Long-term tax strategies for student loan borrowers

If you're one of the more than 40 million Americans paying down student loan debt, it's important to understand the tax implications of that debt - not only on the tax return you'll file this year, but in the long run.

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If you're one of the more than 40 million Americans paying down student loan debt, it's important to understand the tax implications of that debt—not only on the tax return you'll file this year, but in the long run.

Those with student loans are probably aware that the interest you pay on your loans is tax deductible, as long as your income falls within eligibility limits.

If you qualify—see details in Credible's "Guide to tax season"— you can knock up to $2,500 off of your taxable income, saving up to $625 on your taxes (your savings will depend on your tax bracket).

That's nothing to sneeze at. But if you're carrying five- or six-figure student loan debt, there are bigger long-term tax issues to consider.

Carrying a lot of student loan debt means you're probably making sizable monthly payments on that debt. Those monthly payments limit your ability to sock away money for retirement, or pursue dreams and opportunities like becoming a homeowner or starting your own business.

If your employer offers matching dollars for a 401(k) retirement plan, many financial advisors say you shouldn't leave that money on the table. The ability to make contributions using pre-tax earnings, claim employer matching dollars, and take advantage of the power of compound earnings means making room in your budget today for a retirement plan that can provide big returns down the road.

In my last column, I wrote about a study by Boston College's Center for Retirement Research that concluded student loan debt is going to make it harder for the generation coming out of school today to save for retirement. Not only that, the study found that those graduating with student loan debt may also experience lower homeownership rates, and those that do own homes will often have to settle for less valuable ones.

That's because your monthly student loan payments don't just take a bite out of your disposable income—they make it harder to take on more debt. Student loan payments increase your debt-to-income ratio, a key metric used by mortgage lenders to determine whether you'll qualify for a loan.

What does that have to do with the tax implications of student loan debt? If you've never owned a home, you may not have heard of one of the best tax perks around: the mortgage interest deduction. It works a lot like the student loan interest deduction but, because mortgages tend to be bigger than student loans, the mortgage interest deduction can take a much bigger bite out of your tax bill.

You can deduct the interest you pay on up to $1 million in qualified mortgage debt from your taxable income. According to a recent analysis by the Congressional Research Service, Americans who were able to claim the deduction in 2012 knocked an average of $1,906 off their tax bills, with average savings ranging from $891 in Ohio to $2,974 in California.

The government provides several other tax incentives for homeownership, including the ability to deduct your state and local property taxes when you file your federal return.

While homeownership is not for everyone—and nobody should buy a house just to get a tax break—the equity that you build up in your home can be a good vehicle for amassing a retirement nest egg. When you sell your home at a profit, up to $250,000 in capital gains is tax exempt ($500,000 if you're married and filing a joint return).

So far, we've seen how the student loan interest deduction can save you a little money on your taxes. But we've also seen how your monthly student loan debt payments can make it harder for you to take advantage of bigger, government-subsidized opportunities to save—retirement plans and homeownership.

Now let's consider a couple of ways to manage your student loan debt that can free up money for investing, saving, and realizing dreams like homeownership.

Extending Your Loan Term

One approach is to lower your monthly payments by extending your loan term. The government offers several income-driven repayment programs that can lower your monthly student loan payment by extending your loan term to as long as 20 or 25 years. Lowering your monthly payment can free up cash and reduce your monthly debt-to-income ratio.

But there are two important considerations to keep in mind about these programs. First, extending the term of a loan typically means you'll pay more in interest over the life of the loan.

Second, if you have so much student debt that you still owe after making 20 or 25 years of payments, you can qualify for loan forgiveness (the length of time needed to qualify for forgiveness depends on the program). But principal and interest forgiven through income-driven repayment programs is considered income by the IRS, and taxed as such.

While Congress may someday act to defuse what some have characterized as student loan debt's "ticking tax bomb," it's a risk you currently run if you're hoping for forgiveness (debt forgiven through public service loan forgiveness programs is not taxable).

Let's go back and look at what can happen when you stretch out your loan term. If you're paying back $30,000 in student loans at 6.8 percent interest (a rate that is not unusual for older loans) under the standard 10-year repayment plan, you'd make 120 monthly payments of $345, or a total of $41,429.

Let's say you enroll in the government's REPAYE plan, which limits monthly payments to 10 percent of income. With a starting adjusted gross income of $40,000, your payments would start at a more manageable $186 a month. But they would gradually rise to $457 a month, and you'd have to keep making them for more than 14 years.

By the time your student loan debt is paid off, you'd have made $50,145 in principal and interest payments—$8,716 more than under the standard repayment plan (you can run your own numbers through the Office of Federal Student Aid's repayment estimator).

Refinancing

Another way to manage your student loan debt is to refinance it at a lower interest rate.

Refinancing student loan debt with a private lender is currently the only way to lower your interest rate—Republicans have blocked legislation that would raise taxes to pay for government-backed refinancing at reduced rates. If you consolidate several loans to participate in one of the government's income-driven repayment or loan consolidation plans, you'll end up with an interest rate that's a weighted average of the rates you're already paying.

If you've been making payments on your loans and have a good earnings history and credit, there are a number of private lenders that may be willing to refinance your government or private loans at lower rates.

When you refinance, you lose access to some borrower benefits that come with federal loans, like access to income-driven repayment programs and loan forgiveness. But many borrowers are able to save thousands of dollars by refinancing, and ultimately make a decision that a government program will not benefit them.

Topics:
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  • Loans and Debt Management
  • Student Loans
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  • Loans and Debt Management
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This article was written by Stephen Dash from Forbes and was licensed as an article reprint from March 4, 2016. Article copyright 2016 by Forbes.
The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.
Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.
This reprint is supplied by Fidelity Brokerage Services LLC, Member NYSE, SIPC.
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