Should You Hold Onto Student Loans for Tax Benefits?

After we paid off $110,000 in student loans in just four years my wife and I received a lot of nice notes from family and friends supportive of our efforts to prioritize getting out of debt. I was surprised, however, by the few notes I received from concerned friends telling me I was losing out on valuable tax deductions by paying off all that debt! Were they correct? Were my wife and I leaving money on the table by paying off our student loans early? I decided to crunch the numbers to find out.

Student Loan deductions

If you’re one of the millions of Americans with student loan debt who also pays taxes you’re probably familiar with the Student Loan Interest Deduction. The federal government allows you to deduct the interest you pay on your student loans each year on your tax return. You have to have a qualified student loan (read more from the IRS here on that subject), but provided you meet those parameters if you pay interest in a year on those loans you can reduce your taxes. When my wife and I paid off all of our student loans, we gave up that tax deduction. So how much was that going to cost us, and how much did we save compared to our interest payments?

In crunching the numbers I first needed to know how much we could deduct in a year. The government caps your student loan deduction for interest at $2,500/year. If you paid $1,000,000 in student loan interest, the most you could save on your taxes would still be $2,500 (though, if you pay that much in student loan interest you’re probably too busy being a lawyer-doctor-rocket scientist to notice the $2,500 savings). There are income restrictions too: if you’re filing your taxes as an individual you can’t have more than $80,000 in yearly modified adjusted gross income (MAGI) or if you file as married that number is $160,000 (as of 2015). Since we were married we also suffered a second restriction: we could still only deduct a single total amount up to $2,500; it didn’t double just because we were married! That means the student loan interest deduction has a marriage penalty of $2,500.

We also had to remember we were getting a tax deduction, not a tax credit. This means that the student loan interest we paid reduces the amount of income the government sees us as earning but it doesn’t directly reduce the amount we owe on our taxes.  So your tax bracket impacts the amount you can save; the more you pay in taxes the more you save from the Student Loan Interest Deduction. Here’s a look at the chart up to the earnings level restriction for the student loan interest deduction as a single filer.

Salary Range	Tax Rate	Savings
Up to $9,225	10%	$250
$9,226 to $37,450	15%	$375
$37,451 to $90,750	25%	$625

If you paid the maximum amount of student loan interest, $2,500, you could save $250, $375, or $625 depending on which income bracket you’re in. That’s an important lesson: you’re not saving the amount you pay in student loan interest on your taxes, you’re saving your tax rate percentage of that payment which will always be less than $2,500.

For our situation then the math was a no brainer. Our loans were mostly graduate school loans meaning their interest rate was 6.8%. Our maximum savings every year from paying the most in student loan interest we could would be $625 in taxes. With a ten year repayment plan that’s $6,250 saved in taxes. By paying off $110,000 in student loans at 6.8% interest we saved ourselves over $200,000 in interest payments over the course of a decade.

I don’t need to tell you that $200,000 is a lot more than $6,250.

The average American and student loans

Our situation was out of the norm compared to most Americans who have student loan debt, however. The average student loan debt in 2015 was about $30,000 each year. The average rate of interest for that debt was 4.66% for unsubsidized loans in the same year with a ten year repayment timeframe. If our debt looked a little more like most Americans’, would that impact the math at all?

If we assume that each average American in the $30,000/4.66% situation gets the maximum interest payment benefit each year by paying at least $2,500 and enjoys the maximum tax benefit of $625 they’ll benefit from a tax savings of $6,250 over 10 years, just like for my own hypothetical situation. But the amount of interest they’ll pay on their student loans over that time frame? It’ll be just under $50,000 (and you can check my math using the compound calculator from MoneyChimp here). Verdict? If paying the least amount of money is the goal, aggressively paying off student loans will save you far more in interest payments than keeping that debt around for the paltry tax benefits.

(Find out even more ways to save on your student loans with my guide to student loans here).