Should your Child Graduate from College Loaded with Debt?   

Recent surveys show that the second greatest fear parent’s have is how to pay for college. With college costs rising at an average annual rate of 7%, paychecks are not keeping up. Many parents have to choose between saving for retirement and paying for college. Only 4% of parents have saved more than $5,000 for college. The equity in the principal residence is tapped my the majority of cash-strapped parents.

The survey also revealed that 43% of students take five years to graduate. Some of those students probably took so-called sabbaticals, preferring to travel and gain a new perspective. Others may be having academic problems. Whatever the reasons, the effect is to help parents stretch out the payments and the debt. While stretching out the incursion of debt may be a temporary solution to cash-strapped parents, it doesn’t really reduce the total overall debt.

The culture of America is for parents to pay all of the undergraduate college costs and let the kids pay for graduate program costs. Are there tax, financial planning, and psychological benefits of having the kids share some of the burden?
 
Overview of Tax Changes 

Beginning in 2002, the Economic Growth and Tax Relief Reconciliation Act of 2001 increased the phaseout ranges for eligibility for the student loan interest deduction. The new phaseout ranges begin at $100,000 and end at $130,000 for married filing joint taxpayers, and begin at $50,000 and end at $65,000 for single or head of household taxpayers. These ranges were adjusted for inflation after 2002.

Beginning in 2002, there is no time limit for deducting student loan interest. The old rule used to be after a 60 month period, no deduction was allowed.

Beginning in 2002, the annual student loan interest deduction limit is $2,500. Unfortunately, a limit was retained by the new tax Act. Divide the $2,500 by the applicable interest rate and you get the maximum tax-efficient debt that a student should incur. Generally that would be in a range of $27,000 to $42,000.

Massachusetts follows the federal rules on student loan interest. They allow a deduction of up to $2,500 for an unlimited time period.

Unchanged is the rule allowing student loan interest to be deducted towards adjusted gross income. Confusing to some, this simply means that the interest is deductible regardless of whether the taxpayer itemizes or takes the standard deduction. This is a benefit for those who do not own a home and might not otherwise be able to itemize their deductions. It is ideally suited for kids paying off student loans.

Also unchanged is the requirement that the student be enrolled at least half-time in a recognized educational creditional program and that the loan must be from a financial institution, governmental unit, educational institution, and other entities that provide qualified education loans.
 
Income Tax Planning Considerations
 
Planning to maximize the student loan interest deduction is not always predictable, but there are a few certainities. Perkins loans, subsidized Stafford loans, and unsubsidized Stafford loans are all taken out in the student’s name and payment of interest is not due until six months after the student leaves college or ceases to be enrolled at least on a half-time basis. However the most the a student can borrow is currently $17,125 with a Stafford loan and $16,000 with a Perkins loan. Also, these loans are need-based, meaning the fact pattern of financial aid forms demonstrate that the expected family contribution is less than the net cost of college.

PLUS loans offer help without having to show need. The Federal PLUS loans are made to parents, and if the parent is in college, payments are deferred. If the child is in college, payments are not delayed. Sallie Mae has a student loan PLUS program that is unrelated to any need shown by the financial aid forms. This means the student and parents should be able to determine the desirable amount to borrow, both from a tax and financial planning viewpoint. This program also defers payments until after the student leaves college.

All of these loans have standard repayment periods of ten years. Since the new tax law extended the deduction period indefinitely, it doesn’t make any difference who has the obligation to repay.

Phaseout ranges will play a large role in determining the split between parent and student. They will also influence greatly the structure of the loan. In connection with this, the problem is determining the earning potential and marital status of the student upon graduation. Obviously, a student who is looking to enter a highly paid profession may reach the upper limit of the phaseout range rather quickly. In other situations, it can be quite unpredictable.

The phaseout range of the parents is usually more predictable. If the adjusted gross income is expected to exceed the phaseout range, the planning is easy: allocate more of the borrowing to the student.

An important factor to keep in mind is that the interest on PLUS loans cannot be deducted as home equity interest. The home cannot be pledged as security, thus disqualifying the loan interest deduction.

A home equity loan taken out by the parents can make more sense from a tax minimization standpoint. It can also make sense from a financial aid assessment viewpoint. While the interest payments cannot be deferred, they may be fully deductible, depending on the amount of adjusted gross income (AGI). Itemized deductions, which include home equity interest, are reduced when AGI exceeds the phaseout threshold of $132,950 on a joint return or $66,475 on a single or head of household return, itemized deductions are reduced. Usually the reduction is 3% of the difference between the AGI and the phaseout threshold, limited to no more than 80% of the difference.
 
Financial Planning Considerations

How many students think ahead to the time when they will be married, looking towards the purchase of a house, and facing limitations due to the amount of debt they are carrying. The debt load could consist of a car loan, a credit card balance, and the student loan. Currently, the maximum monthly payments of all debt, including the monthly mortgage payment, house carrying costs (insurance and taxes), and all other debt cannot exceed 36% of monthly gross income. Students with an overload of debt will find themselves limited or even shut out from the housing market.

Aside from future house purchases, just the current cash flow constraints of having to meet all living costs plus student debt payments can be financially and psychologically depressing. Before a student loads him or herself down with debt, he or she should seriously consider other alternatives.

One alternative is a half-time schedule. This should permit the student to earn his or her way through college or at least minimize the debt load. An accelerated night school program may fit into the half-time strategy. The student must be careful about going below a half-time schedule since that would sacrifice the loan interest deduction and the HOPE Credit but not the Lifetime Learning Credit which for 2003 and after is a maximum of $2,000 versus the $1,500 maximum for the HOPE credit.

Another alternative is either a community, junior college or an online college.  The terrible decision between the top tier schools and a low cost alternative, such as an online college, can make the difference between financial burdens and financial freedom later on. However, if the student transfers after the second year to a “name” school (assuming it accepts the credits), the only name that might appear on the resume is the college the student graduates from.

Parents also need to make hard choices between college and retirement savings. Maximizing 401K plan contributions alone is not enough to supply a comfortable retirement. Yet, parents who face the enormous cost of higher education usually wind up sacrificing for their children. That’s not always a sensible choice.