Get Deduction for School Loan or Take Lower Rate?

By George

Dear Tax Talk, I currently hold a student loan at 6.75% to the tune of $75,000. I'm making $1,500 a month payments on this debt so it will be gone in 59 payments with $13,000 interest paid. I have the opportunity to have a family member loan me the $75,000 and I'll pay them back at 4%, reducing my payments to 55 months and cutting my interest paid to $7,100.

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I'm wondering whether it is smarter to keep the debt at 6.75% to enjoy the (small) tax deduction of paying interest on a student loan (it was $2,000 for 2011), or to have it paid off, lose the tax deduction and save nearly $6,000 on interest? -- Mark

Dear Mark, In 2012, you can deduct up to $2,500 in interest you paid on a qualified student loan. Among other things, your modified adjusted gross income, or MAGI, cannot exceed $75,000 for unmarried taxpayers and $150,000 for married taxpayers filing jointly. The deduction is reduced proportionately for MAGI in excess of $60,000 for single filers and $120,000 for married joint filers.

A qualified loan is a loan you use to pay for qualified education expenses such as tuition and standard room and board. The loan cannot be from a family member. The student loan interest deduction, or SLID, is an adjustment to gross income, which means you can deduct it even if you do not itemize deductions. The SLID is not scheduled to expire.

To determine if the 4% loan is more beneficial than the after-tax deducted 6.75% loan, you need to look at your AGI as well as your tax rate. If you're paying $18,000 a year toward the loan, I'm thinking you probably have good income. If you're approaching the thresholds for deductibility and your income continues to grow, then you may not qualify for the SLID.

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Ignoring that fact, your after-tax interest rate on the deductible student loan is a function of your marginal tax rate. In order to be under the deduction thresholds, your top marginal tax rate cannot exceed 25%. This means you save 25% of the 6.75% interest rate that you paid, or 1.6875%. Therefore, your after-tax rate on the student loan is just more than 5% (6.75 minus 1.6875). That means even after the deduction, you're better off with the family loan.

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