tax deductions will throw a kink into this system even though it looks like it can save more money on the surface. We have noticed that the idea of saving on interest sometimes isn’t tangible to consumers. They don’t always wrap their heads around it and don’t really feel like they are getting ahead.
Another reason why chasing the tax break is a bad idea might sound like common sense: You will get the deduction at some point. Think about it, if you have $500 in interest that has accrued on a low-interest loan, but you also have a high-interest loan with limited interest accrued, we want you to still focus on the high-interest account. You will get that $500 tax deduction at some point. Maybe it will be next tax year, or maybe it will be gradually from year to year as you pay down that loan each month. The deduction will still come to you over time, so it shouldn’t be your top priority now.
Ok, as promised, here is some math. In our example, we are going to assume that you make $30,000 per year and that you have two loans, Loan A and Loan B. Here is some information about each loan:
|Loan A||Loan B|
Now, we are going to assume that you have $1,000 extra to put toward your loans. In this situation, you have to decide whether to put the extra money toward Loan A, like our efficient method calls for, or to Loan B in order to get the tax deduction.
Here are the results if you pay to Loan A:
|Pay $1,000 to Loan A|
|Loan A Total||$4,050|
|Loan B Total||$6,000|
|Tax Due (15%)||$4,493|
Here are the results if you pay to Loan B:
|Pay $1,000 to Loan B|
|Loan A Total||$5,050|
|Loan B Total||$5,000|
|Tax Due (15%)||$4,350|
As you can see, putting your extra money toward Loan B leads to more initial savings. When you pay Loan B, you save $150 on taxes, but paying Loan A only saves $7. That’s a difference of $143, so paying Loan B provides a short-term savings of $143 over paying Loan A.
But believe it or not, this doesn’t tell the whole story. We need to not only look at the short-term but also the long-term consequences of this decision. By paying the low-interest loan now, we have sacrificed some interest savings we could have achieved by putting our extra to Loan A. Let’s take a look at how this decision will play out over the rest of your repayment.
Let’s take a look at how different scenarios affect the total interest you will pay over time. In the two tables below, the row for “Standard Plan” shows how much interest you will pay in a 10-year plan when you pay only the minimum monthly payments. “Pay $1,000 Now” will show how much interest you will pay over the life of the loan if you apply the extra $1,000 now.
Here are the scenarios for Loan A:
|Loan A Scenarios|
|Total Interest Paid over Life of Loan||$2,302.48|
|Pay $1,000 Now|
|Total Interest Paid over Life of Loan||$1,846.37|
Here are the scenarios for Loan B:
|Loan B Scenarios|
|Total Interest Paid over Life of Loan||$1,289.57|
|Pay $1,000 Now|
|Total Interest Paid over Life of Loan||$1,074.78|
Once we have all of this information, we see a much different perspective. When we just looked at the short-term effects of trying to get the tax deduction, it looked like a great decision. But when we see the long-term results, it’s clear that there is a better option. Here’s why.
If you pay $1,000 now to Loan A, the total interest you will pay during your repayment is $3,135.94. We calculated this by adding the totals from the “Pay $1,000 Now” scenario for Loan A to the “Standard Plan” scenario for Loan B. On the other hand, if you pay $1,000 now to Loan B, the total interest you will pay during your repayment is $3,377.26.
So once we look at it this way, we can see that putting the $1,000 to Loan A is the way to go. By subtracting $3,135.94 from $3,377.26, we see that this approach will save $241.32, which is an additional $98.32 in savings from the tax savings you get by paying Loan B. But there is also an added bonus. You will still be able to deduct that $1,000 worth of outstanding interest from Loan B. You will do this over the years as you pay down that account and it will lead to even more savings with this method.
Stick to your Strategy
The long story short is this: don’t alter an efficient student loan repayment strategy just to pursue a tax deduction. You will get to deduct the interest at some point anyway, and you’re better off saving on your total interest costs, which will climb more quickly if you don’t focus on your high-interest account.
We hope this helps, and feel free to reach out to us for a student loan counseling session to address your other student loan needs.
I have an income based repayment plan and as of now my payment is zero because I was unemployed last year. I know I am still being charged interest but I have made payments yet. Can I still deduct this interest on my taxes? Thanks
Hi Joe! Usually, yes, but you should check with your accountant based on your unique situation.
Why did I get 1098-E forms from Dept of Education for loan interest when I didn’t even make any payments on any of my loans? The loans changed servicer and payment plan changed, but I haven’t paid anything yet so how can I be entitled to interest deductions?
Very good article, but the title could be improved in my opinion. It does not convey the take-home message or thorough consideration of the article itself, and I was initially skeptical b/c of the title. It was helpful though — just constructive criticism.
Thanks Jimmy! Sorry the title didn’t resonate for you. Any recommendations for an alternative?
This article confirms what I was already thinking and gives me confidence. Thank you for writing it.
Great! Glad it was helpful and thank you for the feedback!
Hi all! If this has been addressed already, I apologize. If not I appreciate any feed back. My situation is a little different in that my student loan is a Parent Plus Loan. At about 50k I am taking a rather aggressive approach and am paying 2-3 times my minimum pymt each month. I have am also enrolled in an auto minimum pymt withdrawal which gives me a .25% break on my .. wait for it.. 8.5% interest rate!!!
Luckily my current lifestyle has allowed me to take this approach (with great discipline folks!), so I am doing what I can. With this being a PPL I am not awarded any forgiveness nor can I move this from my mothers name to mine. I continue to pay under her name and it has been discouragingly difficult at times!
When tax time comes around I was really looking forward to a return in all the interest I have paid over this last year. I intended on putting most of my return right back into the loan. Wiping out another chunk.
My question is.. is this not a good idea? My savings is not anything to be proud of.. but I can not see committing to much else while I have this lingering debt weighing over my head.
Appreciate any thoughts! Thanks all!
That’s a great question and will certainly depend on your goals and strategies you are comfortable with. Paying off debt, especially at that interest rate is a very good idea. Saving for retirement is also important, but the interest rate very well may be the deciding factor (many people prefer to pay loans slowly if the loans are at a lower rate than expected market returns, but that is less likely in your case). Also, does your employer offer a retirement plan with a match? If so, you could contribute just up to the match and then put the extra toward debt.
And as for emergency savings, we recommend that people have six months of living expenses set aside, so you should work toward that too. You will be much better off if something unexpected happens than if you had put all of that to the loans instead.
Best of luck to you!
i am thinking about doing and income driven repayment plan. My loan balance is 30,000. Is it true that after 25years my balance will be forgiven? How will my taxes be effected each year????
The taxes likely won’t be a concern year in and year out. you will be able to deduct interest, like usual. The issue comes at the time debt is forgiven. Here’s an article that explains some of the concerns associated with this: http://www.nytimes.com/2012/12/15/your-money/for-student-borrowers-a-tax-time-bomb.html?_r=0
This is also a great read that highlights some strategies you can use to improve your overall situation during IBR (saving for retirement, etc.):
What happens to interest deductibility if you get a 3-4% interest line of credit and consolidate and payoff a basket of Nelnet loans at 6-8%?
My understanding is that there might be a little interest to deduct from the Nelnet loans (since some would have likely accrued), but you wouldn’t then be able to deduct interest from the new loan/line of credit.
In essence, the higher interest rate will hurt you more in the long run. That’s why you need to pay off the most expensive loans.
Think of tax deduction as a percentage of a loan. then it equals Loan * (interest rate on loan) * (effective tax rate)
which means that if you earn interest deduction on a 10% loan with 15% tax, you probably save about 10%*15% = 1.5% interest on loan. But if your second expensive loan is below 8.5% interest rate, there is no point to save small and lose big.
Joe, that’s a great way to look at it. Thanks for sharing!
Okay. I am new to this whole Loan Repayment adventure. This may be a stupid question and forgive me if it is, but I read your thoughts and it makes sense to do both: Pay off more of the loans at a given time AND take a tax deduction each year you pay them. Wouldnt you save more money this way? Please help for I am lost. lol
Yes you are right. I guess the real point here is that delaying your repayment for the sole purpose of letting interest accrue (to then deduct from taxes) can be a bad idea. But yes, even if you pay them down over the course of the year some interest will still accrue and you will still take a deduction, albeit a smaller one.
This is true on a very small scale. What is missing from your equation is incredibly high student loan debt amounts, as mine is about 200,000$. This is more complex after 25 years, the remaining balance is forgiven (but tax still payed on that amount forgiven) So my best bet is to honestly pay just the interest and get a reduction on my yearly taxable income, because I know I am never going to every pay this off before 25 years.
That’s certainly a good point for those who are pursuing forgiveness options. Thanks for mentioning that!
You forgot to mention the AGI salary cap on deducting student loan interest. In 2014 it’s presently $60k. That means if you have a lot of student loans and got a good job with the (potential) ability to pay the loans off in your lifetime, you get no tax break.
Just an opinion here, but if you took out $60k+ in student loans for a low paying job, you’ll likely be paying the loans off for the rest of your life. It’s very sad the Federal government seems to pretend to care, but if you actually got a reasonable starting salary, you get no help as well. Of note, a $50k to $60k salary with no student loans won’t get you much house these days. It seems like a “big number” but really doesn’t go very far.
It seems like we’re getting to the point where we’ve overpriced higher education. The return on investment in college is getting ridiculous.
Really good point, and thanks for catching that. To clarify, it looks like the deduction starts to get phased out if your MAGI is between $65K and $80K and is phased out altogether for those earning more than $80K. Others might find this article helpful: https://ttlc.intuit.com/questions/1901536-can-i-claim-the-student-loan-interest-deduction
I share some of your sentiments regarding “the system” as a whole right now. Luckily, there are some good federal programs in place for the lower income earners, though.
Thanks for reading and commenting!
Do you take into account the future money value? I dont know the math, but $143 today, might be worth more than 241.32 10 years from now. Just a thought.
That’s a great point. I think some other commenters mentioned it too. If you are investing the money in such a way that will gain more return than your interest rate on the loans, that can be a great strategy. If you’re just spending the money on “wants” then you’ll be much better served to pay the loan.
If I have a high interest loan of 8.5% of $30,000 and the rest of my loans (over 200k) are at 6.8% and I have the ability to pay off all $30k of my high interest loan now, should I do it? Would that be good from a tax standpoint and a good strategy? I just don’t want to put a large sum that I would waste if I rode out a 20 year IBR or Pay as you Earn? Any suggestions?
That’s a good question! The tax benefit comes from interest that is paid off, but paying off the loan is more efficient (in terms of money saved) than paying less and allowing more of a tax break rack up. The real two questions you should consider are how is your retirement saving going to be affected and how likely will it be for you to get on and stay on a program like IBR. If you can get on one of those and/or save for retirement, that might be a better long-term use of the $30K. Best of luck in your decision process!
This is good, but there’s several other things to consider. If for example your rate locked in really low, your income and debt amounts, and the state of the market.
For my case for example, I locked in my rate at the bottom of the recession at 3.75%. It’s cheaper than any credit card, cheaper than my mortgage, and cheaper than inflation. It’s basically free money. Instead of paying off the loan, I can invest those funds in the market and still come back with a larger return than the interest paid on the loan.
The other strategy is rolling the loans into a mortgage and locking it in a low rate. That way you can take advantage of the mortgage interest deduction. When you’re in the 28% income tax bracket, you’re screwed either way. Either you’re screwed on income taxes or you buy a home and you’re screwed on mortgage interest and property taxes. Might as well make the numbers work and hedge them in your favor.
Great points Chris!
There are certainly situations, like you describe, where it makes sense to extend the loan(s) because you can make a higher return elsewhere. Thanks for reading and commenting!
Thanks! This is really helpful. As I struggle to come up with any possible way to combat my ever so interest heavy graduate loans, this appeared to be the last means of fighting my ever so growing interest. I’m glad to see you have put my questions to rest as I was contemplating drawing my loans out for the tax purposes.
Awesome Ray! Glad we were able to help. Once you see the numbers, the choice is much more clear.
wooo that was the post i was looking for students loan. as i have taken loan from loansslender usa and was quite confuse how to pay them. that this article is really helpful.
Awesome! Glad it was helpful.