It's a sad fact that in order to afford the rising costs of a college education, tens of millions of American students have to resort to taking out student loans in order to cover tuition, fees, related books and supplies, and living expenses. The loans that students and their families have to take out have had a monumental impact on financial stability among graduates, and that makes it important to take advantage of every available break to help you reduce the cost of your student loan debt.
One way that the federal government aims to help out college students is through a tax break for the interest that they and their families pay on student loans. The break is generally available regardless of whether you have a federal or private student loan, but there are some tricks you need to know in order to make sure you don't lose this valuable tax deduction.
The basics of the student loan interest deduction
Taxpayers are generally allowed to deduct up to $2,500 in interest paid on qualified student loans each year. Unlike most tax breaks, the student loan interest deduction is available even if you don't choose to itemize deductions. That lets those who take advantage of the standard deduction on their tax returns also claim the deduction for student loan interest.
A qualified student loan is a loan taken out to pay solely for qualified higher education expenses. That includes tuition, fees, and required materials, supplies, and equipment. You can also deduct interest on loan proceeds used to cover the cost of room and board as long as you're enrolled at least half-time at a college or university. In order to qualify, the loan must have been for yourself, your spouse, or someone who was your dependent at the time you took out the loan. For the most part, this usually includes your children but might exclude more distant relatives or family friends.
You're generally allowed to claim the student loan interest deduction if you meet five qualifications. First, you have to have paid the interest during the tax year in question. Second, you must be the person legally obligated to pay the interest on the student loan. Third, you must not file as a married person filing separately. Fourth, your income must be below certain thresholds. For 2019, single filers with incomes of less than $70,000 are entitled to a full deduction, but it phases out between $70,000 and $85,000 and disappears entirely above $85,000. Similar rules applied to joint filers, with corresponding income limits of $140,000 and $170,000. And finally, you must not be a dependent on someone else's tax return, and if you're married, your spouse can't be such a dependent either.
When you consider all of these restrictions, they offer two primary ways to get the student loan interest deduction.
1. The student can claim the deduction
The most common situation involving the student loan interest deduction gives the tax break to the student. The reason why this is so common is that for most types of federal student loans, including both subsidized and unsubsidized loans, the student is the only borrower who's legally responsible for repaying the loan. Most federal loans don't require or even allow parents to be cosigners for the loan, and because one of the limitations on deductibility of interest is that the person claiming the deduction be the one liable for repayments, the student is typically the only person who can get the tax break for paying the interest.
As mentioned above, though, students can't claim the student loan interest deduction if they're someone else's dependent. That can create problems for those who remain dependents of their parents even after they complete school, but the fact that personal exemptions are no longer available for parents to take on their own tax returns reduces the incentive to claim a college graduate child as a dependent after finishing school.
For many students, coming up with the money to make repayments is difficult, and some rely on their parents to make loan payments on their behalf. At first glance, that might seem to disqualify the student from taking the deduction for the interest paid on the loan. However, the IRS treats the situation favorably to students, considering it as though the parents gave the money to the student, and then the student used the money to pay the loan interest.
2. The parents can claim the deduction
There's a common misconception that parents are always able to claim the student loan interest deduction if they make a loan payment on a student's behalf. As mentioned above, though, if the student is the only borrower on a loan and the parents don't have any financial obligation to repay the loan on the student's behalf, then the parents aren't eligible to claim the deduction -- even if they're the ones who actually pay the interest.
However, for student loans in which the parents are on the hook for repaying the principal, the student loan interest deduction is available to the parents. For some loans in which the parents are the only borrowers listed, such as Parent PLUS loans, the sole available option for deducting interest will be for the parents to do so. However, in other cases in which both the student and the parents are listed as borrowers, it'll be up to them to decide who pays the interest and therefore who qualifies to take the deduction. This also holds true in situations in which the parents act as cosigners on a loan where the student is the primary borrower. Even though the parents aren't first in line to be legally responsible to repay the debt, they are on the hook if the student doesn't repay the loan according to its terms.
Note, though, that the student doesn't still have to be a dependent of the parents in order for them to claim the deduction. It's only required that the student was a dependent at the time they took out the loan.
Be smart about the student loan interest deduction
In many cases, you won't have a choice about who gets to claim the student loan interest deduction. But when you do, it makes sense for the person in the higher tax bracket to take as much of it as possible. Deductions produce tax savings in direct proportion to the taxpayer's bracket. In most cases, because parents will have higher incomes than recent graduates, that means that it'll make more sense for the parents to claim the deduction. However, income limits can disqualify parents from claiming any deduction at all -- even if it'd be more valuable if they could be the ones to take it. You should run the numbers both ways to see what's smarter in your particular case.
Student loans are a major financial burden, but the student loan interest deduction can make carrying that burden a bit easier. Just be sure to follow the rules to make certain you'll get the maximum savings available from this lucrative tax break.