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What's the Best Way for a Parent to Help Pay off Student Loans?
Dear Carrie: When I went to college, my father told me he would help me get grants and loans. When I graduated, he said he would pay my debt. I never got a chance to ask him how he paid for it, but he did. He thought this was an incentive for me to get a degree — it worked.
Now I have done the same for my children, and my daughter just graduated with about $20,000 in debt. It seemed to work as an incentive for her as well. The question is, do I pay it off if I have the cash, or do I just pay out over multiple tax years? — Ken
Dear Ken: I think you and your father are on to something here. The responsibility of paying for college with grants and loans can really motivate a student to make every moment in school count. The fact that you're now willing to shoulder the debt yourself is a wonderful graduation present and reward for your daughter's academic achievements. But don't let the learning stop there. You may not have had the chance to find out how your father paid off your student loans, but you now have a perfect opportunity to include your daughter in your own payment decision, teaching her some financial lessons.
Before we get into your payment choices, I just want to be clear that, subject to income limitations, up to $2,500 of student loan interest is tax deductible annually for the individual who is obligated to make the payments (the qualified student could be either you, your spouse or your dependent) . So, the first question is: Do you or your daughter qualify for the yearly tax deduction? According to IRS Publication 970, the following conditions must be met for deductibility:
— Your filing status is any, except married filing occurs separately.
— No one else is claiming an exemption for you on his or her tax return. — You are legally obligated to pay interest on a qualified student loan. — You paid interest on a qualified student loan.
Beyond that, the ability to deduct the student loan interest expense phases out when modified-adjusted gross income reaches $60,000 to $75,000 for single filers and $120,000 to $150,000 for married couples filing jointly.
Taxes aside, here are some things to consider — and discuss with your daughter — to help you examine your choices and make your decision.
— What's the interest rate on the loan?
Student loans typically have low interest rates. If the rate on the loan is 5 percent, for instance, and you think you could make more by investing the $20,000, you're probably better off not paying off the loan early. Add up the interest you'd end up paying overtime.
— What's the repayment plan?
Repayment options vary according to loan source. For example, new federal regulations tie repayment of federal loans to the borrower's income, potentially making the required monthly payment quite low. But if you can easily afford to make higher payments than required, perhaps paying the loan more quickly makes sense.
— Do you have another use for the funds?
If you do have the cash, is this the best use for it? Do you have other higher interest debts that you should pay off first? Or would it be wiser to put the $20,000 toward your retirement? This could provide an opening to discuss your overall financial situation with your daughter, share with her your spending and savings plans — especially retirement savings — and help her develop a plan as she becomes financially independent.
— Can you turn this into a tax benefit for you?
If you want to pay off the student loan in its entirety and you own your home, you might consider a low-interest home equity line of credit. With this type of loan, you can deduct the interest expense on up to $100,000 ($50,000 for married filing separately). You'd be exchanging one type of debt for another, but you might be eligible for a tax break yourself — subject to alternative minimum tax, since the proceeds of the loan are not being used to purchase or make capital improvements to your principal or secondary residence — and you'd be preserving your capital.
SOME FINAL THOUGHTS
It sounds like you've already given your daughter a great start toward independence and responsibility. And by discussing your repayment choices, you can give her the gift of greater financial awareness as well. One final thought would be to encourage her to use this unexpected windfall to jump-start her savings. By directing at least a portion of those funds, that would have gone to loan repayment, to a retirement or other savings account, she will put the benefit of time on her side.
Congratulations to you both on her academic success, and best of luck for a secure financial future.
Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER (tm) is president of the Charles Schwab Foundation and author of "It Pays to Talk." You can e-mail Carrie at firstname.lastname@example.org. This column is no substitute for an individualized recommendation, tax or personalized investment advice. To find out more about Carrie Schwab-Pomerantz and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.
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