This week, Gail has a list of tax breaks available to those who want to further their education, and explains the (strict) rules governing IRA withdrawals to pay for education expenses.
I returned to college last year. Financial grants help out a lot, but I can receive government-subsidized loans to help the remaining costs. I can take out a substantial amount even after all my tuition and books are paid. The interest rate is 3% and of course does not start payments until I am done with school.
My question is this: We have a car loan with about $5,000 left on it at 9% interest. It will be paid off in 2 years. Should I take out extra on my student loans to pay off our car loan at a lower interest? I will be finished with my degree in about 3 years.
Thank you for your advice!
Dear Pamela —
In general, whenever you can replace higher interest debt with lower interest debt, it makes sense to do so. I'm surprised you could get a loan for more than your actual college expenses, but it sounds as if this is something you have already looked into. So I say go for it.
Another thing to consider is that the interest on your car loan is not tax-deductible. Your student loan interest might be. Changes included in the 2001 Tax Act make that a lot more likely.
As of this year, there's been a big increase in the income limit on who can deduct student loan interest charges. Married persons who file jointly and whose adjusted gross income (AGI) is under $100,000 can deduct up to $2,500 per year. There's a partial deduction up until your AGI hits $130,000. Once your AGI exceeds this amount you are no longer eligible. The income phaseout for single filers is $50,000-$65,000.
In addition, there is no longer a 60-month time limit during which the interest on a student loan is deductible. Under the new rules, you can deduct student loan interest for as long as it takes to pay off your loans, provided you meet the income restrictions above.
But don't overlook some important federal tax breaks you might be eligible for right now. The Hope and Lifetime Learning tax credits represent a dollar-for-dollar reduction in your income tax bill — a tremendous saving.
The Hope tax credit is only available to offset expenses (essentially only tuition and fees) incurred in the first two years of post-secondary school. And you have to be carrying at least half a full course load. The maximum credit is $1,500.
The Lifetime Learning tax credit covers also higher education expenses. However, unlike the Hope credit, it's not limited to certain years of college, a certain course load or to a certain time period. If you qualify, you can get this credit for as long as you're attending school —
undergraduate or graduate. This year the maximum credit is $1,000, but it jumps to $2,000 next year.
As you might expect, both credits are only available to taxpayers in certain income brackets. They happen to be the same for either the Hope or Lifetime Learning credit. Married filers will get the full credit if their modified adjusted gross income is under $80,000; for single filers it's $40,000. The credits get phased out above these amounts. And keep in mind you can't qualify for both tax credits in the same year! But this is something you should definitely talk to your tax preparer about.
Furthermore, for a limited time only (no kidding...) taxpayers who are currently paying higher education expenses; can also qualify for another type of tax break. This one isn't subtracted directly from your tax bill; instead , you can use it to reduce the income that you're going to have to pay tax on. In fact, it can help you reduce your income so that you qualify for the tax credits above (although you can't take a deduction and a tax credit for the same expenses).
Married taxpayers who file jointly and whose AGI is under $130,000, can deduct up to $2,000 worth of tuition and fees from their taxable income. For single filers, the AGI limit is $65,000. In 2004, the maximum deduction jumps to $3,000. But in 2006, the deduction completely disappears!
It's really worth your while to sit down with someone who can sort through all of the tax breaks available to make sure you take full advantage of everything you are eligible for. I applaud your decision to further your education.
I have read information stating that if you withdraw money permanently from your 401k that you can waive the 10% penalty IF it is for higher education.
Do you know if this is true? Where can I get information on this?
Dear Terese —
You are confusing the rules which cover withdrawals from your 401(k) plan with those which pertain to withdrawals from your IRA.
Under regulation 72-t in the tax code, if you are under age 59 1/2 and withdraw money from your IRA to pay for higher education expenses (yours, your spouse's, your children or grandkids'), you are not subject to the regular 10% penalty for an "early" withdrawal.
Keep in mind that if you are taking a withdrawal from a traditional (tax-deductible) IRA you will still owe ordinary income tax on the amount.
There are special rules which cover Roth IRAs. Contributions you've made to a Roth IRA can be withdrawn at any time income tax and penalty-free. However, if you start to withdraw either converted dollars or earnings, a penalty could apply.
There is no similar rule which covers withdrawals from your company retirement plan. If you take out a loan, you'd better be prepared to pay it back. If you fail to do so in the allotted time (often 5 years), you will owe both income tax and a 10% penalty.
I strongly recommend you consult a tax professional before making a move. The wrong one could be extremely expensive.
If you have a question for Gail Buckner and the Your $ Matters column, send them to firstname.lastname@example.org along with your name and phone number.
The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.