The budget law wrote some new rules for financing higher education. The choices, for borrowing and saving, are going to complicate decision-making. But they’ll save some money for a majority of students and parents. Here’s what’s starting on Jan. 1:
– The tax deduction on loans for higher education.
You qualify for the maximum deduction if you’re single with an adjusted gross income under $40,000 or married under $60,000. As incomes rise, the deduction declines, phasing out at $55,000 for singles and $75,000 for marrieds. After 2002, these income levels will be adjusted for inflation.
The maximum deduction is $1,000 for 1998, $1,500 for 1999, $2,000 for 2000 and $2,500 for 2001 and each year thereafter.
Next year, that roughly equals the interest on a $12,000 Stafford student loan; by 2001, the deduction will cover a loan in the $30,000 range, says Benjamin Tobias of Tobias Financial Advisors in Plantation, Fla.
You can take the deduction only for interest paid during the first five years in which payments are required. If you started repayments in 1996, the write-off ends with your 2000 tax return.
You get the write-off even if you don’t itemize deductions. That will be a big help to new graduates who normally take the standard deduction.
Interest is deductible on loans taken for your own education, that of your spouse or of a dependent. Exception: You can’t deduct interest on loans given by relatives.
What’s your best borrowing strategy going to be? Take the cheapest loans you can get. For most students, that would be subsidized Staffords (currently at 8.25 percent) if you qualify for student aid. Some states and colleges lend at Stafford rates or even below.
Next, turn to unsubsidized Staffords and Plus loans for parents. Ask about them at the college financial-aid office.
Once you’ve borrowed the maximum deductible education loan, borrow against your home equity. Interest is deductible on home-equity loans as large as $100,000.
Divorcing parents may want to rearrange their separation agreement. If one parent claims the child as a tax dependent and the other borrows money for college, as often happens in divorce settlements, neither of you will get the deduction.
– Tax-favored savings accounts.
There’s a new education individual retirement account (although it has nothing to do with retirement). If you qualify, you can invest up to $500 a year for each of your children under 18.
You can’t use your contribution as a tax deduction, but the earnings are entirely tax-free if used for higher education.
Singles qualify for a full contribution with adjusted gross incomes as high as $95,000. When you earn more, the allowable contribution shrinks, phasing out at $110,000. Marrieds get a full contribution with incomes as high as $150,000, phasing out at $160,000.
This isn’t big money. Still, any tax-free account is better than a taxable one. If the child doesn’t use all the money, you can transfer it to another one of your children. If the beneficiary reaches 30 without using the money, it must be withdrawn by the beneficiary, and taxed.
The new law also lets you take money from a regular IRA for education expenses without paying the usual 10 percent tax penalty if you’re under 59 1/2.
What’s your best savings strategy now?
Education IRAs are worth doing only if you start when your child is very young, says financial planner Warren Mackensen of Hampton, N.H.
In the year you use the IRA money, you can’t also use the new education tax credits: the Hope Scholarship credit or lifetime learning credit. If your education IRA is small, these credits will be worth more.
It’s not yet known whether the mutual-fund companies will even offer low-fee education IRAs because they’re so small, Benjamin Tobias says.
Neither you nor anyone else can contribute to an education IRA and a state prepaid tuition plan for the same child in the same year. If you’re sure your child can benefit from the tuition plan, it’s the better choice because you can put more money in.
Anyone, regardless of income, can put up to $2,000 of after-tax money into a regular IRA, let it accumulate tax-deferred, then use it for college, paying income taxes on the gains as they’re withdrawn.
The same withdrawal rules apply to the new Roth IRAs or IRAs funded with pretax dollars. But they’re best left as retirement accounts.
