Author Topic: Student Loan Interest Deduction  (Read 3848 times)

freeedom

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Student Loan Interest Deduction
« on: May 05, 2014, 09:06:23 PM »
I've read many posts advising people to pay student loans before fully funding tax advantaged investment accounts (401k, Roth, etc). With the existence of the student loan interest deduction at $2,500... this should only make sense if the individuals interest amounted to more then $2500 a year.

Granted, there is peace of mind with paying them off. But since the interest is tax deductible, even if you don't itemize.

https://ttlc.intuit.com/questions/1901536-can-i-claim-the-student-loan-interest-deduction

Am I missing something here? It seems like it would make a whole lot more sense to fully fund investment accounts and then use anything extra to pay the loans off.

taekvideo

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Re: Student Loan Interest Deduction
« Reply #1 on: May 05, 2014, 09:34:41 PM »
It's a deduction not a credit... so you're still paying most of the interest yourself
It really depends on the interest rate of course... if it's at 7% or something then definitely pay it off first, but if it's like 3% then maybe do minimums.

MDM

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Re: Student Loan Interest Deduction
« Reply #2 on: May 05, 2014, 11:12:34 PM »
Here's one scenario: a person starts with $10,000 in the bank earning 0%, a $35,000 student loan balance, $60K/yr salary, no state tax and $25K/yr expenses not including federal tax.  Any positive annual cash flow goes into that same 0% bank account.  Net worth = $10K - $35K = -$25K.

Assume student Loan interest rate = 7% and the loan term = 10 years.  That gives a monthly payment of $406.38.  In the first 12 months, total payments will be $4,877: $2,371 interest, $2,506 principal.

The $10,000 is invested in a taxable fund that yields 7% in interest and short term capital gains, so $700 ordinary income.

With standard deduction and 1 exemption, that's a taxable income of $48,179 and a federal tax of $7,901.
At the end of the year, net worth =
-$32,494 (SL principal)
+$10,700 (taxable fund balance)
+$60,000-$4,877-$7,901-$25,000   (annual cash flows)
= $428.


If, instead, the $10K is used to pay down the loan principal to $25K, there is no $700 income and the same $406.38/mo will include $1,648 interest and $3,229 principal.

With standard deduction and 1 exemption, that's a taxable income of $48,202 and a federal tax of $7,907.
At the end of the year, net worth =
-$21,771 (SL principal)
+$0 (fund balance)
+$60,000-$4,877-$7,907-$25,000   (annual cash flows)
= $445.

...and all the above merely confirms the fact that, even accounting for taxes, pre-paying a student loan that has X% interest rate can be essentially identical to investing the same prepayment in a taxable account that earns the same X%.  Because the student loan savings are guaranteed, however, from a risk-adjusted perspective it is better to pay the SL than try for a similar return in a non-guaranteed investment.


But...the OP noted "many posts advising people to pay student loans before fully funding tax advantaged investment accounts (401k, Roth, etc)."  (italics added)
That's a different question.  In the first example above, assume the $10000 was put into a 401k and earned the same 7%.

With standard deduction and 1 exemption, that's a taxable income of $37,479 and a federal tax of $5,226.
At the end of the year, net worth =
-$32,494 (SL principal)
+$10,700 (401K fund balance)
+$60,000-$4,877-$5,226-$25,000   (annual cash flows)
= $3,103.

So that looks much better!   ...except...when that 401k balance is withdrawn, the IRS will take its cut.  Assume the person is in the same 25% bracket when that happens, and subtract 25% * $10,700 from $3,103, and we get...$428, same as the first example.  So the same logic applies: take the guaranteed return if the risky return is, on average, about the same.

Lots of assumptions and calculations above.  I think the calculations are correct - if not, please advise.  I know that using different assumptions is likely to lead to different conclusions, so no quarrels with different conclusions if based on different assumptions.
« Last Edit: May 08, 2014, 02:06:46 PM by MDM »

franny61390

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Re: Student Loan Interest Deduction
« Reply #3 on: May 06, 2014, 10:48:26 AM »
So you going to keep debt so you can keep "earning" a tax deduction? Say you have a student loan of 10,000 dollars at 7% (like the above example) you will pay $700 in interest in one year. This will earn you a $700 tax deduction which will only save you $196 come tax time (assuming a 28% tax rate).

So you are delaying paying off a debt that costs you $700/year to save $196. Nice. 

freeedom

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Re: Student Loan Interest Deduction
« Reply #4 on: May 06, 2014, 10:53:54 AM »
It's a deduction not a credit... so you're still paying most of the interest yourself
It really depends on the interest rate of course... if it's at 7% or something then definitely pay it off first, but if it's like 3% then maybe do minimums.

Makes a lot of sense... all the deduction does is reduce your taxable income... I get it now. Thanks!

seattlecyclone

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Re: Student Loan Interest Deduction
« Reply #5 on: May 06, 2014, 11:55:49 AM »
You can think of the deduction as reducing your effective interest rate. If you're in the 15% tax bracket, for example, the deduction will reduce the interest on a 6% loan to 5.1% (85% of 6%). At the margin, this can make the difference between whether a particular loan should be your top priority right now or not. In general I would say even a 5.1% loan should be prioritized pretty highly. But if you have a 5.5% mortgage and don't itemize your deductions, maybe you would pay that off first.

Cheddar Stacker

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Re: Student Loan Interest Deduction
« Reply #6 on: May 06, 2014, 01:24:35 PM »
So you going to keep debt so you can keep "earning" a tax deduction? Say you have a student loan of 10,000 dollars at 7% (like the above example) you will pay $700 in interest in one year. This will earn you a $700 tax deduction which will only save you $196 come tax time (assuming a 28% tax rate).

So you are delaying paying off a debt that costs you $700/year to save $196. Nice.

I see the general point and it's one I tell people all the time - "It doesn't make sense to spend $1 just to save $0.25 in taxes".

However, you are ignoring the other side of the argument. If you don't pay that $10K towards a SL, you would presumably invest it. If you earned 7%, you would end up with a $700 profit gross, net of $196 in taxes, or $504 net. It would likely be less in taxes since you would get special tax rates for LT Cap Gains and Qualified Dividends.

The real reason to keep the debt (if it makes sense to do so) would be to earn a higher return by investing. This would assume a low interest rate on the SL debt, an employer match on a 401K, or a number of other potential factors.