We are approaching the end of 2020 and it is a time when many people set goals for the New Year. It is a busy time but it should include a quick review of your 2020 finances. For families, in the thick of paying for college and student loan repayment, now is the time to do a review that could result in thousands of dollars in free money. Since the tax year and school years do not match, some actions may be required before 12/31 of this year.
We call this planning “Tax Scholarships”. Many people overlook these strategies due to timing and lack of information. College funding and student repayment are complicated personal financial decisions that are often minimized but many of these items could provide a family with thousands of dollars of savings.
These Tax Scholarships do not cost any money and you get free money back by understanding the different education tax rules. Each strategy is unique to each situation and person. How you pay for college and manage your income will directly impact your educational tax credits and savings. Below is a quick snapshot of the key areas to review. Each strategy has a more in-depth explanation of the benefits below:
- Financial Aid Position Planning
- Income Taxes and Financial Aid
- 529 Plan Review
- American Opportunity Credit & Other Tax Incentives
- Student Loan Plan/Review current Student loans
- Tax Review for the Student Loan Borrower
- Review Company benefits for Student Loan Allowance benefit
To properly pay for college, parents, and advisors must understand the financial aid process, college saving plans, educational tax credits, student loans, and student loan repayment. This lack of college planning and transparency has resulted in student debt reaching 1.6 trillion dollars. This is the second-largest debt held by Americans only behind home mortgages.
Here is a list of ideas that are often overlooked that you may find helpful for both maximizing 2020 and creating a better plan for 2021. The PayForED website provides helpful insights and software tools to help you during these educational financial decisions.
Financial Aid Positioning Planning
One of the first things, parents and students need to understand is their financial aid position. The financial term for this is your EFC or Expected Family Contribution. There are two methods of this calculation: Federal and Institutional. The Federal EFC is determined by completing the FAFSA form and for the Institutional EFC; the most common method is the CSS Profile.
For most families, the biggest part of their EFC is their income, which is driven by a family’s tax information on both the 1040 and W2 forms.
An important aspect of this planning is to understand that the tax year and school year do not match for the FAFSA. To maximize your positioning, this timing review needs to do before 12/31 of your child’s sophomore year in high school. A dependent student’s base EFC number will start with the tax year of the second semester of the high school sophomore year and the first semester of their high school junior year.
High School FAFSA Planning Calendar Example
Financial aid position planning is somewhat disconnected from the college application process due to a term called Prior Prior. The goal of the Prior Prior FAFSA change was to simplify the process and add more transparency. Under this change, families will have their taxes completed when completing the FAFSA. It makes the FAFSA completion easier and less stressful.
As an example, a current senior, completing the financial aid form will be using 2019 income tax information for financial aid year 2021-22. The first-year financial aid submission is called your base year and it is very important. The chart below will help high school parents better understand the timing of financial aid and the tax year used.
Income Taxes and Financial Aid
As stated above, a family’s income is normally the biggest component of a family’s EFC. Most parents are trying to save for retirement and reduce their taxes. The most common strategy is to contribute to a tax deferral program such as an IRA, 401k, or 403b. There is a downside to this strategy in the years that you file for financial aid. Contributions to tax deferral programs are added back in as income for the financial aid calculations. Depending on a family’s income, this deferred income could be weighed in the EFC calculation up to 47%.
Review the timing chart above, so that you can better understand the timing of these contributions to your financial aid position. For some parents, this will be a difficult decision. They will need to weigh the long-term tax defer benefits versus the cash flow advantages of not making the contributions.
Estimating your EFC
To evaluate your financial aid position, a family will need to calculate their Expected Family Contribution or EFC. Most people believe it is one number. In reality, it is four separate calculations that are summed to one number. They are Parent’s Income, Parent’s Assets, Student’s Income, and Student Assets.
By understanding your EFC at each college, families will be able to determine if they will be eligible for need-based financial aid. Understanding your EFC number is the starting point for any college financial plan.
Student Assets in Financial Aid Positioning
Another big myth in college financial aid positioning is to have no assets in the child’s name. That is not always true. To make a decision, a family needs to understand the details of their EFC, which methodology the college uses, and the list price of that college or cost of attendance (COA).
If the parent’s portion of the EFC is greater than the COA then the student assets will not affect qualifying for need-based financial aid. The student may still qualify for merit-based money depending on their application strength for that college. If you have the details of the parent’s part of the EFC calculation then you can complete the full analysis. It is also important to know which EFC method each college uses on your list.
Here is an example of knowing your numbers and the common myth of taking all of the assets out of the student’s name. It is illustrated with the numbers below.
Before liquidating any assets, you need to review this with your tax and financial advisor. There are legal and tax regulations that a parent could trigger. These triggers may work against you. As an example, the “Kiddie Tax Law” requires a student who has 2019 unearned gains over $2,200 to be taxed at the trust income rate. This could be as high as 37% versus a tax-free gain of zero if managed and liquidated correctly.
Prior Prior Timing Impact on College Students
The Prior Prior change also affects the financial planning position for the current college students. The tax year in the FAFSA process could work to the advantage of the current college student. The assumption is the child will graduate in four years.
Under the current FAFSA rules, the last tax year needed for the FAFSA documentation is the tax year that ends during the first semester of the college sophomore year. The forward movement of the tax year helps the family in the back end years while their child is in college. This is true only for full-time students who will graduate in four years. If the student will be extending their undergraduate studies or is a part-time student, additional timing planning will be needed.
Students who are enrolled in the five-year combined programs are also affected. Once a student has their first Bachelor’s degree, they become an independent student and their parent’s information is not required for the FAFSA submission. This timing varies program by program.
Another timing example is liquidating stock options. If you can delay the liquidation of stock options to pay for college, it may have little to no impact beginning in the second semester of their sophomore year in college. This assumes the student is graduating on time and there are no other children.
If you have multiple children who will be attending college, creating a family timeline will be helpful so you can see the overlaps but even more important which tax years will impact your EFC.
Using Grandparent or other Relatives 529 Money
This Prior Prior timing change is especially important when grandparent’s 529 plans are being used to help pay for college or the student is planning for a well-paid co-op or internship position. If the student qualifies for need-based financial aid, both grandparent’s 529 distributed money and paid wages are considered student income. Both of these incomes will be included in the student’s income section of the EFC calculation. It may raise their EFC number and would reduce their need-based financial aid. By delaying both of these events, the need-based financial aid would not be affected.
Grandparents and non-parent funds are outside resources. If the college is able to determine when these resources were used, then the student could lose any need-based financial aid dollar for dollar. The timing of outside resources is critical in lowering your out of pocket cost.
529 Plan Review
A common goal for many families is to start a college saving plan for their children or grandchildren. If this was a goal for 2020 or is a goal for next year, you may want to do it before December 31 of this year. Many states offer income tax deductions for contributing to a 529 savings plan. This is why you should look at your state’s plan first.
Currently, 32 states offer some type of state income tax incentives. Many of these require a family to use their in-state 529 college saving program. Six states do not require the contribution to be to in-state 529 plans. These states are Arizona, Kansas, Maine, Missouri, Montana, and Pennsylvania.
Often overlooked are these tax incentives for the current college student. In most cases, contribution to a 529 plan while the student is still in college can offer some additional tax benefits depending on the state and plan. Most people think 529 plans are only a pre-college opportunity. Using the state income incentives can add up to thousands of dollars over multiple years, depending on the state. A 529 plan could enhance a family’s tax deductions and college saving opportunities, each year.
If you have relatives that want to help pay for college, knowing the different state plans can work to your advantage. This could allow the donor to compare state plans and maybe open the plan in their state of residency or gift the parent the money if their state offers a better option. The donor should consider other factors such as the financial aid impact and asset control.
It is important to realize that these tax deductions follow a calendar tax year and do not have an extended date link to an IRA contribution. To get the state income deduction, it must be done before December 31.
American Opportunity Credit and Other Income Tax Incentives
Timing is everything in proper tax planning. Just the simple task of when you paid a tuition bill can make or break your ability to take advantage of an educational tax credit.
Many of these tax savings are often not properly planned since we do not think about our taxes until after the first of the year. As college funding has become more complex, it may be important for families to review their year-end situation with their tax advisor prior to 12/31. This will minimize the risk of forfeiting some of the educational tax incentives.
A good example is the American Opportunity Credit. Many families will use their 529 plan money to pay college bills. This may include the qualified expenses of tuition, fees, room, board, and books. If a family can pay these costs with only 529 money, the family may be forfeiting a $2,500 tax credit. Under current tax rules, you are unable to use the same qualified expenses for multiple tax incentives. In other words, if tuition was paid with 529 plan money, a parent would then be unable to reuse that same tuition expense to qualify for the American Opportunity Credit.
To qualify for the American Opportunity Credit, the income criteria must be under $90,000 if filing Single or Head of Household and under $180,000 if filing a Married return. To receive the maximum credit of $2,500 then the Single and Head of Household’s Adjusted Gross Income (AGI) must be under $80,000 and for the married filer, it is a $160,000 AGI limit. In addition, only certain qualified expenses can be used. These are tuition, fees, and books.
This is a common mistake if proper planning is not done. If a family has paid all of the qualified expenses using 529 money, they will not qualify for the credit due to the rule stated above. The solution is easy if you feel that you qualify for this credit. You could move up your payments for the upcoming semester. The amount to be paid will need to be $4,000 of the qualified expenses to fully take advantage of this credit. It must be paid by December 31.
Due to the new tax code and exemptions are no longer a tax benefit. Some people may be able to use this credit even though they do not qualify due to income limits. They could not claim their child and the child would qualify if they had federal income tax due.
Student Loan Plan
A missing piece of the college financial process is projecting the amount of student debt at graduation. Colleges only provide financial information one year at a time. As college costs continue to rise, more families need to finance a larger portion of that expense. The problem with the current system is parents and students are not able to envision the monthly payments after graduation.
The year-end may be a great time to review what debt has been incurred and what the future looks like for your child currently in college. Our PayForED, In-College Payer software helps students and parents understand their financial future by gathering the current debt and projecting the debt needed till graduation. It will then calculate all of the loan repayment options and build a personal budget. As more students change majors and transfer, being able to see the financial consequence could be very helpful.
As pointed out at the beginning of this article, student debt is a growing concern for our children’s financial future. There are various studies identifying student debt as a reason for delays in home purchases, getting married, and starting a family to name a few. For parents, approximately 33% will be delaying retirement due to educational costs.
Reviewing Your Student Loans
To review your federal student loans, the student and parent will need their FSA ID. First, you need to log onto the National Student Loan Database System (NSLDS.ed.gov). Then enter your FSA ID. Both your student loans and federal grants will be listed. For parents with Parent PLUS loans, these will be listed under the parent’s FSA ID.
The importance of understanding the student loan structure is critical. The type of student loans used to finance a college education will dictate what loan repayment and forgiveness options that the student will have in repayment. Many parents do not realize that by co-signing for a private student loan or taking a Parent Plus loan, they are legally directly or indirectly responsible for that debt. The loan co-signer has the same financial responsibility as the student. If the student defaults, this may affect the parent’s credit score and their ability to borrow other money.
Tax Review for the Student Loan Borrower
One of the complexities of having student loans is that as your income level and life changes as a borrower. A married couple could have up to 126 option to select from and is a reason why they need to review their tax filing options. It gets even more complex as a borrower who recently got engaged or married in the past year.
In our blog titled, “Married Filing Separately with Student Loans”, we discuss the complexity of repayment combinations borrowers need to sort through. Borrowers should review how to file their taxes, understand how their student debt is structured, estimate future increases in income, and whether future employment decisions would qualifying for public service loan forgiveness. The Income Drive Repayment Methods use Adjusted Gross Income in the calculations and is the reason why couples need to analyze the married filing separately and married filing joint tax decision more carefully.
Review Your Benefits
Student debt affects such a large segment of the workforce. As a result, more and more employers have determined that offering a student loan assistance benefit is critical to building a well-rounded employee benefits package. Review your company benefits to determine if your company has programs to help relieve the stress of paying for college or the repayment of student loans.
PayForED’s suite of paying for college and student loan repayment solutions can now be found on a financial wellness platform as a voluntary benefit. Alleviating employee stress is critical to creating a positive and productive work environment. Taking advantage of this benefit may help you make more informed decisions.
Under the CARES Act for 2020, there is an additional tax-free incentive for employers to match student loan payments. It follows the rules of the tuition reimbursement rules under Section 127. This would allow employers to match up to $5,250 of student loan interest and principal payments that were made during the tax year of 2020. This applies to both federal and private loans.
As you can see, paying for college and student loan repayment has become much more complex. By being proactive, families and borrowers can make better decisions and lower their expenses. The PayForED approach is to simplify the college funding decisions so that students can envision their financial future and not be burdened later with unexpected, excessive student debt. It is designed to help borrowers with student debt and help them understand all of the repayment and forgiveness options.