Now that the Senate has approved subsidized Stafford loan rates at 3.86% for the next two years, students will see higher rates beginning in 2015 and lose tax savings if the IRS keeps student interest deduction limits at their current level. With rates potentially rising to 8.25%, students need to prepare for the tax consequences of the rate hike.
NerdWallet Taxes crunched the numbers on how higher interest rates and the lost tax benefits will impact students’ bank accounts as they pay off their loans over the next 10 years.
Even at 3.86%, current IRS limitations could cost a typical student $530 in lost tax benefits over 10 years
An $500 increase in the interest deduction limit could collectively save students up to $950 million over 10 years
IRS deduction limits hurt future students who will pay higher rates than current students
IRS income eligibility requirements penalize new grads who earn more than $75K by not offering them any tax deductions
A $500 Increase in the IRS Deduction Limit Could Generate 25% Savings for Students
Under the Senate’s new agreement, our hypothetical student, Sara, will lock in two years of loans at 3.86%, but starting in 2015 her rate could rise to 4.5% or more based on the 10-year treasury yield. Assuming she pays an average interest rate of 4.57% on $23,000 of loans, Sara has to make annual payments of $2,935. Under current IRS limitations, she is only allowed to deduct $2,500 of that payment on her tax return.
If the IRS raised the limit by $500 to $3,000, as it has done historically, Sara would save an additional $534 over the life of her loan, or 25% of her total increased costs. If each of the 1.7 million students in Sara’s graduating class borrowed similar loans, were eligible for the deduction and realized this extra $534 in savings, collectively they would save $950 million over ten years.
To help students quantify the extra interest and lost tax savings they will face under higher interest rates and current IRS limits, NerdWallet has calculated their costs based on various rates and college entry dates assuming total borrowings of $23,000 and a 10-year repayment schedule.
Total Interest Paid
Lost Tax Savings
Rising Rates Will Hurt Future Students if IRS Limits Remain Unchanged
For students entering college in 2017, rates will likely be much higher than 3.86% and can rise as high as 8.25%. If Sara plans to enter college in 2016 and borrows the maximum amount of Stafford loans at 8.25%, she will lose $950 in tax benefits over her repayment period unless the IRS raises the limit.
Unfortunately for students like Sara, a bill to raise the cap from $2,500 to $5,000 has stalled in the House of Representatives. According to Govtrack.us, a government transparency monitor, the bill is unlikely to be passed in time to allow future students paying higher interest rates to reap additional tax benefits.
Higher Income Grads Don’t Qualify for the Tax Deduction
In addition to limiting the amount of interest students can deduct, the IRS also imposes income restrictions. Sara’s numbers assume that she remains eligible for the entire $2,500 deduction throughout her ten-year repayment period, an unlikely scenario because she will probably receive salary raises and bonuses that eventually make her ineligible for the deduction.
The table below shows the eligibility breakdown for new grads filing single based on information provided in IRS Publication 970.
New Grad's Salary
Eligible for Deduction?
If Sara graduated and earned a job paying $75K a year, she would not get to use any of the $2,500 deduction, so the burden of increased interest rates and payments falls squarely on her. At 4.57%, she would pay $1,590 in extra interest compared to the recent rate of 3.4%, and lose $3,600 in tax benefits, totaling $5,190 of increased costs. The table below summarizes total costs imposed on Sara by the interest rate hike and the IRS interest deduction limit based on her income after graduation.
Sara’s Starting Salary
Eligible for Deduction?
Lost Tax Savings
According to David Hersch, CPA and tax manager at Armanino LLP, a Bay Area accounting firm, the IRS deduction limit and income restrictions effectively “penalize students for obtaining a good education and making a good income coming out of school.”
Recommendations for Students
Now that many students are faced with uncertainty regarding future loan rates and cannot afford private loans without parental cosigners or excellent credit, NerdWallet recommends that students do the following to reap tax savings as loan rates rise:
1. Minimize Overall Loans
The best option is to limit borrowing from any sources, public or private, by competing for fellowships, scholarships, grants, university financial aid packages, or participating in a work-study program.
2. Consider Crowdfunding
To fund additional borrowing needs not met by work-study or scholarships, students can consider campaigning for funds in the burgeoning crowdfunding sector, which may offer lower rates than Uncle Sam or commercial banks.
3. Research Tax Credits
For students who don’t qualify for the $2,500 deduction or who want to realize tax benefits, they may consider using tax credits under the Lifetime Learning credit or American Opportunity credit. Depending on a student’s tax bracket and other eligibility requirements, educational credits can be more valuable than interest deductions when it comes to tax savings. One caveat is that the credits must be used in a year in which a student paid tuition, so students should take advantage of the credits while they’re still in school.
The calculations above assume that the hypothetical average student Sara borrows the total maximum allowed under subsidized Stafford loans ($23K) at an average rate of 4.57% and takes 10 years to pay off the loan. Interest accrued over the 6 month grace period following graduation is capitalized and added to the loan principal. Lost tax benefits from the $2,500 limitation assume that Sara pays an average income tax rate of 20%, files as single, and qualifies for the full amount of the deduction in each of the 10 years she takes to pay off her loans. Aggregate calculations assume that 1.77 million students will also borrow these loans for their 4-year academic period. Read More From NerdWallet:
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