Question

After reading the article No More Gotcha: Bill Would Exempt Student Loan Forgiveness from Tax, state your recommendation for a new tax rule regarding the forgiveness of student debt. Specifically, state whether you would encourage an exclusion for both insolvent and solvent student borrowers.

Answer 1

As national student loan debt climbs over $1.5 trillion, students all over are desperate for ways to lower their debt. A popular means to do this is by taking a student loan interest deduction. The federal government offers several ways to reduce your loan interest burden based on factors like income level, student status, and family size.

Average Student Loan Interest Rates

Interest rates for federal student loans range from 4.45% to 7% depending on the type and first disbursement date. Federal loans offer fixed interest rates that remain the same throughout the loan’s lifetime. Congress controls the interest rates, so the rates for new loans could change pending legislation. Compared to private loans, federal loans more often than not have higher rates. Private loans’ rates typically fall into the 3-8% range, but vary greatly depending on the borrowers credit. Most private loans also have variable interest, meaning the interest rate changes at any given time.

Both federal and private loans are eligible for some of the student loan interest deduction and forgiveness programs outlined below.

Student Loan Interest Deduction

Anyone with federal or private student loans may be eligible for student loan interest deductions. The student loan interest deduction lets student loan holders or cosigners (one or the other) deduct the yearly interest paid up to $2,500. Remember, this is the total interest paid on your federal AND private loans in a given tax year. Considered an above the line deduction, you can make this deduction even if you choose not to itemize.

The student loan interest deduction program depends on your modified adjusted gross income. If your MAGI is $65,000 or less, you can claim up to the full $2,500. Those with a MAGI between $65,000 to $80,000 have a reduced deduction. Any individual earning $80,000 or more or any couple earning $160,000 or more is ineligible. Married couples who file separately are also ineligible. This deduction is great for recent grads with entry-level salaries, but it brings no benefit to those with high earnings.

STUDENT LOAN INTEREST DEDUCTION EXAMPLE

Zach pays off $4,000 worth of student loan interest in the 2017 tax year. His modified adjusted income is $55,000. Since the interest he paid exceeds $2,500, he qualifies to receive the full $2,500 refund. This reduces his taxable income by $2,500, thus saving him around $625 per year. Erin pays off $6,000 of student loan interest. Her modified adjusted income is $82,000. She makes too much to qualify for the same $2,500 tax deduction as Zach.

Interest Forgiveness from Income-Driven Repayment Plans
To make your federal student loan payments more manageable, the Department of Education provides many repayment options. Currently, many borrowers are enjoying the cost-saving perks of these income-driven repayment plans. Depending on your eligibility, you could receive at least partial interest forgiveness for all of your federal loans. While forgiveness of interest isn’t exactly a student loan interest deduction, it acts in a similar fashion to reduce your debt liability.

CALCULATE YOUR INTEREST FORGIVENESS HERE

Income-Based Repayment (IBR)
Income-based repayment (IBR) simply means that your loan payment is based on what you earn. It also makes it possible to receive interest forgiveness for three years or loan forgiveness after 25 years of qualifying payments.

Your IBR payment will not exceed 15% of your discretionary income. Discretionary income is determined by calculating the difference between your adjusted gross income and 150% of the poverty guideline for your family size and state of residency. Your IBR payment is based on 15% of your discretionary income if you took out a loan before July 1, 2014 and 10% if the loans were taken out after.

Use our instant calculator to see what your IBR payment could be.

Loans that qualify for this program include:

• Direct PLUS Loans
• Direct Consolidation Loans (unless they contain parent loans)
• Direct Subsidized Loans
• Direct Unsubsidized Loans
• FFEL PLUS Loans
• FFEL Consolidation Loans (unless they contain parent loans)
• Interest Forgiveness in IBR

Along with reducing your monthly payments, the income-based repayment program can also forgive some of your interest payment. Since your new monthly payment is lower, in many cases, it will not cover the accruing interest. The government will then pay your loans’ interest for up to three consecutive years. Only subsidized loans qualify for this specific perk. The interest on your unsubsidized loans will continue to accumulate.

IBR INTEREST FORGIVENESS EXAMPLE

Jeff and his wife, who live in Florida, struggle meeting Jeff’s loan payments. They apply for the income-based repayment plan. Their adjusted gross income is $25,000. Taking 150% of the poverty line in Florida equates to $24,360. That leaves Jeff’s discretionary income at $640. He took his loan out in April 2012, so his IBR payment is 15% of his discretionary income. This equates to $96. Based on his $30,000 student loan with 6.8% interest, his 10-year repayment amount is $328. His IBR payment of $96 would be less than $328, so Jeff qualifies for IBR. The new monthly payment would be $8. Since this is between $5-10, he will owe $10 per month. His subsidized loans accrue $100 of interest each month. His monthly payment does not cover the accrued interest, so the government will pay the remaining $92 for up to three years.

Interest Forgiveness in the Pay As You Earn Plan

Created in 2011, the Pay As You Earn (PAYE) repayment plan helps those who can demonstrate partial financial hardship. It caps your monthly loan payment at 10% of your total discretionary income. This plan forgives interest for those with who qualify for a payment that is less than the accruing monthly interest on the loan. Take note that only borrowers who took out their first federal student loan on or after October 1, 2007, and who took out a Direct Loan or a Direct Consolidated loan after October 11, 2011 qualify. Eligible loans include all Stafford, Direct Subsidized, Unsubsidized and student PLUS loans. Consolidated loans are also eligible unless they include parent loans.

PAY AS YOU EARN INTEREST FORGIVENESS EXAMPLE

Joe, who lives in Hawaii, earns $30,000 per year and owes $45,000 in student loans. The poverty line for his state and family size of one is $13,860, bringing his discretionary income to $9,210. He applies for the PAYE plan because he cannot afford his $518 per month standard payment. His new monthly payment is now as low as $77 per month. His subsidized loans accrue $150 in interest each month. His $77/mo payment will first be applied to the interest on the loan, and then a government subsidy will kick in to cover the remaining $73 for the first three years that Joe uses the PAYE program.

After qualifying for the plan, you can continue making payments even if you are no longer under financial hardship. Borrowers who make 20 years of qualified payments are offered loan and interest forgiveness. If your PAYE payment becomes too high, you have the option of switching back to the standard 10-year repayment plan.

Revised Pay As You Earn Repayment Plan

The Revised Pay As You Earn (REPAYE) plan helps those with high student debt loads who earned too much to qualify for other programs. This program caps monthly payments at 10% of your income based on family size. There is no income limit to qualify, making it a highly popular option. Eligible loan types include Federal Direct Loans or Direct Consolidation Loans. This program excludes Perkins loans and Federal Family Education Loans.

After 20-25 years of qualifying payments, you are eligible for complete loan forgiveness. This also includes forgiveness of all accumulated interest. Keep in mind, however, that loan forgiveness is viewed as taxable income.

Revised Pay As You Earn Interest Forgiveness

Like the IBR and PAYE repayment plans, your REPAYE monthly amount is calculated by using your discretionary income as determined by the poverty level for your state of residency and family size. Use the equation below to estimate your monthly payment:

With REPAYE, you might also be eligible for extensive loan interest subsidies or forgiveness. If the amount you pay monthly is less than the accruing interest, the government will pay your interest for up to three consecutive years. They will also cover half of the unpaid interest after the first three years. For your unsubsidized loans, the government will cover half of the remaining interest beginning the day you start the REPAYE plan.

REVISED PAY AS YOU EARN INTEREST FORGIVENESS EXAMPLE 1

Kara, who has a four-member family, and her husband have an adjusted gross income of $120,000. She owes $75,000 in student loans with a 6.8% interest rate. She currently pays $863 per month. Using the formula above with a poverty level of $24,600, she will owe just $692 per month with REPAYE. This saves her $171 every month. Her monthly payment covers her interest amount in full and puts money toward her principal.

REVISED PAY AS YOU EARN INTEREST FORGIVENESS EXAMPLE 2

Sharon’s subsidized and unsubsidized loans accrue $60 each per month. Her REPAYE payment of $50 only covers $25 for each. For the first three years, the government will pay $35 toward her subsidized loan interest and $17.50 toward her unsubsidized loan interest. After three years, the government will continue to pay $17.50 toward her unsubsidized loan interest and will reduce the amount it pays on her subsidized loan interest to $17.50. As Sharon’s monthly REPAYE payment changes year to year, so will the amount the government subsidy covers.

Direct Subsidized vs. Direct Unsubsidized Loans

Direct Subsidized Loans are granted to students who demonstrate financial need. The federal government covers their interest payments while you are at least a half-time student, within the first six months after you leave school, and during deferment periods. For qualifying individuals, subsidized loans are eligible for interest forgiveness under REPAYE, PAYE, and IBR plans. These are the only loan type that PAYE and IBR plans help pay interest for.

Students do not need to exhibit financial need to take out a Direct Unsubsidized Loan. These loans are available to both undergraduate and graduate students. The interest accumulates while you are in school and during your grace period. You have the option of paying off the interest during this time. Only the Revised Pay As You Earn repayment plan helps cover qualifying Direct Unsubsidized loan interest. It covers 50% of the interest your monthly payment cannot cover for the entire time you are in the REPAYE program.

Remember, the type of loan you have affects its eligibility for government loan forgiveness programs. Knowing this ahead of taking out student loans will help you to make the best choice for your situation. Learn more about the differences between subsidized and unsubsidized loans.

Other Deductions To Consider

American Opportunity Tax Credit
When filing taxes this year, check to see if you or someone in your household qualifies for the American Opportunity Tax Credit (AOTC). This tax credit lowers a person’s (or family’s) tax bill by up to $2,500 per eligible student. Parents can claim this credit on behalf of their children for a total of $10,000 per child over their four years in college.

Students or families who spend at least $4,000 on qualified education expenses have the potential to receive the full $2,500 tax credit. You earn credit for 100% of the first $2,000 spent and then 25% of the next $2,000 spent. If this tax credit lowers your tax down to zero dollars, you will receive 40% of the remaining credit (up to $1,000) as a refund.