Student Loan Tax Deduction and Student Loan Management

Consider these tax changes before you pay for college and review your student loan tax deduction

IN A PERFECT WORLD, WE ALL HAVE ENOUGH MONEY SAVED TO PAY FOR SCHOOL without taking out a student loan. Unfortunately, that is not the reality we live in. The average annual tuition cost for a four-year college education is $25,362, while a chiropractic education and degree totals over $200,000. Most people don’t have that kind of money lying around. Some, if they planned well, might have it in an investment account, but everyone should be aware of their personal student loan tax deduction.

If you already have student loans, you can start paying them off with 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 your education. You may still need a student loan after all of this, but that’s a topic for another day. Let’s look at 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). Depending on your family income, financial assistance may be available to you in the form of low-cost student loans, federal grants, and work-study programs.

Adult students who pay cash for tuition and employees with education supplements from their employers often feel that FAFSA is unnecessary. Complete the form anyway. There are grants available for career retraining and people overcoming difficult childhoods or disabilities. You are not eligible for any federal assistance 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 are not your typical investment vehicle. This also means that they are subject to state tax rules, including maximum contribution rates, which vary from state to state. You are not required to use your home country’s 529 plan.

Like a retirement account, 529 plans are invested in stocks and ETFs to grow your money over time. Contributions are made after tax and withdrawals are tax-free, provided they are used for qualifying expenses. This is an important distinction because using 529 plan funds for ineligible expenses could subject you to penalties and additional income tax.

Eligible expenses include tuition and fees, room and board, on-campus meal plans, books, supplies, and electronics if required for enrollment. In 2019, the SECURE Act added student loans to the list of eligible expenses for the 529 plan. You can use up to $10,000 (lifetime) to pay off any outstanding student loan balance. It is important if you have the funds for it.

529 plan strategies to minimize tax liability

This is where we come into tax strategies. Start by adding up all of your qualifying expenses, then subtracting any non-taxable assistance you may be entitled to when you completed your FAFSA form. Employer assistance should also be deducted since you receive it tax-free from your employer. The rest of your eligible expenses can be paid with your 529 plan.

Before you start writing cheques, find out about US Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC). These are two IRS tax credits that must be applied to your total expenses before withdrawing funds from the 529 plan. You cannot use them for expenses that you have already paid with 529 funds. This is considered “double-dipping” by the IRS.

The important thing to understand about tax credits is that you have to pay the expense up front before you can get a credit for it when you file your taxes. This money must come from somewhere other than your 529 plan. With AOTC, it’s up to $2,500 per year for your first four years (undergraduate). LLC credit can be applied when pursuing higher education.

Use of non-parental 529 funds could create tax liability

Distributions from a student-owned or parent-owned 529 plan used for eligible educational expenses are tax-exempt – however, under current tax rules, if a student uses funds from a 529 non-parental (i.e. grandparent) funds to pay educational expenses, the student may be required to report those funds as additional income on next year’s FAFSA.

The FAFSA form is set to be amended under a law called the Consolidated Appropriations Act of 2021 (CAA), but the Department of Education has delayed those revisions for now. When fully implemented, they will eliminate the penalty for using non-parental 529 funds. It may take some time for this to impact your student loan tax deduction and take effect.

Education and the cost of college education are both active debates and ongoing policy issues for the United States Congress. Don’t make any plans based on rumors or reports. Concepts like “free college” and “forgiven” student loans are often just buzzwords for winning over voters. Focus on what you can do now, not what might happen tomorrow.

Compensate for new taxes with the collection of tax losses

This is a more advanced tax strategy, but one you can easily participate in if you have an investment portfolio in addition to a 529 plan. The IRS, as you know, requires you to report 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, thereby reducing their tax liability.

Let’s say you have 10 stocks or ETFs in your portfolio. Seven posted an annual gain this year. Three show losses. If you sell all three, you can claim those losses and your net income goes down, reducing 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

This is a great time to learn more about tax strategies and how the IRS and state tax departments are working toward your student loan tax deduction. Unless you’re majoring in finance or accounting, your college professors probably won’t teach you this. Feel free to dig deeper now that you have some general information about it.

Life doesn’t start after college. You already live it. Making the right choices today will benefit you financially down the line. This includes applying for federal student aid, using tax credits, and using funds from your 529 plan selectively. Try to finish school with as little debt as possible and you’ll thank yourself 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, visit credello.com.

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