4 Things Recent Graduates Need to Know About Student Loan Debt and Taxes

Recent Graduates, Student Loan Debt, and Taxes

No doubt, student loan debt and taxes can feel pretty overwhelming to newly graduated students, which is why this post might come in handy to explain the relationship between the two. Here are 4 things recent graduates need to know about taxes and repaying student loans.

Student Loan Interest Can Be Tax Deductible

Let’s start off with some good news right off the bat. However much you pay off in student loan interest can be deducted from your taxes—up to $2,500. It’s a nice break that can lower how much you pay in taxes. In order to qualify for that deduction, however, you’ll need to match the following criteria:

  • You paid interest on a qualified student loan within that tax year
  • You’re legally responsible for a qualified student loan
  • You’re unmarried filing separately
  • If married and filing jointly, neither you nor your spouse are claimed as dependents

So what makes a student loan “qualified?” How do you know if your loan is qualified or not? Fortunately, the short answer is pretty simple: A qualified student loan is one you took out solely to pay for higher education expenses.

For the slightly longer answer, let’s look at the nitty-gritty details of what is considered an “educational expense”

  • The educational expenses were for you, your spouse, or for a person you claimed as your dependent.
  • The expenses were for the education of an eligible student enrolled during an academic period.
  • The expenses were paid or incurred within a reasonable period of time before/after you took out the loan.

Do you qualify? If so, congratulations and enjoy your tax break.

If You Can’t Repay, You May Lose Your Federal Income Tax Refund

Now for the not-so-good news. Not being able to pay back your student loans is scary enough in its own right, but it has snowballing consequences as well. One such negative effect is losing out on your federal income tax refund. Instead, that refund will go towards satisfying your federal student loan debt. This is known as a tax offset.

Ok, so, how do you avoid that? Ideally, by not going into student loan default in the first place. Prevention is key, and fortunately there are a number of ways you can avoid defaulting on your student loans.

  • Set up your loan payments on auto-pay, so you never miss a due date (sometimes this can also lower your interest rate!).
  • Lower your monthly payment amount–it may extend the life of your loan, but can make the month-by-month payments more manageable in the short term.
  • Select a new repayment plan that works for you. If your current plan isn’t working, see if you can switch to something else, like an Income-Based Repayment Plan or a Graduated Repayment Plan.
  • Refinance or consolidate your student loans. This is one way to get new terms, change your interest rate, alter your monthly payment amount, and otherwise manage your loans (but be aware that you may lose certain benefits on a Federal loan).

Forgiven and Canceled Debt is Taxable

Student loan forgiveness can be a blessing. Depending on your repayment plan or the benefits you qualify for, you may be able to have a portion of your student loan debt forgiven after you’ve made steady payments for a certain amount of time. It can be a great relief for student borrowers…so what’s the catch?

Unfortunately, forgiven student loan debt is counted as income in the eyes of the IRS. Since you don’t technically owe the money, it’s treated like you earned it instead, which means it’s taxable.

The same goes for canceled debt. If your lender determines that you’re unable to pay what you owe, they may decide to settle the debt with you (or pursue legal action, which is even less fun). Either way, if your debt is canceled, the IRS can (and will) tax the amount you “saved.”

So, in a way, forgiven or canceled debt is both a blessing and a curse. Still, better to focus on the silver linings.

You May Be Able to Claim Insolvency on Canceled Debt

Speaking of silver linings, there are some exemptions to the “canceled/forgiven debt is taxable” rule. One of the more common exemptions is insolvency.

How do you know if you qualify as insolvent? The IRS defines it as: “For purposes of relief under the cancellation of debt income rules, you are insolvent if the total of all of your liabilities was more than the fair market value of all of your assets immediately before the cancellation.”

Which is a fancy way of saying that if your loan debts outweigh the assets you own, you’re insolvent. So if your liabilities—in this case, your student loan debts—are greater than the fair market value of your assets—cash/bank accounts, real estate, retirement plans, physical items like cars, etc.—then you may be considered insolvent, and won’t have your canceled debt taxed. However, your credit score can take a huge hit, so it’s not an option to aim towards or take lightly.

It Pays to Be Informed

When it comes to student loan debt and taxes it definitely pays to be informed. By knowing the ins and outs of how the two are entwined, you can avoid costly mistakes and even save money!

 

Allison Wignall author bio imageAbout the author: Allison Wignall is the editor and lead writer at College Raptor, a site where students can find their best college matches, discover personalized college cost estimates, learn helpful tips for boosting acceptance odds, and even compare private student loan lenders and rates—all for FREE!

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