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The New Alternative
The extreme cost of higher education is well documented. Saving and paying for a child’s college education is a daunting task. The price tag will knock your socks off and the complexity around funding from student loans to scholarships to financial aid will leave you in a maze. Traditional advice in today’s world of higher education funding is to set up a 529 plan and contribute monthly to the account at a level so that when the child reaches age 18 the 529 account balance is sufficient to cover the costs. If the parent was fortunately and disciplined enough to accomplish this goal the parent would pay for all the eligible higher education expenses out of the 529 plan. However, a new tax law has flipped this traditional wisdom on its head in certain scenarios. Taxpayers with the right set of facts (namely, less than $160,000 of modified adjusted gross income) could receive up to $9,000 in tax credits by taking out $10,000 in student loans even when 529 plan dollars are available.
The Costs of Higher Education
The cost of higher education has historically inflated at higher rates than general goods and services. This high inflation has led to the below 2019-2020 prices for schools of choice for high school graduates in Tyler, Texas namely, Texas A&M University, The University of Texas at Austin, The University of Texas at Tyler, Baylor University.
2019 - 2020 Estimated Costs of Higher Education
|Texas A&M||UT Austin||UT Tyler||Baylor|
|Tuition & Fees||$10,926||$11,852||$8,742||$47,564|
|Housing & Meals||$10,400||$11,812||$9,502||$13,413|
|Books & Supplies||$1,222||$700||$1,292||$1,264|
|Total Annual Costs||$28,792||$28,756||$22,118||$65,503|
It is worth noting that the above estimates were taken from the universities’ websites and do not factor in financial aid or scholarships that are more easily obtained at some schools. Nonetheless, the numbers above are intimidating and parents and students find themselves looking for every possible way to lighten the financial burden of higher education. Congress recognized this sharp increase in cost and responded in 1996 by creating the 529 plan and again in 1998 by creating two tax credits, the Lifetime Learning Credit and the Hope Scholarship Credit which was expanded and renamed the American Opportunity Tax Credit in 2009.
The creation of 529 College Saving Plans by Congress introduced a “retirement-like” vehicle for higher education expenses. The account functions much like a ROTH IRA in that it enables parents or others to contribute to the account on an after-tax basis. In other words, there is no federal tax deduction for contributions to the account. Unlike ROTH IRAs, 529 plans can theoretically receive unlimited contributions up to the aggregate contribution limit set by each state ranging from $235,000 to $529,000 in 2020.
The assets inside the 529 plan can then grow and be withdrawn tax free as long as they are used for qualified higher education expenses. Assets that are withdrawn from the plan and not used for qualified higher education expenses are subject to income tax and a 10% penalty to the extent of any pro-rata income included in the distribution. For this reason, if parents have saved 529 plan assets, they tend to default to funding higher education expenses with the 529 plan so as to not have left over funds after graduation, reducing the risk of any tax and penalty on withdrawal. It is worth noting that the beneficiary of the 529 plan can be changed if excess funds are left after a child finishes college.
However, the recent SECURE Act might give people a reason to think twice about where they source their education funds. The SECURE Act provided a widely overlooked provision that allows up to $10,000 of 529 plan distributions to pay interest or principal toward student loans of the beneficiary or the beneficiary’s siblings. This seemingly minor provision could open the door to $9,000 of tax credits for families without incurring any non-qualified withdrawal income tax or penalties. Let me explain the credits below.
The Tax Credits
There are two tax credits available to lessen the blow of tuition bills. The Lifetime Learning Credit and the American Opportunity Credit have different limits, rules, and phase outs but in general both credits are available for the first four years higher education costs paid out of pocket. This means the costs cannot be paid by scholarship, financial aid, or out of a 529 plan since 529 plans have their own tax advantages described above. The American Opportunity Tax Credit is the more advantageous of the two credits and therefore is discussed exclusively below when analyzing the new flexibility provided by the SECURE Act.
Taxpayers must have less than $160,000 in MAGI to be eligible for the full American Opportunity Tax Credit which is calculated by taking 100% of the first $2,000 and 25% of the next $2,000 of qualified expenses not paid out of a 529 plan. Once the taxpayer exceeds $160,000 of MAGI the credits begin to phase out until they are eventually eliminated once MAGI reaches $180,000. The maximum credit is $2,500 each year for the first four years of college per student.
Parents of recent high school graduates with healthy 529 account balances and MAGI of less than $160,000 should now consider taking out $2,500 of student loans each year for the first four years of college. Taking out these student loans to pay for tuition would generate $2,125 of American Opportunity Tax Credit each year resulting in a cumulative reduction in federal income tax of $9,000 over the four years. The student will graduate with $10,000 in student loans and, thanks to the new SECURE Act provision, can pay off those loans with the remaining 529 plan funds tax free and penalty free. For those parents with children approaching college, strong consideration should be given to utilizing student loans even when 529 plan assets are available to maximize any available American Opportunity Tax Credit.