Loan Refinancing And Taxes—How Do They Work Together?

Many graduate students consider refinancing their student loans to get a lower interest rate and change the terms of repayment. A lower interest rate means you can reduce the overall repayment time and pay off your debts quicker. Refinancing also allows you to get a longer repayment term, which will lower your monthly payment and make repayments more affordable.

There are also other advantages to refinancing your student loans, such as making only one monthly payment and paying only one lender instead of paying off multiple lenders.

Looking at these refinancing benefits, it sounds like a win-win; but there’s something you must consider before you decide to refinance your student loans—the impact of refinancing on your taxes.

Some questions that arise when refinancing—especially with regard to its effect on taxes—include, “will a deduction in student loan interest lead to an increase in taxes? Are there any tax breaks that I’ll be eligible for? How is my student loan connected to income tax?”

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Today, we’re here to answer your questions by looking at the relationship between refinancing and taxes in detail.

Saving money with student loan interest deductions

One tax break that most students are eligible for is a deduction in their student loan interest. Student loan interest is the interest you pay on your student loan, whether federal or private.

This applies if you’ve taken out a qualified student loan, meaning you borrowed the money to pay solely for education-related expenses such as tuition, books, stationery costs, accommodation costs, etc. for either you, your spouse, or a dependent.

The education for which you took out the loan must be within the academic year. The interest payments include both required payments and those which you voluntarily pre-paid.

The student loan interest deduction is a federal income tax deduction that allows taxpayers to annually deduct a maximum of $2,500 in interest to pay back their student loans.

You can deduct this amount every year from your interest payments, but not from the money you contributed toward the principal loan amount.

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Student loan deductions reduce a student’s taxable income, so even if you don’t itemize this deduction on your tax returns, you can still claim a student loan deduction. You can use this to decrease the amount you owe or increase the tax refund you get from the federal government.

Do you qualify for student loan interest deduction?

You must fulfill several requirements as a student if you want to be eligible for a student loan interest deduction. The following list details all the requirements, as stated by the IRS:

  • You paid the interest on a student loan in the same tax year as your tax return.
  • You are bound by law to pay interest on your student loan.
  • You are not filing your taxes under ‘married filing separately.’
  • You are not listed as a dependent on someone else’s tax returns.
  • Your modified gross adjusted income is less than the amount mentioned for a particular year.
  • Your modified adjusted gross income needs to be less than $70,000 if you’re filing as a single person or below $140,000 if you and your spouse are filing jointly.

The annual limit of your modified adjusted gross income is $85,000 or $170,000 for joint filing. The student loan interest deduction is slowly reduced, and when your income reaches the annual limit, the deduction completely stops.

How much of a deduction can you get in your student loan interest?

To calculate the amount you are eligible for, you can use free online sources or the IRS worksheet. These sources will calculate your deduction based on how much you earn annually and which tax bracket you are in based on your income.

How much you can save in taxes depends on which state you live in. For example, if your state charges income tax, you can further increase your federal tax savings. It’s important to note here that the maximum amount you will be allowed to deduct is based on how much student loan interest you paid in the previous year.

If you have federal loans and you are on an income-driven repayment plan, then your modified adjusted gross income will decrease, and this will lead to a reduction in your monthly payments as well.

The process of claiming a deduction for your student loan interest

On Internal Revenue Service (IRS) Form 1040, your student loan interest deduction is claimed as a decrease in your taxable income. You don’t have to itemize the interest deduction on a Schedule A form.

The servicer or the lending institution will send you Form 1098-E if you paid above $600 in student loan interest to that lender. If you’re confused about the specific amount you paid in interest, you can call your lender to ask for your interest amount or request the correct form so you can claim the interest deduction.

Reasons why refinancing student loans won’t affect your taxes

If you’re thinking of refinancing your student loans to claim a tax deduction, your income needs to be less than what the IRS mentioned. If you have a higher income, you are not eligible for student loan interest deduction, and as such, it will not affect your taxes.

Refinancing allows you to save a higher net amount. If your student loan interest deduction is around $2,500 each year and you pay around $925 in federal and state taxes, you are still saving $1575 each year. Hence, even if student loan interest deduction is losing you a certain amount in taxes, you are saving more money overall.

Refinancing your student loans also helps you avoid a student loan tax bomb in the long-term. If you are on an income-driven repayment plan and your loan was discharged, the discharge amount might be treated as taxable income.

You are legally obligated to report any loan amount that was forgiven, discharged, or canceled on your tax returns as income. Depending on your income, you could get a tax bomb between 10 to 37% of the amount forgiven on your student loan.

By refinancing your student loan, your student loan tax liability gets reduced, and you can strategize to maximize your student loan repayment.

Two tax credit options

If you’re still in school, you can opt for the American Opportunity Tax Credit, which will offer you a maximum of $2,500 in annual credit. If these credits bring your tax amount to zero, 40% of the remaining credit is refunded back to you. This tax credit has a higher income limit, but to qualify, you must be an undergraduate and enrolled for at least half-time in one academic term.

Another tax credit is Lifetime Learning Credit, which you can use for an undergraduate, graduate, or postgraduate degree or even part-time courses. Still, the maximum credit is $2,000 per tax return, and it is not refundable.

About the Author

The author is a financial expert on refinancing student loans at ELFI (Education Loan Finance) — a national private lending company. He has helped several college graduates strategically manage their finances and pay back student debt faster.

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