7 key tax questions about paying off student loan debt

July 21, 2023 2:21 PM

Student loan debt jumped 54% over the past decade to $1.76 trillion

Student loan forgiveness after 20 to 25 years in a repayment plan often causes people to think, "I'll just wipe my hands clean" of the debt, according to financial planner Adrienne Davis.

Adrienne Davis, Zenith Wealth Partners — Adrienne Davis is a financial planner with Zenith Wealth Partners, a Philadelphia-based registered investment advisory firm.

"But that's not the case," said Davis of Philadelphia-based Zenith Wealth Partners. Instead, as she and other financial advisors warn clients who aren't eligible for certain temporary or career-based exemptions from the infamous "student loan tax bomb" tied to income-based repayments, they could be facing surprise payments to Uncle Sam for the forgiven sum.

The tax complexities of those plans and other strategic intricacies surrounding student loan debt include questions about eligibility for deductions on interest payments, 529 plans and employee benefits. With over 43 million Americans holding more than $1.77 trillion in student loan debt set for restarted monthly bills due in October, tax professionals and planners are guiding clients through a plethora of issues on top of the burden to budgets and investment portfolios.

Legislative "sunsets" in particular could carry significant tax implications in a couple of years.

"Paying something off is one thing, but you have to really understand the cash flow," said Catalina Franco-Cicero, a certified financial planner with Plantation, Florida-based Tobias Financial Advisors. "If we are really going to serve these younger generations, we have to start thinking that, 'Hey they're going to come with these loans, and we have to be ready to train them.'"

College admissions, higher education expenses, tuition and student loans are "interlinked with taxes like never before," according to Rupa Pereira, an IRS-credentialed enrolled agent who is the founder of Raleigh, North Carolina-based FWJ Planning.

She added the new direct transfer of taxpayers' information from the IRS when filling out the Free Application for Federal Student Aid in the 2024-25 school year to the mix of topics to bring up with clients. Many clients are retiring later or withdrawing money from their nest eggs to pay for college tuition.

For federal student loans, a borrower's adjusted growth income and filing status determines the size of their payments and how to ensure their household is in the "best position to maximize cashflow while minimizing debt burden," Pereira said in an email. "Cashflow planning becomes a critical factor for households navigating student loans — something that a tax preparer or loan servicer may not be able to assist with."

Clients should understand that the type of loan they received often decides their eligibility for various tax deductions and credits, as well as refinancing and repayment programs, according to Emily Stead, founder of the ByMethod Financial Collective, a Phoenix-based office of Cetera Investors. Their best option might look different from the course taken by friends, she pointed out in an email interview, recommending that borrowers with complicated tax situations start by consulting a certified public accountant or an enrolled agent.

"The most efficient way to make sure you are making the best possible financial decisions is to gather all of the information on your current loan(s) from your current loan servicer, and then speak with a licensed tax professional for information on your current tax standing and for advice on potential deductions and credits," Stead said. "From there you can speak with a financial planner to help you understand what options would be most suitable for you and your goals and put in place an actionable plan based on your financial picture as a whole."

Wealth management

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For seven tax subjects that planners like Stead suggest clients consider when paying off student loans, scroll down the slideshow. To see a listing of three potential strategies in response to the recent Supreme Court decision blocking the Biden Administration's student loan forgiveness program, click here. And follow these links to find an advisor's reflection on college expenses as a parent and a discussion of how and when to begin talking to families about higher education.

Standard or repayment plan?

High-income clients may have sufficient money to pay off their debt in the "standard" 10-year repayment plan rather than choosing among the 20- or 25-year schedules of the Pay as You Earn Repayment Plan, the Revised Pay as You Earn Repayment Plan, the Income-Based Repayment Plan and the Income-Contingent Repayment Plan.

"Besides loan forgiveness payment strategies, higher-income clients might actually benefit from a 10-year standard repayment method paying down the loan through regular amortization rather than an income-based method," Pereira said. "Filing status and AGI and, hence, tax consequences would be irrelevant to higher-income clients who can work toward getting debt-free in the shortest time possible."

Married, filing jointly or separately?

Advisors and households working with them must think through an array of factors relating to the question of filing jointly or separately, according to a 2021 study in The Tax Adviser, a monthly publication from the American Institute of CPAs. Most borrowers on the path to forgiveness under an income-based repayment plan must weigh the potential lower monthly payments of filing separately in households with one spouse earning significantly more than the other against the 11 tax credits, deductions and other breaks open to those on a joint return.

"Many clients automatically assume that the benefit from reduced loan payments exceeds the additional tax cost of [filing separately]," authors Nancy Nichols and Irana Scott wrote in the study. "However, when questioned about the difference in payment associated with only using the individual borrower's income, the clients eventually admit that they do not know the amount of the payment difference."

Student loan interest deduction?

For example, neither spouse filing separately will qualify for a tax deduction of up to $2,500 each year for interest payments on their debt. No borrowers whose payments have been paused since 2020 have received the deduction in the past few years, but the restarted monthly bills later in 2023 will restore the deduction for those with modified adjusted gross incomes below $85,000 or $175,000 if filing jointly in 2022. The deduction also shrinks in gradual phaseouts between $70,000 and $85,000, and $145,000 to $175,000 for couples.

Questions about those thresholds and "strategic moves" to get within them or the parameters of any state tax credits — as well as the impact of a change in marital status — represent some of the most important quandaries facing borrowers, Stead said. "A lot of borrowers tend to think these loans are set-and-forget, rather than something you can evaluate and potentially reposition over time, which can cause them to stick with a rate or repayment plan that may not be the most beneficial for their individual situation," she added.

529 Plans?

The use of 529 savings plans with assets left in them following tuition payments and other college expenses can pay off toward student loan debt as a qualified, tax-free benefit of up to $10,000, thanks to the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019. However, clients still owe income taxes on the distributions above that level and on any state liabilities in jurisdictions that treat them as non-qualified expenses.

"What we do as advisors is help the clients ask the right questions and look for possibilities that they never knew existed," Franco-Cicero said.

Employee benefits?

Under the Coronavirus Aid, Relief, and Economic Security Act, up to $5,250 in payments from employers to each member of their workforce through student loan repayment assistance programs can be excluded from payroll taxes and income through 2025. Prior to the passage of that legislation, the share of employers offering student loan repayment assistance had already jumped to 8% in 2019 from only 3% just four years earlier, according to the Society for Human Resource Management.

Death or disability discharges?

The cancellation of student loan debt due to death and disability turned tax-free for clients or their estates through 2025 as well, with the passage of the Tax Cuts and Jobs Act of 2017. Future lawmakers in Congress and the White House will face pressure to extend both exclusions past their current sunset date through additional legislation.

Tax bomb?

The American Rescue Plan Act of 2021 gave any borrowers in income-driven repayment plans whose loans are forgiven during the subsequent five years a free pass on the tax hit through 2025, although a few states are treating the discharged debt as income. Nonprofit and public employees have permanent protection from the "tax bomb" through Public Service Loan Forgiveness or programs such as Teacher Loan Forgiveness. Other borrowers won't be so lucky, Davis noted.

She called the potential hit "probably" the biggest tax issue relating to student loan repayments for most borrowers.

"This is something that we talk about with our clients because we do have to plan ahead if this is the route that you want to take," Davis added.