Student loan debt is a problem that plagues millions of Americans. It’s no wonder that the majority of people who default on their student loans wind up with a 10-year or even lifetime ban from refinancing their student loans again. Even with the best of intentions, refinancing student loans can still have some big tax consequences. Below, we’ll break down what you need to know about student loan refinancing and its tax implications.
Refinancing student loans in order to pay less interest is a smart financial move that many borrowers do. However, it can significantly increase your federal taxes and affect your eligibility for tax credits, subsidies, and other benefits.
If you are considering refinancing your student loan, you are probably hoping to lower your interest rate. But if some of the interest is deductible, how can refinancing student loans affect your taxes? Can paying less interest on student loans negatively impact your tax bill?
These are questions that many student loan borrowers want answered before applying for refinancing. After all, if the refinancing results in a tax increase, your total real savings will be smaller.
Let’s take a look at the interest deduction for student loans and how refinancing can affect the amount of interest you can deduct. We will also look at how student loans and federal income taxes are related and how you can take advantage of the tax credits for which you qualify.
The tax benefits that students taking out student loans are most likely to claim are the interest deduction on student loans. Here you can read how this deduction works and how much it can save you in taxes.
Under current IRS tax law, eligible borrowers may deduct up to $2500 of the interest they pay each year on their student loans. This deduction applies only to interest payments, not to the money you paid for the principal. It is also important to note that this is a deduction and not a credit. It may reduce your taxable income, but it will not reduce your taxes dollar for dollar.
On a positive note, the student loan interest deduction is an online deduction. This means you can use it to reduce your tax bill, even if you don’t itemize your deductions (unlike the mortgage interest deduction).
In 2017, a proposal to eliminate the interest deduction for student loans was introduced as part of the Tax Cuts and Jobs Act (TCJA). Fortunately (for student loan borrowers), this particular provision was not included in the final TCJA.
Not all U.S. taxpayers who pay interest on student loans can claim the student loan interest deduction. According to the IRS, you can only take the deduction if you meet the following conditions:
- You paid interest on a qualified student loan in the same tax year as your tax return.
- You are required by law to pay interest on a qualified student loan.
- You don’t file as a married man who’s divorced.
- Your adjusted gross income (MAGI) is below the annually established limits.
- You cannot be listed as a dependent on another person’s return. This also applies to your spouse if you file your tax return jointly.
You can take the full interest deduction for student loans if your MAGI does not exceed $70,000. This amount is progressively reduced for taxpayers with incomes between $70,000 and $85,000 ($140,000 to $170,000 if they have a joint family). If your MAGI exceeds $85,000 ($170,000 if you apply together), you are not eligible for the deduction.
There are no restrictions on the type of credit. Whether you have public or private student loans, or both, you can take advantage of the student loan interest deduction if you meet the above criteria.
Related: How can you deduct student loan interest from your taxes this year?
The student loan interest deduction can reduce your taxable income by up to $2500. But if you only paid $1000 in interest on a student loan last year, for example, that’s the maximum you can deduct.
The Student Loan Planner® interest deduction calculator allows you to quickly calculate your estimated student loan interest deduction. For example, let’s say you make $60,000 a year, which puts you in the 22% tax bracket in 2021, and allows you to take the full $2,500 deduction.
Looking at the results of the calculator below, the federal tax savings would be $550. And if you live in a state with income tax, you can save another $125, for a total of $675.
If you also have an income-driven repayment plan (IDR), the student loan interest deduction can also lower your monthly payments by reducing your MAGI.
So after deducting about $250 per year in lower IDR payments, deducting interest on student loans can save you a total of $925 per year.
Unlike other deductions, the student loan interest deduction does not need to be reported on Schedule A. Instead, you can simply claim it as an adjustment to income on your Form 1040.
If you paid more than $600 in student loan interest to a lender or servicer, the lender or servicer must automatically send you and the IRS a Form 1098-E Student Loan Interest Statement.
Even if you paid less than $600 to the loan servicer, the servicer may send you a Form 1098-E. However, if you do not receive such a form, you can call the service provider and ask for the exact amount of interest paid so that you can deduct it from your taxes.
Those considering refinancing their student loans will be happy to know that the chances are that it will have virtually no impact on their taxes. Here are some reasons why:
1. Income Restrictions. You can only claim the interest deduction for student loans if your income is below the limit mentioned above. But borrowers who refinance often do so because they have high incomes and no longer enjoy the benefits of the IDR. And in this case, you don’t have to worry about taxes because you can’t claim the student loan interest deduction anyway.
2. Refinancing can bring big savings. Even if you qualify for the student loan interest deduction, refinancing can still make financial sense. For example, if you save $2500 per year in interest while losing $500 in savings due to the student loan interest deduction, you will be left with a $2000 profit. Remember, you never lose the full benefit of the student loan interest deduction because you continue to pay a portion of the interest on your student loans after refinancing.
3. The IDR tax liability for the cancelled debt. Refinancing can reduce the tax burden on your student loan if you participate in an IDR plan. StudentAid.gov says the IRS may consider remission of IDR student loans as taxable income. And, depending on the amount of the exemption, this can result in an unexpectedly high tax bill. So if you refinance your federal loans into private student loans, you can not only get a lower interest rate, but also avoid potential taxes on your student loans in the future.
The tax deduction for student loan interest is not the only way student loans can affect your income taxes. Here are two other situations where student loan debt can reduce or increase your tax bill.
The IRS currently offers two tax credits for undergraduate students: The American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC). Student loans are considered student expenses. So even if you fund your studies entirely with loans, you may still qualify.
Of the two credits, the OATC has a higher maximum benefit of $2,500 and higher income limits. It is also the only education tax credit that is refundable. The threshold for tax refund is 40%. However, to be eligible for AOTC, you must be enrolled as a student for at least half of the school day.
The maximum benefit for an LLC is slightly lower, $2,000, and the loan is non-refundable. However, the eligibility requirements are much more lenient. You can still benefit from an LLC while in graduate school. And you don’t even have to have a college degree. It is sufficient to attend at least one course per year.
For more information, read the full comparison of the two credits from the IRS’ point of view.
Some employers offer student loan repayment as an employment benefit to attract talent. While this is an important benefit, employer-paid student loans are generally considered taxable income. For example, if your employer paid $3,000 for your student loans last year, this will increase your tax liability by $3,000.
However, the CARES Act, passed in March 2020, allows employers to stay in business until the 31st. December 2020 to contribute up to $5,250 per year toward an employee’s repayment of tax-free student loans. And the Consolidated Appropriations Act (CAA) extended these provisions to 31. December 2025.
Related: Student loans and taxes – everything you need to know
Taxes are just one piece of the puzzle to consider when comparing refinancing options to other student loan repayment options, such as IDR or debt forgiveness.
Your income, residence and even marital status can affect your tax and repayment strategies. For example, if you qualify (through your work) for the government loan forgiveness program, refinancing your federal loans could be a costly mistake.
When you refinance your federal loans, you give up a number of other benefits. First, you are no longer eligible for a government deferment or repayment plan. They will also no longer be able to enroll in income-contingent installment plans.
Our Student Loan Planner® advisors are experts in helping borrowers develop strategies to save on student loans and income taxes. They have helped thousands of borrowers set up the right student loan plan to save more money. And they’d like to help you too. Sign up today for student loan advice.
Frequently Asked Questions
How does refinancing student loans affect taxes?
If you refinance your student loans, the interest rate on your new loan will be lower than the interest rate on your old loan. This means that you will pay less in interest over time. If you are in a higher tax bracket, this could mean that you end up paying more taxes over time.
Which is a downside of refinancing out of federal student loans?
The downside of refinancing out of federal student loans is that you will have to pay a fee.
Can refinanced student loans be forgiven?
No. Student loans cannot be forgiven or discharged in bankruptcy.