Make Student Loans Less Taxing

With the 2013–2014 academic year about to begin, parents of college students and youngsters preparing for college must confront the costs of higher education. As those costs soar, you or your children (or both) may have to use student loans to pay the bills. Repaying such loans can create painful choices.
In a recent AICPA survey of student loan borrowers, 75% of respondents said that they or their family members have made personal or financial sacrifices because of student loan repayments. Those sacrifices included postponing contributions to retirement plans (41% of respondents), delaying car purchases (40%), putting off buying a house (29%), and even deferring marriage (15%). Of those surveyed, 60% have at least some regret over their choice of education financing.
Deductive reasoning
Some of the hardships faced by student loan debtors may be reduced by deducting the interest paid on a student loan. If you qualify for the deduction, you take it as an “adjustment to income” on page 1 of your tax return, so you don’t need to itemize deductions on Schedule A to get the deduction. Adjustments to income also lower your adjusted gross income (AGI), and a lower AGI can help you claim other income tax deductions and credits.
In order to deduct interest on student loans, you must meet several criteria. For instance, you must be legally obligated to pay interest on a qualified student loan. Your loan qualifies if you borrowed solely to pay certain education expenses for yourself, your spouse, or a dependent. Those expenses include tuition, fees, room and board, books, supplies, equipment, and other necessary expenses, such as transportation. There are some limits to room and board in this context, but you can borrow enough to cover the cost of school-operated housing and meal plans.
Even if you pass all of the tests mentioned here, you can’t deduct the interest on a loan from a relative. Similarly, if you borrow from an employer plan, such as a 401(k), the interest you pay will not be deductible student loan interest. Among other restrictions, you can’t take this deduction if your filing status is married filing separately or if you can be claimed as a dependent on someone else’s return. However, you can take the deduction if you borrowed to pay for the education of someone—such as your child—who is married and files a joint return.
Income limits
You can deduct up to $2,500 of qualified student loan interest you pay each year. (Your lender probably will send you IRS Form 1098-E, showing the amount of interest you paid on your student loans for the year in Box 1.) However, your deduction might be capped or eliminated because of your modified adjusted gross income (MAGI). Typically, your MAGI for this deduction is the same as your AGI, before subtracting any deduction for student loan interest.
You can take a full $2,500 tax deduction for qualified student loan interest with MAGI up to $60,000, if you are a single taxpayer, a head of household, or a qualifying widow(er). You’re allowed smaller deductions with MAGI up to $75,000, but no deduction for student loan interest is allowed if your MAGI is higher than $75,000. For couples filing joint returns, this deduction phaseout is between $125,000 and $155,000 of MAGI.
As you can see, a lower MAGI can boost your deduction, if you are near the phaseout range. You can reduce your MAGI with 401(k) contributions and by taking capital losses. In addition, graduates who are beginning their careers might have lower MAGI than their parents and, thus, be more likely to qualify for the student loan deduction. This can be a consideration for families trying to decide whether parents or students should be the borrowers on student loans.