Tax Tips
College Expenses - How to Pay For Part II - November 2002
Richard Scrivanich - Partner
This month we'll wrap up our discussion on paying for your children's college expenses by looking at three more methods.
Student loans.
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. However, the deduction phases out for taxpayers who are married filing jointly with AGI between $100,000 and $130,000 (between $50,000 and $65,000 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 he performs the required services. This is an exception 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 generally not deductible (unless you qualify for the deduction for education loan interest, described above). However, if the loan is "home equity indebtedness," and interest on the loan is "qualified residence interest," the interest is deductible for regular income tax purposes, although not for alternative minimum tax purposes. If interest is deductible as qualified residence interest, it can't be deducted as education loan interest.
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 59 ½. (Note, however, that you cannot roll over a 401(k) plan "hardship" distribution into an IRA to set up a later penalty-free withdrawal to pay college costs.)
A younger plan participant may avoid triggering the penalty tax by annuitization payouts from an IRA or a SEP. This method doesn't work for 401(k) type plans. The strategy works because the penalty tax doesn't apply if annual or more frequent withdrawals are made in substantially equal payments over the life or life expectancy of the taxpayer (or the joint lives or joint life expectancies of the taxpayer and designated beneficiary).
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 me at (562) 698-9891.
Return to Tax Tips Archives
All rights reserved. For personal use only.
Do not duplicate or distribute without permission. All information in this
article is for informational purposes only.
Some of the articles included here were written in a prior
year or before a current tax law change. Therefore some of the information in
the older articles may not still be valid. Any dollar thresholds indicated
relate only to the year for which the article was written and could be different
for the current year. Please discuss with us your personal situation before
acting on any of the information provided. If you have any questions,
please give us a call at (562) 698-9891.
|
