It’s tax time, and your kitchen table is littered with papers and forms. As if this isn’t bad enough, you recently paid your child’s college semester bill, and you don’t know where you’ll find the money to pay the taxes that you expect to owe. Well, you might finally catch a break. Now that your child is in college, you might qualify for one of two education tax credits — the American Opportunity credit and the Lifetime Learning credit. And because a tax credit is a dollar-for-dollar reduction against taxes owed, it’s more favorable than a tax deduction, which simply reduces the total income on which your tax is based.
The American Opportunity credit is a tax credit that covers the first four years of your, your spouse’s or your child’s undergraduate education. Graduate and professional courses aren’t eligible. The credit is worth a maximum of $2,500. It’s calculated as 100% of the first $2,000 of tuition and related expenses that you’ve paid for the year, plus 25% of the next $2,000 of such expenses.
To take the credit, both you and your child must clear some hurdles:
The American Opportunity credit can be taken for more than one student in the same year, provided each student qualifies independently. So, if you have twins who are in their freshman year of college (and you otherwise meet the requirements), your credit would be worth $5,000.
However, there are other restrictions. You can’t take both the American Opportunity credit and the Lifetime Learning credit in the same year for the same student. And whatever education expenses you cover with a tax-free distribution from your 529 plan or Coverdell education savings account can’t be the same expenses you use to qualify for the American Opportunity credit.
The Lifetime Learning credit is a tax credit for the qualified education expenses that you, your spouse, or your child incur for courses taken to improve or acquire job skills (even courses related to sports, games, or hobbies qualify if they meet this requirement!). The Lifetime Learning credit is less restrictive than the American Opportunity credit. In addition to college expenses, the Lifetime Learning credit covers the tuition expenses of graduate students and students enrolled less than half-time.
The Lifetime Learning credit is generally worth a maximum of $2,000. It’s calculated as 20% of the first $10,000 of tuition and related expenses that you’ve paid for the year.
One major difference between the American Opportunity credit and the Lifetime Learning credit is that the Lifetime Learning credit is generally limited to a total of $2,000 per tax return, regardless of the number of students in a family who may qualify in a given year. So if you have twins who are in their senior year of college, your Lifetime Learning credit would be worth $2,000, not $4,000.
To qualify for the maximum Lifetime Learning credit in 2019, your MAGI must be below $58,000 if you’re a single filer and $116,000 if you’re a joint filer. A partial credit is available for single filers with a MAGI between $58,000 and $68,000 and joint filers with a MAGI between $116,000 and $136,000.
As with the American Opportunity credit, if you withdraw money from your 529 plan or Coverdell ESA in the same year that you claim the Lifetime Learning credit, your withdrawal cannot cover the same expenses that you use to qualify for the Lifetime Learning credit.
The American Opportunity credit and the Lifetime Learning credit cannot be claimed in the same year for the same student, so you’ll need to pick one. Because the American Opportunity tax credit is available for all four years of undergraduate education, is worth more ($2,500 vs. $2,000), and the income limits to qualify are higher, that credit will probably be your first choice. But if your child is attending school less than half-time, the Lifetime Learning credit will be your only option (assuming you meet the income limits).
Every year that you pay college tuition you should receive Form 1098-T from the college, showing the tuition expenses you’ve paid for the year. Then, at tax time, you must file Form 8863 to take either credit. If you are married, you must file a joint return to take either credit. For more information, see IRS Publication 970 or consult a tax professional.
If you own a home and have equity in it, you might consider taking out a home equity loan as a source of funds for your child’s college expenses. Alternatively, you might decide to refinance your mortgage to one with a lower interest rate or a longer term in order to create more discretionary income each month that can be used for education purposes. To qualify for a home equity loan or mortgage refinancing, you usually need a good credit history.
Mortgage refinancing refers to the process of taking out a new home mortgage and using some or all of the proceeds to pay off an existing mortgage. The main purpose of refinancing is to save money by taking advantage of lower interest rates or to lower monthly payments by extending the term of the loan. By doing so, you free up money that can immediately be used for education expenses.
There are actually two types of refinancing: a no-cash-out refinancing and a cash-out refinancing. A no-cash-out refinancing is when the amount of the new loan doesn’t exceed the mortgage debt you currently owe, plus points and closing costs. You can generally borrow up to 95 percent of your home’s appraised value with this type of refinancing.
A cash-out refinancing is when you borrow more than you owe on your current mortgage. You can then use the excess proceeds however you wish. Many people use this type of refinancing to pay off other outstanding loans. However, you are generally limited to borrowing no more than 75 to 80 percent of your home’s appraised value with this type of refinancing.
Keep in mind that closing costs are charged when you refinance your mortgage (points, application fees, filing fees), but lenders may eliminate these costs in an effort to gain your business. And, of course, your home serves as collateral for the new mortgage, just as with your original mortgage.
Home equity financing uses the equity in your home to secure a loan. It is structured as either a home equity loan or a line of credit.
With a line of credit, the lender establishes a credit limit, which depends on the equity in your home and your ability to make payments. You can then access as much money as you need (up to the limit), whenever you need it, by writing a check or using your credit card. Generally, interest rates are variable and tied to an index. Your monthly payments will also vary, depending on your outstanding balance.
With a home equity loan (often referred to as a second mortgage), you borrow a fixed amount (typically no more than 80 percent of the equity in your home), which is transferred to you in full at the time of the closing. You must then repay that amount over a fixed term. If you repay the loan, the lender discharges your mortgage. If you do not repay the loan, the lender can foreclose on your home to satisfy the debt.
Home equity financing generally means a more favorable interest rate compared to an unsecured, personal loan, because your home secures the loan.
The major disadvantage of home equity financing is that your home is at risk because it serves as collateral for the loan. As such, the lender can foreclose on your home if you fail to repay the loan.
If you need to borrow funds for college, a home equity loan might be appropriate. Compare the interest rate you can get on a home equity loan or line of credit with the cost to borrow elsewhere. If you think there is any chance you will have difficulty paying the loan back in the future, you should think twice. A home equity loan or line of credit is secured by your house, and the lender can foreclose on it if you default.
The decision whether to refinance your mortgage is usually dependent on current mortgage rates. If the current rate is more favorable than the rate of your current mortgage, the decision to refinance will likely hinge on whether you expect to stay in your current home long enough to recoup the costs of refinancing. You might also choose to refinance to a mortgage with a longer term in order to lower your monthly mortgage payment. For example, you now have a 15-year mortgage but will refinance to a 30-year mortgage.
As the name suggests, an employer-sponsored retirement plan is a plan that an employer sets up and maintains for its employees’ retirement. A qualified retirement plan is an employer-sponsored retirement plan that receives special tax treatment under federal law. 401(k) plans and profit-sharing plans are common examples of qualified employer-sponsored retirement plans.) The tax benefits of a qualified plan generally include pretax contributions and tax-deferred growth of investment earnings. In return for such benefits, qualified plans generally must comply with specific federal rules set forth under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC).
If your employer offers a qualified retirement plan and you have money in the plan, this may be a source of funds for college expenses. However, most financial professionals recommend tapping retirement accounts for college expenses only as a last resort.
There are two possible ways to access funds in your employer retirement plan: borrowing or withdrawing. However, not all employer plans may allow borrowing.
Some employer-sponsored plans allow you to borrow against the funds in your plan, as long as you have a vested balance in the plan. The amount of the loan you can take is generally limited to the lesser of $50,000 or one-half of your vested plan benefits. The advantage of plan loans is that they are not taxed or penalized like withdrawals, as long as the loan is repaid on time. Also, the interest rate is usually reasonable (e.g., one or two points above the prime rate), and the interest you pay is credited to your own plan account.
Drawbacks? If you do not repay a plan loan when required, it will generally be treated as a taxable distribution. Typically, you have to repay the loan within five years by making regular payments, at least quarterly. (The repayment period can be longer if the funds are used to purchase a primary residence.) Even worse, if you leave your employer’s service (whether voluntarily or not) and still have an outstanding balance on a plan loan, you may have to immediately repay the loan in full. Other disadvantages are that the interest is usually not tax deductible, and the borrowed funds miss out on tax-deferred growth opportunities.
Another option is to withdraw funds from your employer-sponsored retirement plan. Your first step should be to find out your distribution options. Your plan may offer several methods of taking distributions, or your choices may be very limited. Consult your plan administrator to find out which distribution options from your retirement plan (if any) are available to you.
In general, you can take distributions from your plan upon certain specified events. For example, you may be entitled to take distributions when you retire, or when you reach the plan’s normal retirement age. You may also be entitled to take a distribution upon job termination, disability, plan termination, or financial hardship. Depending upon the type of retirement plan and the provisions of the plan, you may be eligible to receive certain distributions while you are still working for your employer as well as after your employment has ended. However, some plans may only allow distributions after your employment has ended.
Unlike plan loans that are repaid on time, distributions you take from an employer-sponsored retirement plan generally must be included in your taxable income for federal (and possibly) income tax purpose. Any plan distribution you receive will increase your taxable income for the year of the distribution, possibly even pushing you into a higher federal income tax bracket. In addition to ordinary income tax, you must also pay a 10 percent premature distribution penalty tax if you are under age 59½ at the time of the distribution (unless an exception applies).
If you have ever made any after-tax contributions to your employer’s retirement plan, those amounts will not be included in your taxable income when distributed from the plan. Consult a tax advisor for further details.
Unlike a traditional IRA or a Roth IRA, a qualified employer-sponsored retirement plan offers no special advantages to parents who use the money to fund higher education expenses. If you are faced with a choice between withdrawing or borrowing from your plan, borrowing is generally the better of the two options.
There are typically no taxes or early withdrawal penalties on a plan loan, and you will eventually replace the money in the future. Plus, the interest rate is relatively low, and you are essentially paying interest to yourself. Yet this does not necessarily mean that borrowing from your plan is a good idea. The loan must be repaid in regular installments within five years, which may create a strain on your budget, and the interest you pay is not tax deductible in most cases. You also lose out on tax-deferred growth opportunities when you borrow from the plan. Under most circumstances, this is probably not the best option for funding your child’s private school or college tuition.
Plan withdrawals fare even worse, assuming they are even available to you. If you have other options available (including loans from your plan), you probably should not even consider withdrawing money from your employer’s plan. A plan withdrawal will generally be included in your taxable income (excluding any portion that represents after-tax contributions to the plan), and may push you into a higher income tax bracket. You may also have to pay a 10 percent premature distribution tax if you are under age 59½. Finally, unlike a plan loan, a plan withdrawal cannot be repaid. Nevertheless, plan withdrawals may be a ready source of cash if your plan does not allow loans, you have few other assets, and you believe you’ll have trouble borrowing elsewhere (due to poor credit, for example).