Student loans: Borrowing today for a brighter future

Now that your loved one is off to school, it’s time to begin paying the tuition and other related expenses. We have a number of tax-advantaged strategies you can consider to help with the high cost of college.

Skyrocketing costs of higher education prompt many college students and their parents to borrow money today as an investment in the future.

The good news is you can deduct interest on loans used to pay for your child’s education at a post-secondary school, including some vocational and graduate schools. (This is an exception to the general rule that interest on student loans is personal interest and, therefore, not deductible.) The deduction is an above-the-line deduction (meaning that it’s available even to taxpayers who don’t itemize). The maximum deduction is $2,500. For 2022, the deduction phases out for taxpayers who are married filing jointly with AGI between $145,000 and $175,000 (between $70,000 and $85,000 for single filers).

Some student loans contain a provision that all or part of the loan will be cancelled if the student works for a certain period of time in certain professions for any of a broad class of employers—e.g., as a doctor for a public hospital in a rural area. The student won’t have to report any income if the loan is canceled and the student performs the required services. There’s also no income to report if student loans are repaid or forgiven under certain federal or state programs for health care professionals. Further, for cancellations of student loans after 2017 and before 2026, there’s no income to report if a student loan is discharged either under certain federal statutes, or due to the death or total and permanent disability of the student. These are exceptions to the general rule that if a loan or other debt you owe is canceled, you must report the cancellation as income.

 Bank loans 

The interest on loans used to pay educational expenses is personal interest which is not deductible unless you qualify for the deduction for education loan interest, described above. The deduction for interest on “home equity loans” (for this purpose, a loan that’s (1) secured by the taxpayer’s home, and (2) not incurred to acquire, construct, or substantially improve the home) is suspended from 2018 through 2025. After 2025, interest on such “home equity loans” will again be deductible, as it was before 2018; thus, after 2025, taxpayers will be able to deduct the interest on “home equity loans,” the proceeds of which is used to pay college expenses. Interest on a “home equity loan” won’t be deductible for purposes of the alternative minimum tax (AMT), a factor which needs to be considered by taxpayers who are subject to the AMT.

Borrowing against retirement plan accounts

Many company retirement plans permit participants to borrow cash. This option may be an attractive alternative to a bank loan, especially if your other debt burden is high. However, the loan must carry an interest rate equal to the prevailing commercial rate for similar loans, and, unless you qualify for the deduction for education loan interest (described above), there’s no deduction for the personal interest paid. Moreover, unless strict requirements are satisfied, a loan against a retirement account is treated as a premature distribution (withdrawal) that’s subject to regular income tax and an additional penalty tax.

Withdrawals from retirement plan accounts. IRAs and qualified retirement plans represent the largest cash resource of many taxpayers. You can pull money out of your IRA (including a Roth IRA) at any time to pay college costs without incurring the 10% early withdrawal penalty that usually applies to withdrawals from an IRA before age 59½. However, the distributions are subject to tax under the usual rules for IRA distributions.

Some qualified plans either don’t permit withdrawals or restrict them. For example, a 401(k) cash-or-deferred plan may allow distributions if the participant has an immediate and heavy financial need and lacks other resources to meet that need. IRS regs name a college education as such a need. To the extent they represent previously untaxed dollars and earnings, amounts withdrawn from a retirement plan are fully subject to tax and are also hit by a 10% penalty tax if they are made before the participant reaches age 59½. (Note, however, that you can’t roll over a 401(k) plan “hardship” distribution into an IRA to set up a later penalty-free withdrawal to pay college costs.)

Not all of the above breaks may be used in the same year, and use of some of them reduces the amounts that qualify for other breaks. So it takes planning to determine which should be used in any given situation. If you would like to discuss one or more of the above planning or payment possibilities, or any other alternatives, in more detail, please call.

Read about tuition tax credits here

Read about scholarships and other gifts here

Read the latest about student loan forgiveness here

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