The Internal Revenue Service makes the effective interest rate on a student loan much lower than the advertised price because the agency allows you to deduct interest payments. However, if you make too much money you cannot take this deduction, which means you may need to start tax planning early to reduce your adjusted income.
Income Limit
In 2010, the IRS limited the student loan interest deduction to taxpayers that earn less $75,000 in modified adjusted gross income or $150,000 for joint payers. Modified adjusted gross income refers to income before factoring above-the-line deductions. The student loan interest deduction is an above-the-line tax break, which means you deduct it from income before choosing to itemize or take the standard deduction. Thus, you cannot use the student loan interest deduction to qualify for the deduction itself.
Phaseout
The IRS phases out the student loan interest deduction for certain income ranges. In 2010 this was $60,000 to $75,000 for single payers and $120,000 to $150,000 for joint returns. To calculate your phaseout, multiply the interest you paid by your modified adjusted gross income minus the upper tier of the deduction's income limit and divide by the range of phaseout. For example, if you paid $600 in interest and had a MADGI of $70,000 as a single payer, the deduction is ($600) x ($70,000 - $60,000/$15,000) or $400. Then subtract that value from the interest paid or ($600 - $400) for a deduction of $200.
About Modified Adjusted Gross Income
If you take the student loan interest deduction, you may need the help of a tax professional to compute your MADGI. While you can subtract certain expenses, such as self-employment tax and losses on investments, you must add back some deductions and expenses, such as the foreign housing deduction and foreign earned income, as well as any earned income if you are a resident of Puerto Rico or America Samoa.
Tip
If you have a high income, you should start preparing next year's taxes now. For example, you can lower your MADGI by making contributions to an individual retirement account. Also, even if you meet the income limits of the deduction you may not qualify to take it. For instance, you cannot take the student interest deduction unless you have a legal responsibility to pay the loan, which means you took out the loan or cosigned on it.
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