Greetings, fellow taxpayers! At last we meet again. It’s your pal Penny, fresh from the holidays and back in action.

Another day, another tale of IRS adventures in the Taxwise household. This time, ‘ol Penny wrestled the student loan monster into submission with a little help from the pros here at Tax Connections.

To Close or Not to Close, That is the Question

So here’s the skinny. Mr. Taxwise has no student loans to his name. Must be nice. I’m not so lucky: I’ve saddled myself with one mother of a federal consolidation loan. I rolled my undergrad and graduate school debt into one big ball, Uncle Sam tagged it with a 6.1% interest rate, and I’ve been paying on it ever since.

I’m one of the fortunate few that was able to take advantage of the government’s new breed of student loan repayment plans. I am enrolled in an ICR (Income-Contingent Repayment) plan, and it rocks. Here’s some of the perks for those of you who aren’t in the know: qualifying borrowers make manageable monthly payments based on their annual income. The payment changes as income rises or falls, and the maximum loan term is 25 years.

If I manage to stay in the program and I pay as agreed for the life of the loan, any remaining balance will be forgiven when the 25 years are up. Cool, right? But wait – there’s a “little” (and by little I mean huge) caveat: The amount you pay under the ICR plan must be less than the interest your loan accrues. You must make a bulk interest payment once a year or your student loan company will capitalize the unpaid interest.

I learned this the hard way – I have automatic payments set up and my loan’s in pristine standing, but I opened a letter a little late (oops) to discover that my unpaid interest had been tacked to my loan’s principal. Ouch.

I freaked and proceeded to manically review my records. Horrors – they did it last year too. Sneaky, sneaky, sneaky. After almost two years of payments, my loan jumped from $56,000 to almost $59,000. Um, aren’t loan balances supposed to go down?

This leads me to the tax portion of the program. Hubby and I have a rare opportunity to make a one-time payment to kill the loan entirely. However, some family members urged us to consider our tax situation before we made a move.

It’s All About the Taxes

Without going into too much detail and getting Mr. Taxwise all hot and bothered, I’ll just tell you what you need to know for the sake of this little tax talk. In our situation, making the payment would mean turning the money into taxable income for 2013. Currently, the funds are in an account protected from taxation. Therefore, a quandary presents itself quite clearly. If we use the money to pay off the loan, would our increased 2013 tax liability outweigh the student loan interest we’d pay if we kept on paying as agreed?

I spent half a day of frustration looking for an answer to that one. After tears, sweat, and a whole lotta research, I finally came up with some coherent figures. First, I found out that we can deduct up to $2,500 of the student loan interest we pay each year as long as our joint modified adjusted gross income does not exceed $150,000.

That means that we can keep deducting the interest from the loan if our income stays under the limit for the next 20 years. But wait – there’s more! The total interest that we’d pay if the loan continued for the next 25 years would be a whopping $47,311.97. At first glance, you’d think that the tax deduction would offset this amount. $2,500 multiplied by 25 year would come to $62,500, right? We’d be covered.

Not so fast.

The interest is calculated based upon the amount outstanding, which means it starts out high and drops along with the balance. When I checked out the actual amortization schedule for my loan, I found that over its lifetime, we’d only be able to deduct a total of $41,461.32 of interest on our taxes. Since the total interest would be $47,311.97, we would still be $5,850.65 in the red.

Based upon that info alone, it makes sense to pay the thing off now.

However, there’s one final piece to this crazy jigsaw puzzle of mine: what about our increased 2013 tax liability? Even though we’d be $5,850.65 poorer if we chose to keep paying as agreed, wouldn’t next year’s tax hit far outweigh that amount?

That sent me on a quest for info about tax brackets – the new 2013 figures to be exact. I had a hard time finding what I needed online, and I kept getting search results with 2011 and 2012 tax tables. I was about to call it quits, but I had a sudden light bulb moment and headed over to Tax Connections to have a look around.

Before I asked my tax question, I hit the answered questions to see if the info was there. Hallelujah –there it was. The million-dollar question:

 

Debbie Tolbert, Owner/ Manager of Friends Doin Taxes, LLC in Missouri answered with exactly the info I was looking for:

So we’re looking at a major discrepancy between the taxes we’d pay without the added income and those we’d cough up with it. Using Debbie’s table, I was able to calculate the exact figures I needed for Mr. Taxwise and I to mull over our options.

The Final Verdict

Ultimately, it remains to be seen what Mr. Taxwise will do. I, however, have made my choice. Our taxes will be higher in 2013 if we do this – that’s a given. However, we’re going to be taxed on the money when it comes out anyway, so we’ll be paying taxes on it regardless of whether we claim it as income in 2013 or use it later on. No matter what, once we use it, it will be taxed. There is something we can avoid, though: paying all that student loan interest we won’t be able to deduct from future taxes.

So there you have it. I’ve made up my mine – now I’m off to convince Mr. Taxwise to see things my way.

Until we meet again, my taxpaying amigos.

Making Cents Count,

Penny