Written By Adam S. Minsky, JD
Updated on June 13, 2024
It’s tax season, believe it or not. And student loan borrowers are facing an array of confusing new initiatives, reforms and changes, both to student loan programs and the tax code. Many of these changes will be beneficial, but may directly impact borrowers’ tax strategies. Now is the time to start thinking about these issues.
Here are a few things borrowers need to know.
Federal student loan forgiveness is not taxable this year
The cancellation of any debt, including student loans, can sometimes have tax consequences. That’s because federal and state tax laws can treat debt cancellation as “income” to the borrower for tax purposes – requiring that the borrower report the canceled debt as income, often leading to higher taxes.
But that’s not the case for federal student loan forgiveness, at least for now. The American Rescue Plan Act of 2021 exempts federal student loan forgiveness from taxation through December 31, 2025. That means that student loan forgiveness under all of the recent Biden administration initiatives – including the Limited PSLF Waiver, the IDR Account Adjustment and Borrower Defense to Repayment – are all tax-free under federal law.
Be aware, however, that for states with an income tax, state law treatment of federal student loan forgiveness does not always align with federal law, especially for temporary exemptions like those in the American Rescue Plan. It would be prudent for borrowers to consult with a tax advisor.
After 2025, certain federal student loan forgiveness programs – such as disability discharges and loan forgiveness under Income-Driven Repayment plans – will become taxable again unless Congress passes new legislation to extend the temporary relief or make it permanent. Borrowers expecting to receive taxable student loan forgiveness in 2026 or beyond should start working with their tax or financial advisors now to prepare for those possible tax consequences.
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You can deduct student loan interest – but only if you made payments
The federal tax code allows many borrowers to deduct student loan interest on their tax return up to $2,500 that was paid during the prior year (although the benefit is phased out for higher income earners). Importantly, however, borrowers must have specifically paid student loan interest to qualify.
This year, many borrowers won’t qualify for this deduction. That’s because the ongoing Covid-related student loan pause has suspended payments on all government-held federal student loans since March 2020 (Biden recently extended the relief to June 2023). Many borrowers have, thus, not needed to make any payments. If you don’t make payments, you don’t get the deduction.
And even borrowers who made voluntary payments may still not qualify for the deduction. The payment pause has also frozen all interest accrual. This is beneficial for many borrowers in that any voluntary payments may go entirely to principal, but paying down the loan principal does not qualify for the student loan interest deduction. Only borrowers who made voluntary payments on outstanding, uncapitalized accrued interest could potentially be able to claim the deduction if the payment pause covered their loans.
Borrowers who may qualify for the student loan interest deduction should receive a Form 1098-E interest statement from their student loan lender or servicer.
Related: How to qualify for a private student loan interest deduction
Watch your adjusted gross income for student loan payment benefits
If you were repaying your federal student loans on an income-driven repayment (IDR) plan, payments are typically not based on your gross salary. Instead, payments are usually based on your Adjusted Gross Income (AGI) as reported on your federal tax return. A person’s AGI is often less than their gross salary because their AGI takes into account certain pre-tax deductions. The lower your AGI, the lower your student loan payments may be under an IDR plan.
It may be prudent for borrowers to consult with their tax advisor about strategies for lowering their AGI. Several potential ways to do this include contributing to a Health Savings Account (HSA), a pre-tax retirement plan or taking a student loan interest deduction.
Employer retirement match for student loan payments
The recent omnibus bill passed by Congress in the lame duck session in December 2022 included a provision that will allow certain student loan payments to be treated as employment retirement plan contributions for the purpose of company retirement matches associated with employer-sponsored retirement plans, like a 401(k). In other words, if you pay $100 towards your student loans, your employer may be able to “match” that by contributing $100 towards your 401(k).
The benefits are still constrained by normal retirement plan contribution limits, and some paperwork may be required for employees to certify their student loan payments for their employer. Borrowers should consult their tax advisor and employer’s benefits department for more information.
Married borrowers should evaluate their marital tax filing status
Married borrowers on income-driven repayment (IDR) plans have often had to deal with confusion regarding student loan repayment and tax filing status. All IDR plans factor in the combined income (and combined federal student loan debt) for married borrowers who file taxes jointly with their spouse.
But existing IDR plans – specifically, Saving on a Valuable Education (SAVE), Income Based Repayment (IBR), Income Continent Repayment (ICR) and Pay As You Earn (PAYE), married borrowers can file taxes separately to exclude spousal income and keep their payments based on their individual incomes. While this may lead to higher taxes, it can sometimes save borrowers quite a bit of money, especially when the borrower has relatively low income compared to their non-borrower spouse.
Related: How to Decide When to Use Married Filing Separately on Your Tax Return
Tax changes thanks to the new SAVE plan
Under the previous Revised Pay As You Earn (REPAYE) plan — which was replaced with the SAVE plan — both the borrower’s income and their spouse’s were used to calculate the borrower’s monthly student loan payment, regardless of their tax filing status. As a result, some borrowers who didn't qualify for the PAYE plan (which has more flexibility, but also has disbursement date eligibility restrictions) were forced to choose between REPAYE as married-filing-jointly, or the more expensive IBR plan as married-filing-separately.
However, the Biden administration's SAVE plan resulted in significant changes, including lower monthly payments for many borrowers and mirroring the treatment of married borrowers under IBR, ICR, and PAYE – meaning married borrowers are able to exclude spousal income by filing taxes separately. This may lead to separately filing married borrowers who have been repaying their student loans under IBR to re-evaluate both their repayment plan and tax filing strategy.
Married borrowers should consult with their tax advisor to determine the pros, cons and potential costs of filing jointly versus separately.
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