Consider these tax moves before paying for college and review your student loan tax deduction
IN A PERFECT WORLD, WE’D ALL HAVE ENOUGH MONEY SAVED TO PAY FOR COLLEGE without taking out any student loans. Unfortunately, that’s not the reality we live in. The average annual cost of tuition for a four-year university education is $25,362, while a total chiropractic education and degree is upwards of $200,000. Most people don’t have that kind of cash lying around. Some, if they’ve planned properly, might have it in an investment account, but everyone needs to be aware of their personal student loan tax deduction.
If you’ve already taken out student loans, you can start to address them using a debt repayment calculator. We’re going to talk about how to minimize your tax liability by selectively using your savings and investment accounts to pay for college. You might still need a student loan after all this, but that’s a topic for another day. Let’s examine the costs of going to college and how best to manage them with the resources you have.
The importance of FAFSA
Before you do anything, fill out your Free Application for Federal Student Aid (FAFSA) form. Depending on your family income there may be financial assistance available to you in the form of low-cost student loans, federal grants and work-study programs.
Adult students who pay cash for classes and employees with education supplements from their employers often feel that FAFSA is not necessary. Fill the form out anyway. There are grants available for employment retraining and individuals overcoming challenging childhoods or disabilities. You’re not eligible for any federal aid without a FAFSA form.
Student loan tax deduction: the 529 plan
A 529 plan is an investment account that can be used to save for your education. They are sponsored by states or state agencies, so they’re not your typical investment vehicle. That also means that they are subject to state tax rules, including maximum contribution rates, which vary from state to state. You’re not required to use the 529 plan from your home state.
Like a retirement account, 529 plans are invested in equities and ETFs to help your money grow over time. Contributions are made after-tax, and withdrawals are tax-free, provided they’re used for qualified expenses. This is an important distinction because using 529 plan funds for non-qualified expenses could subject you to penalties and additional income tax.
Qualified expenses include tuition and fees, room and board, on-campus meal plans, books, supplies, and electronics if they’re required for enrollment. In 2019, the SECURE Act added student loans to the 529 plan qualified expense list. You can use up to $10,000 (lifetime) to pay off any unpaid student loan balances. That’s significant if you have the funds for it.
529 plan strategies to minimize tax liability
This is where we get into tax strategies. Begin by adding up all your qualified expenses and then subtracting any tax-free assistance you may have qualified for when you filled out your FAFSA form. Employer assistance should also be deducted since you’re receiving it tax-free from your employer. The remainder of your qualified expenses can be paid with your 529 plan.
Before you start writing checks, investigate the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC). These are both IRS tax credits that should be applied to your expense total before you withdraw funds from the 529 plan. You cannot use them for expenses you’ve already paid with 529 funds. That’s considered “double-dipping” by the IRS.
What’s important to understand about tax credits is that you need to pay the expense up front before you can take a credit on it when you file your taxes. That money needs to come from someplace other than your 529 plan. With the AOTC, it’s up to $2,500 per year for your first four years (undergraduate). The LLC credit can be applied when you go to graduate school.
Using non-parental 529 funds could create a tax liability
Distributions from a 529 plan owned by the student or parent and used for qualified educational expenses are tax-free — however, according to current tax rules, if a student uses funds from a non-parental (i.e., grandparent’s) 529 plan to pay for educational expenses, the student may be required to declare those funds as additional income on next year’s FAFSA.
The FAFSA form is scheduled for changes according to a piece of legislation called the Consolidated Appropriations Act of 2021 (CAA), but the Department of Education has delayed those revisions for the time being. Once fully implemented, they will eliminate the penalty for using non-parental 529 funds. It could take a while for that to impact your student loan tax deduction and go into effect.
Education and the cost of going to college are both active debates and ongoing political issues for the United States Congress. Don’t make any plans based on rumors or news stories. Concepts like “free college” and “forgiven” student loans are often just buzzwords to win voters. Focus on what you can do now, not what might happen tomorrow.
Offset new taxes with tax loss harvesting
This is a more advanced tax strategy, but one that you can easily participate in if you have an investment portfolio in addition to a 529 plan. The IRS, as you know, requires that you declare all your income. They also allow you to declare losses. Many investors look for losses in their portfolio at the end of the year to offset income, thus lowering their tax liability.
Let’s say you have 10 equities or ETFs in your portfolio. Seven have posted an annual gain this year. Three are showing losses. If you sell the three, you can report those losses and your net income comes down, lowering the amount of income tax you owe. Learning to do this while in college will give you a valuable tool for the “real life” that comes after.
Plan your finances for life after college
Now is a great time to learn about tax strategies and how the IRS and state revenue departments work toward your student loan tax deduction. Unless you’re in school for finance or accounting, your college professors are unlikely to teach you this. Feel free to delve deeper into the subject now that you have some general information on it.
Life doesn’t begin after college. You’re already living it. Making the right moves today will benefit you financially down the line. That includes applying for federal student aid, taking advantage of tax credits, and using your 529 plan funds selectively. Try to get through school with the least debt possible, and you’ll thank yourself for it later.
KEVIN FLYNN is a former fintech coach and financial services professional. When not on the golf course, he can be found traveling with his wife or spending time with their nine wonderful grandchildren and two cats. For more information go to credello.com.