Student Loan Debt - Paying and Avoiding It, Plus Tax Benefits

Article Highlights:

  • Tax Advantaged Repayment of Student Loans

  • Employer Provided Educational Assistance

  • Qualified Tuition Programs

  • The Deductibility of Student Loan Interest

  • Student Loans Forgiven in 2021 through 2025

  • Avoiding Student Loan Debt

  • Section 529 Plans

  • Coverdell Education Savings Account

  • Education Tax Credits

  • The American Opportunity Credit

  • The Lifetime Learning Credit

Despite recent rounds of forgiveness for thousands of borrowers, nearly 43 million Americans are responsible for roughly $1.6 trillion in federal student loans which results in a significant long-term burden for students after graduation. The average debt varies by state from $28,600 in North Dakota to $54,900 in the District of Columbia.

Although the U.S. Department of Education has, as a COVID-19 pandemic relief measure, currently suspended loan payments, reduced the interest rate to zero and stopped collections on defaulted loans, all that is scheduled to end after Aug. 31, 2022. Unfortunately, it is time start thinking about how to deal with the resumption of payments and interest charges

This article looks at the issue of student loan debt from an income tax perspective including:

  • Tax Advantaged Repayment of Student Loans

  • The Deductibility of Student Loan Interest

  • Treatment of Forgiven Student Loans

  • Avoiding Student Loan Debt

Tax Advantaged Repayment of Student Loans

The tax code provides two tax advantaged ways of repaying student loan debt that may apply to individuals under certain circumstances that should be employed to reduce the debt when available:

  • Employer Provided Educational Assistance – The tax code (Sec 127) includes a provision that allows employers to pay for employees’ education as a working condition fringe under an educational assistance program of the employer. It is limited to $5,250 per year and is not taxable income to the employee.

    The CARES Act of 2020 expanded the definition of expenses available to qualify for the $5,250 employer-provided educational assistance exclusion to include employer payments of the employee’s student loan debt. This special allowance is available for payments made through December 31, 2025

    Thus, where the individual works for an employer that has an educational assistance program, they should take advantage of the plan to pay down their debt.

    Tax Tip - The employee isn’t allowed to claim the above-the-line student loan interest deduction for interest that the employer paid. So, in some cases it may be advantageous for the employer to designate their payment as going to principal only so the employee can claim a deduction for the interest that they paid.

  • Qualified Tuition Programs – Qualified Tuition Plans (sometimes referred to as Section 529 plans) are plans established to help families save and pay for education expenses in a tax-advantaged way that allow taxpayers to gift large sums of money for a family member’s education expenses, while continuing to maintain control of the funds. The earnings from these accounts grow tax-deferred and are tax-free, if used to pay for qualified education expenses.

    Normally, funds from these accounts are only allowed to pay for education expenses. Distributions from a 529 plan of up to $10,000 can be used to pay the principal and interest on qualified higher education loans of the account’s designated beneficiary or a sibling of the designated beneficiary. However, the $10,000 limit is a lifetime limit.

    To prevent double-dipping, Sec 529 plan distributions used to pay interest on the education loan cannot also be used for the above-the-line deduction for student loan interest.

The Deductibility of Student Loan Interest

The student loan interest deduction is not limited to the interest paid on government student loans. In fact, virtually any loan interest will qualify as long as the loan proceeds are used solely for qualified higher-education expenses (that is, it is a sole-purpose loan). However, the maximum interest that is deductible each year is $2,500. Thus, in addition to government student loans, home equity lines of credit, personal loans from unrelated parties, and even credit cards can be used if they otherwise qualify. Pension plan loans and loans from related parties do not qualify.

Example #1 – Jack takes out an equity line of credit on his home and borrows $30,000 to finance a solar electric installation on his home and $10,000 to pay his daughter’s qualified education expenses. Because this loan is not used for a single purpose (he used it to borrow funds for more than education), he cannot deduct a portion of the interest as above-the-line education loan interest. However, if Jack had only used the loan to pay for qualified education expenses, then up to $2,500 of the loan interest could have been deducted as above-the-line student loan interest.

Example #2 – Mark has a Visa card that he uses for a variety of purposes, and he also uses it to pay his daughter’s qualified education expenses. Because the credit card is not used exclusively to pay for qualified education expenses, none of the interest will qualify as student loan interest. However, if Mark had only used the credit card to pay for qualified education expenses, then up to $2,500 of the credit card interest could have been deducted as above-the-line student loan interest. Caution: Although we use a credit card as an example of an alternate student loan, it is not practical because of the high interest rates.

The deduction is ratably phased-out in 2022 for taxpayers with an AGI (income) of $70,000 to $85,000 ($145,000 to $175,000 for joint returns) and not allowed at all for taxpayers filing as married separate or an individual who is a dependent of another. These phaseout levels are periodically adjusted for inflation.

If a loan is not subsidized, guaranteed, financed, or otherwise treated as a student loan under a program of the federal, state, or local government or an eligible educational institution, a payee (the lender) must request a certification from the payer (the borrower) that the loan will be used solely to pay for qualified higher-education expenses. Form W-9S, Request for Student’s or Borrower’s Social Security Number and Certification, is provided by the IRS for this purpose.

The deduction for student loan interest can be deducted whether the standard deduction or itemized deductions are claimed since it is an adjustment to income, often referred to as an above-the-line deduction.

To qualify as an eligible loan, the loan must have been taken out solely to pay the costs of attending an eligible educational institution for an individual during a period when the individual is a qualified student. Eligible costs include:

  • Tuition

  • Fees

  • Room and board

  • Books and equipment

  • Other necessary expenses (including transportation)

The expense must be incurred within a reasonable time before or after the debt is incurred. The regulations provide that a loan is incurred within a reasonable period if:

  • The expenses are paid with the proceeds of a loan from a federal post-secondary education loan program; or

  • The expenses are related to a particular academic period and the loan proceeds used to pay the expenses are disbursed within a period that begins 90 days prior to the start of, and ends 90 days after the end of, that academic period. A home equity line of credit can be used to meet these requirements by paying education expenses as they become due, provided that the loan is not used for any other purpose.

Such expenses must be reduced by any:

  1. Income excluded from employer-provided educational assistance;

  2. Income excluded from U.S. savings bonds used to pay higher-education expenses;

  3. Nontaxable distributions from Coverdell ESAs; and

  4. Scholarships, allowances, or other payments (such as distributions from Sec. 529 plans) that are excludable from gross income.

An eligible student is one enrolled in a degree or certificate program who is at least a half-time student. What constitutes half the normal course load will be determined by the definition of the school being attended. Generally, a full-time student is one carrying at least 12 units.

The above-the-line interest deduction may only be claimed by a person who is legally obligated to make the payments on the qualified educational loan. However, tax regulations allow payments on above-the-line education interest made by someone other than the taxpayer/borrower to be treated as a gift, allowing the interest to be deductible by the taxpayer.

Student Loans Forgiven in 2021 through 2025

Normally, when a debt is cancelled, and unless a specific exception applies, the borrower is required to include the forgiven amount as taxable income. A provision was included in the American Rescue Plan Act, signed into law March 11, 2021, that student loans forgiven in 2021 through 2025 will be free from income tax if the loan was provided expressly for post-secondary educational expenses, regardless of whether provided through the educational institution or directly to the borrower, if such loan was made, insured, or guaranteed by:

(A) The United States, or an instrumentality or agency thereof; a State, territory, or possession of the United States, or the District of Co1umbia, or any political subdivision thereof; or an eligible educational institution.

(B) Generally, any private education loan.

(C) Generally, most loans made by educational organizations.

Avoiding Student Loan Debt

Although not everyone has the resources, if you have children below college age, there are tax-advantaged plans that allow you to save for the costs of their higher education and possibly avoid or minimize student debt. There are also tax credits that will help pay for tuition and expenses while the student is in school.

  • Section 529 Plans - Section 529 Plans (named after the section of the IRS Code that created them) are plans established to help families save and pay for education expenses in a tax-advantaged way and are available to everyone, regardless of income. These state-sponsored plans allow you to gift large sums of money for a family member’s college education while maintaining control of the funds. The earnings from these accounts grow tax-deferred and are tax-free, if used to pay for qualified higher education expenses. They can be used as an estate-planning tool as well, providing a means to transfer large amounts of money without gift tax. With all these tax benefits, 529 Plans are an excellent vehicle for college funding. Section 529 Plans come in two types, allowing you to either save funds in a tax-free account to be used later for higher education costs, or to prepay tuition for qualified universities. For 2022, an individual can contribute $16,000 without gift tax implications (or $32,000 for married couples who agree to split their gift). The annual amount is subject to inflation-adjustment. There is also a special gift provision allowing the donor to prepay five years of Sec 529 gifts up front without any gift tax consequences.

    Contributions are not limited to parents, and it is not uncommon for grandparents and other relatives to also contribute to these plans.

  • Coverdell Education Savings Account - These accounts are education trusts that allow nondeductible contributions to be invested for a child’s education. Tax on earnings from these accounts is deferred until the funds are withdrawn, and if used for qualified education purposes, the entire withdrawal can be tax-free. Qualified use of these funds includes elementary and secondary education expenses in addition to post-secondary schools. A total of $2,000 per year can be contributed (but is not deductible) for each beneficiary under the age of 18. The ability to contribute to these plans phases out when the modified adjusted gross income of the contributor is between $190,000 and $220,000 for married taxpayers filing jointly, and between $95,000 and $110,000 for all others.

  • Education Tax Credits - If you currently have a child or children attending college, there are two tax credits, the American Opportunity Credit (partially refundable) and the Lifetime Learning Credit (nonrefundable), that you may be able to take advantage of. Both are available for qualified post-secondary education expenses for a taxpayer, spouse, and eligible dependents. Both credits will reduce your tax liability dollar for dollar until the tax reaches zero.

    o The American Opportunity Credit (AOTC) - is a credit of up to $2,500 per student per year, covering the first four years of qualified post-secondary education. The credit is 100% of the first $2,000 of qualifying expenses plus 25% of the next $2,000 for a student attending college on at least a half-time basis. Forty percent of the American Opportunity credit is refundable (if the tax liability is reduced to zero). This credit phases out for joint filing taxpayers with modified adjusted gross income (MAGI) between $160,000 and $180,000, and between $80,000 and $90,000 for others (except no credit is allowed for those who file married separate returns).

    o The Lifetime Learning Credit - is a credit of up to 20% of the first $10,000 of qualifying higher education expenses. Unlike the American Opportunity Credit, which is on a per-student basis, this credit is per taxpayer (family) not per student. In addition to post-secondary education, the Lifetime Credit applies to any course of instruction at an eligible institution taken to acquire or improve job skills. The MAGI phaseout ranges are the same as those for the AOTC, and like the AOTC, the Lifetime Learning Credit is not allowed for taxpayers who file married separate returns.

    Qualifying expenses for these credits are generally limited to tuition. However, if required for the enrollment or attendance of the student, activity fees and fees for course-related books, supplies, and equipment qualify, but for the Lifetime Learning Credit course materials and supplies are eligible only if purchased directly from the educational institution.

While it is possible that Congress may add more tax-related benefits for assisting parents and students to pay for higher education costs, you shouldn’t depend on their actions (or inactions). You should consider starting the planning process as soon as possible, and don’t overlook the credits and deductions available for the current students in your family.

If you would like assistance in planning for your children’s future education or are considering borrowing money to pay for higher-education expenses, it may be appropriate to consult with this office for assistance.

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