Let's play tax games with student debt repayment Forum

[ben4847]

Here is what I need to figure out.

After a year of living like a church mouse, and spending money only on beer, I have about 10k extra in student loans. So I want to pay down debt at the beginning of the summer (2L summer).

Now, the question is, does it make more sense to wait until January 1 to do so.

See, I will get a deduction for any of it which is interest. I don't know how much that is. (have about 100k in debt outstanding). Meanwhile, my 2012 gross income will be 30k. But, my 2013 gross income (assuming offer, and september start date) will be 42k. So will my deduction be worth more in 2013, and will it be worth more enough to justify the 8% interest for an extra 8 months?

[dingbat]

The simple answer is that what you're proposing will never work (learn the difference between a tax credit and a tax deduction)

But, just to show you the math, assuming 8% interest on $10k you're looking at about $530 interest for 8 months
at a tax rate of 25% (federal only) you're saving $137
So the cost to you in delaying is $397

Not to mention, the maximum deduction for student loans is $2.5k and I'm pretty sure the interest on your $100k debt will be much greater than that

[ben4847]

The simple answer is that what you're proposing will never work (learn the difference between a tax credit and a tax deduction)

But, just to show you the math, assuming 8% interest on $10k you're looking at about $530 interest for 8 months
at a tax rate of 25% (federal only) you're saving $137
So the cost to you in delaying is $397

Not to mention, the maximum deduction for student loans is $2.5k and I'm pretty sure the interest on your $100k debt will be much greater than that

1. We are talking about the 10k I can repay, not the whole 100.

2. I am not trying to delay in order to accrue more interest; I am trying to delay so that the interest I pay will be deductible against income for that year.

Imagine that all 10k will be interest. And imagine that my marginal rate for 2012 would be 15%. If so, then the deduction would be worth 1500.
Now imagine I wait until 2014, when my marginal rate will (hopefully) be 36%. The deduction would then be worth 3600, which is 2100 more.

The interest on the loan for 1.5 years is 1200, so it would be worth it. This assumes that the entire 10k would be interest payment, and that I would be itemizing anyway in both years (is this an itemized deduction?)

This does not mean that one should borrow in order to get the deduction, since I need to pay interest on 100k in order to be in this position. I'm only talking about the marginal cost of letting the interest accrue further.

3. But, if you are correct that the maximum deduction is 2.5k a year, then perhaps I should pay only 2.5k this year, and save more for later. But, if I am going to pay 2.5k in 2014 anyway, that would not make sense. In which case, the problem is solved and I should pay it all now.

[Samara]

I do not think tax deduction means what you think it means.

[dingbat]

I just realized my answer before is wrong for one simple reason.

You get the deduction whether you pay today or December first, so you may as well pay today and not get charged 8 months of interest in the portion you pay down.

As for the rest, there's so much wrong here that I don't even know where to begin

[ToTransferOrNot]

Student loan interest deduction has both a cap and a phase-out, but it is above-the-line. That said, the deduction isn't going to mean much for you this year; your federal taxes on your SA income are going to be near-0 already because of education credits and such.

You won't make it into the 35% bracket next year: you won't start working until September at the earliest, so you might have $40-60k in pre-tax income (depending on what you get from your firm as far as relocation help, bar stipend, blah blah). You'll also still have access to some education credits. But even if you were up at 35% and still avoided the phase-out, the deduction is only worth $875. If you pay off $10k now instead, how much that is "worth" depends on how much is applied to principal (keep in mind, interest does not capitalize until you enter repayment, so you don't get any benefit from avoided interest until 6 months after you graduate). How much accrued-but-uncapitalized interest do you have on your highest interest rate account?

[ben4847]

I just realized my answer before is wrong for one simple reason.

You get the deduction whether you pay today or December first, so you may as well pay today and not get charged 8 months of interest in the portion you pay down.

As for the rest, there's so much wrong here that I don't even know where to begin

january first. so that it would be in 2013.

Deduction means you deduct it from gross income or from AGI to reach taxable income. A deduction saves you money at your marginal rate, by reducing taxable income. I know what it means, and I'm using it correctly.

For example, there is a deduction for medical expenses under 213. It is currently limited to the excess over 7.5% of AGI (rising to 10% under the ACA, to offset the costs of the ACA).
So suppose your taxable income is 200k, and you are itemizing already. Your marginal tax rate is 36%--that is, each additional dollar you make is taxed at 36%.
Now suppose you have 50k in medical expenses. You get to deduct the excess over 7.5% of AGI. 7.5% of AGI is 15k, so you can deduct 35k.
200k-35k=165k. So your taxable income is 165k.
200k*.36=72k
165*.36=59.4k A savings of 12.6k.

(I wrote the best basic tax exam in my class.)

[ben4847]

Student loan interest deduction has both a cap and a phase-out, but it is above-the-line. That said, the deduction isn't going to mean much for you this year; your federal taxes on your SA income are going to be near-0 already because of education credits and such.

You won't make it into the 35% bracket next year: you won't start working until September at the earliest, so you might have $40-60k in pre-tax income (depending on what you get from your firm as far as relocation help, bar stipend, blah blah). You'll also still have access to some education credits. But even if you were up at 35% and still avoided the phase-out, the deduction is only worth $875. If you pay off $10k now instead, how much that is "worth" depends on how much is applied to principal (keep in mind, interest does not capitalize until you enter repayment, so you don't get any benefit from avoided interest until 6 months after you graduate). How much accrued-but-uncapitalized interest do you have on your highest interest rate account?

Can you explain that some more. Are you saying that even my gradplus loans don't capitalize the interest until I enter repayment?
But, I should still pay now to prevent it from accruing on the capital. So then I should pay down the loans with the least interest rate, to prevent my payment from being credited to interest which is not accruing interest on itself anyway?

[ToTransferOrNot]

Student loan interest deduction has both a cap and a phase-out, but it is above-the-line. That said, the deduction isn't going to mean much for you this year; your federal taxes on your SA income are going to be near-0 already because of education credits and such.

You won't make it into the 35% bracket next year: you won't start working until September at the earliest, so you might have $40-60k in pre-tax income (depending on what you get from your firm as far as relocation help, bar stipend, blah blah). You'll also still have access to some education credits. But even if you were up at 35% and still avoided the phase-out, the deduction is only worth $875. If you pay off $10k now instead, how much that is "worth" depends on how much is applied to principal (keep in mind, interest does not capitalize until you enter repayment, so you don't get any benefit from avoided interest until 6 months after you graduate). How much accrued-but-uncapitalized interest do you have on your highest interest rate account?

Can you explain that some more. Are you saying that even my gradplus loans don't capitalize the interest until I enter repayment?
But, I should still pay now to prevent it from accruing on the capital. So then I should pay down the loans with the least interest rate, to prevent my payment from being credited to interest which is not accruing interest on itself anyway?

Don't quote me on the gradplus not capitalizing; I could be wrong about that, but my understanding (buttressed by my own experience) is that federal loans don't capitalize interest until you enter repayment.

I'm not sure what you're asking in the second sentence. I doubt it would be helpful for you to pay the lower-interest-rate loan in hopes of getting some benefit from the interest deduction, though; whatever benefit you received would probably be offset by extra interest you accrue later when the gradplus interest capitalizes.

[ben4847]

Student loan interest deduction has both a cap and a phase-out, but it is above-the-line. That said, the deduction isn't going to mean much for you this year; your federal taxes on your SA income are going to be near-0 already because of education credits and such.

You won't make it into the 35% bracket next year: you won't start working until September at the earliest, so you might have $40-60k in pre-tax income (depending on what you get from your firm as far as relocation help, bar stipend, blah blah). You'll also still have access to some education credits. But even if you were up at 35% and still avoided the phase-out, the deduction is only worth $875. If you pay off $10k now instead, how much that is "worth" depends on how much is applied to principal (keep in mind, interest does not capitalize until you enter repayment, so you don't get any benefit from avoided interest until 6 months after you graduate). How much accrued-but-uncapitalized interest do you have on your highest interest rate account?

Can you explain that some more. Are you saying that even my gradplus loans don't capitalize the interest until I enter repayment?
But, I should still pay now to prevent it from accruing on the capital. So then I should pay down the loans with the least interest rate, to prevent my payment from being credited to interest which is not accruing interest on itself anyway?

I doubt it would be helpful for you to pay the lower-interest-rate loan in hopes of getting some benefit from the interest deduction, though; whatever benefit you received would probably be offset by extra interest you accrue later when the gradplus interest capitalizes.

Yeah, that is what I was getting at.

Lemme think about this.
Suppose I will not pay off all my 8% during the first year out, I will want to have the least possible at the 8%. So then it will depend on how much I will save by hitting at the capital in my 6%? ones, compared to an extra year at the 8%. (I'm planning to have no 8% after 2 years. I'm going to continue only spending money on beer, until I'm old and spending it on nursing homes.)

[ben4847]

so then maybe I should make sure to pay at least 2.5k in interest, and then hit the rest at capital on the low interest.

[gionnovi]

As far as I know the only loans that don't capitalize are subsidized staffords (govt pays interest), assuming $100k you probably do have loans where the interest is capitalizing.



Okay even if you graduate May 2012, I'm guessing you'll have six month deferment so you'll have two months in 2012 where you'll be required to pay interest so figure roughly...

Rough estimates. I'd suggest plugging your situation in Excel.

@90k (100k -10k you'd pay) * 8% * 2/12= $1200 interest so the $2500k cap is no issue (unless you start paying in sept when you start, then you'll hit the $2500 cap)

Now if you pay the $10k June 2012 you'll save 6 months of interest...

$10k * 8% = $800

Since your loans are capitalizing your going get the full interest rate deduction...

$30k- $5500 (roughly) - $3800 personal exemption= $20700 taxable income
That results in a tax bill $2670...
Subtract $2500 for student loan interest and your at a taxable income $18,200 and tax of $2295
(then of course you'd use your lifetime learning credit of $2000; irrelevant for our analysis)

So the $2500 student loan deduction saves you $375 in taxes. $375/15%= $2500
The sames tax bracket you'll be in 2013!
Plus you'll save an extra 8 months of interest of $800.

Total savings $800+375= $1175

Now if you deduct in 2013 you only get the marginal benefit of

$2500-$1200 you'd pay anyways for an extra tax deduction of $1300
$1300*15%= $195 extra savings

So by delaying until 2013 you'd cost yourself

$1175-195= $980

Don't forget to consider state taxes.

[dingbat]

As far as I know the only loans that don't capitalize are subsidized staffords (govt pays interest), assuming $100k you probably do have loans where the interest is capitalizing.



Okay even if you graduate May 2012, I'm guessing you'll have six month deferment so you'll have two months in 2012 where you'll be required to pay interest so figure roughly...

Rough estimates. I'd suggest plugging your situation in Excel.

@90k (100k -10k you'd pay) * 8% * 2/12= $1200 interest so the $2500k cap is no issue (unless you start paying in sept when you start, then you'll hit the $2500 cap)

Now if you pay the $10k June 2012 you'll save 6 months of interest...

$10k * 8% = $800

Since your loans are capitalizing your going get the full interest rate deduction...

$30k- $5500 (roughly) - $3800 personal exemption= $20700 taxable income
That results in a tax bill $2670...
Subtract $2500 for student loan interest and your at a taxable income $18,200 and tax of $2295
(then of course you'd use your lifetime learning credit of $2000; irrelevant for our analysis)

So the $2500 student loan deduction saves you $375 in taxes. $375/15%= $2500
The sames tax bracket you'll be in 2013!
Plus you'll save an extra 8 months of interest of $800.

Total savings $800+375= $1175

Now if you deduct in 2013 you only get the marginal benefit of

$2500-$1200 you'd pay anyways for an extra tax deduction of $1300
$1300*15%= $195 extra savings

So by delaying until 2013 you'd cost yourself

$1175-195= $980

Don't forget to consider state taxes.

Great analysis
But, I'm not sure if you can take a deduction for interest on student loans if you take the personal exemption rather than itemized deductions. (which would make this whole conversation rather moot, come to think of it)
Anyone with more experience care to chime in?

[bdubs]

You can pay off only the accrued interest on your 100k in loans. It will probably be less than 10K, but you will get to deduct all of it. Student loan interest is deductible regardless of whether you itemize or not, in fact most people who itemize make too much money to qualify anyway.

Your interest does not capitalize on your loans until you enter repayment. So any payments you make during school will have no effect on your future loan balance, they will only reduce the amount of interest that capitalizes as of the day you enter repayment.

If you wait until after graduation you might make too much money to get any interest deduction (depends on your start date).

[gionnovi]

You can pay off only the accrued interest on your 100k in loans. It will probably be less than 10K, but you will get to deduct all of it. Student loan interest is deductible regardless of whether you itemize or not, in fact most people who itemize make too much money to qualify anyway.

Your interest does not capitalize on your loans until you enter repayment. So any payments you make during school will have no effect on your future loan balance, they will only reduce the amount of interest that capitalizes as of the day you enter repayment.

If you wait until after graduation you might make too much money to get any interest deduction (depends on your start date).

I think the phaseout for student loan interest is $75k a year of income.

At 8% his capitalized interest will almost certainly be more than $10k... Don't forgot the capitalized interest compounds

E.g. Assume 8% interest borrow $100k Jan 1 Yr1..

loan balance Jan Yr2
$108k

loan balance Jan Yr3

$108+(108*.08)= $11640

and on it goes. Except the bank probably does this daily.



In any case, you can certainly pay off your principal early. I know because I've done it. For all practical purposes the principal/capitalized interest are the same thing (except for purposes of the tax deduction).

[bdubs]

At 8% his capitalized interest will almost certainly be more than $10k... Don't forgot the capitalized interest compounds
...

and on it goes. Except the bank probably does this daily.

Capitalization on student loans doesn't work the same as it does for normal loans. The interest calculated is simple interest for the entire period you're in school. After you exit deferrment and enter repayment, then the interest begins to compound.

[gionnovi]

At 8% his capitalized interest will almost certainly be more than $10k... Don't forgot the capitalized interest compounds
...

and on it goes. Except the bank probably does this daily.

Capitalization on student loans doesn't work the same as it does for normal loans. The interest calculated is simple interest for the entire period you're in school. After you exit deferment and enter repayment, then the interest begins to compound.

Interesting.. I didn't know that, I guess I just assumed it would compound like a normal loan..

I only took out subsidized loans so I don't have any first knowledge. Anyways, good to know.

So in my example
it'd be
$116,000 at year 2 and not $116640.....

That probably changes some of my other math from above too, if the payments first apply to that capitalized interest and don't reduce the principal. I.e. your not really paying interest on the interest until deferment, so if the early payment is applied to interest your not really getting the 8% savings.


So I guess if the payment is then first applied to the interest just pay $2500 and get the max deduction.. and then take the other $7500 and invest it until you exit deferment.
Or maybe there are some private loans he has that don't work that way.. and he'd still get a benefit from paying those sooner.

[dingbat]

Does anyone know if you can even deduct student Liam interest if you don't itemize your deductions?

If student loan interest can only be deducted if you itemize, I bet the entire foregone discussion would be pointless (I assume OP would take standard deduction instead - therefore no benefit to waiting)

[gionnovi]

Does anyone know if you can even deduct student Liam interest if you don't itemize your deductions?

If student loan interest can only be deducted if you itemize, I bet the entire foregone discussion would be pointless (I assume OP would take standard deduction instead - therefore no benefit to waiting)

Student loan interest is above the line. You deduct it before you arrive at your AGI.

After you get to AGI you choose to itemize or standard deduction.

See line 33 and 40 respectively... http://www.irs.gov/pub/irs-pdf/f1040.pdf

[bdubs]

The big deal here is the origination fees on your loans for 3L. The origination fee is a flat 4% up front. I think you're most likely better off not taking out 10k in loans for 3L since you'd have to pay 4% on the principal + 7.9% interest throughout the year (for grad plus).