Consider Taxes When Choosing and Paying Off College Loans
RIA Senior Tax Analyst Focuses on the Fine Print of the Education Loan Interest Deduction—Plus Some Other Tax Breaks For Students and Their Parents.
New York, NY 08/16/2007
By now, the excitement of receiving college acceptance letters may be replaced by the shock of tuition bills that follow enrollment. Or the joy of a child’s graduating from college—and no longer incurring tuition—is eclipsed by the obligation to repay student loans. “As families scramble to get the largest grants and lowest interest rate loans available, they should not overlook the tax implications of the plans they choose and the way they choose to make their payments,” advises Bob D. Scharin, RIA Senior Tax Analyst from Thomson Tax & Accounting, a part of The Thomson Corporation (NYSE:TOC,TSC:TOC).
“The tax breaks fall into two categories: ones for paying the education costs themselves and deductions for paying interest on loans used to pay the bills. Most of the tax relief provisions are restricted to those with incomes below specified amounts, and those amounts vary from one tax provision to another,” Scharin says. “This adds confusion for families attempting tax planning.”
Education loan interest. In 2007, you can deduct (regardless of whether you itemize your deductions or claim the standard deduction) up to $2,500 of interest paid on qualified education loans. These loans must be used to pay college tuition for yourself, your spouse, or your dependents within a reasonable period before or after the debt is incurred. (The deduction is also available for interest on loans used to refinance qualified education loans.) Families should be aware of these crucial restrictions on the deduction, however:
• The deduction phases out in the $110,000 to $140,000 modified adjusted gross income range for joint return filers ($55,000 to $70,000 for others).
• Your child cannot claim the deduction if he or she is your dependent.
• If you are married, you must file a joint tax return to claim the deduction.
• The $2,500 limit on the deduction applies to married individuals filing joint returns as well as to singles. “This can result in a marriage penalty, as individuals with large student loans would see their deduction amount reduced from an aggregate of $5,000 to only $2,500 after marriage,” Scharin observes.
• You must be legally obligated to make payments or order to deduct the interest you pay. “If only your child has a legal obligation to repay his or her education loan, you cannot deduct interest payments you make on the loan, even if your child is your dependent,” Scharin explains.
• If you are not legally obligated to make the payments, but you make them for your non-dependent child, your child may claim the deduction. The tax law treats the situation as if you gave the money to your child, who subsequently used it to pay the interest.
• If both you and your child are legally liable for the loan, and you intend to make the repayments but your income is too high to claim the interest deduction, Scharin suggests this strategy: “Consider giving the funds to your child to make the repayments. Assuming your child’s income is low enough to qualify for the deduction and is not your dependent, your child will get the deduction that you earn too much to claim.”
Alternatively, instead of claiming the education loan interest deduction, you can claim a deduction for interest paid on a home equity loan that is used to pay college expenses. This type of deduction is classified as an itemized deduction, so it is not available if you claim the standard deduction. Unlike the other education tax breaks, however, it is available to married individuals filing separately. The aggregate home equity loan amount on which interest is deductible is $100,000 ($50,000 for married individuals filing separately). Eligibility for this deduction is not subject to income limitations, but the debt must be secured by your residence.
Education costs. You may be entitled to a Hope credit, Lifetime Learning credit, or higher-education expense deduction if you pay tuition and fees for yourself, your spouse, or your dependents to attend college. Married individuals who file separate returns do not qualify for these tax breaks. For 2007–
• The Hope credit is generally capped at 100% of the first $1,100 you pay per eligible student and 50% of the next $1,100 for each of the first two years of an individual’s college education. Thus, the maximum annual tax savings from this credit is $1,650 per student.
• The Lifetime Learning credit is generally capped at 20% of the eligible expenses of up to $10,000. (The $10,000 figure is an aggregate amount, regardless of how many students the taxpayer is putting through college.) Consequently, the maximum annual tax savings from the credit is $2,000.
• The tuition deduction is a maximum of $4,000 (or $2,000 if your income exceeds a certain level—see below). The tax savings that this deduction produces depends on your tax bracket.
In 2007, the Hope and Lifetime Learning credits phase out in the $94,000 to $114,000 modified adjusted gross income range on a joint return ($47,000 to $57,000 for other taxpayers).
The higher-education expense deduction has a $4,000 maximum if your modified adjusted gross income does not exceed $130,000 on a joint return ($65,000 for others); the maximum deduction is $2,000 if your income is $130,001 to $160,000 on a joint return ($65,001 to $80,000 for others). Note that these income maximums are cutoff points, rather than phaseout ranges. If you have one dollar of income above a cutoff point, you get no deduction. Also, the higher-education expense deduction is scheduled to expire at the end of 2007—although it has been extended in the past and could certainly be given new life again.
Other tax provisions. Subject to various restrictions, families may also qualify to cash in U.S. savings bonds tax-free if the proceeds do not exceed eligible college costs. Eligibility phases out in for modified adjusted gross income in the $98,400 to $128,400 range for joint return filers and $65,600 to $80,600 for others. Also, because the bonds must have been issued after the owner reached age 24, this tax break is geared more to parents than to the students themselves. And this break is not available to married taxpayers filing separately.
Another education incentive in the tax law is that taxpayers may withdraw funds tax-free from a Section 529 plan or Coverdell IRA to use for qualified higher-education costs.
“College students and their parents undoubtedly need to keep up to date on the latest rules for financial aid and student loans. While doing so, they should not overlook the variety of education incentives in the Internal Revenue Code,” says Scharin.
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