While most families do considerable research prior to purchasing a home and a car, many of these families take a more impulsive approach to financing college. Their idea of due diligence is to attend a ‘financial aid night’ at their high school, pour over voluminous college books in the library, or search endlessly through Google for answers. And while their effort may produce some grants, scholarships, and student loans, the net result is they will either write the college a large check, or take on major additional debt.
Regardless of how you pay for college, an issue you must face is the effect that this college payment will have on your ability to fund your retirement at the same time. Have you ever asked yourself these important questions:
- What will be the total cost to educate all my children?
- Will I need to use retirement funds to pay for college?
- Will I need to stop funding my retirement while my children attend college?
- What age will I be when my last child graduates from college?
- How many years after my last college payment will I need to work before I retire?
- Will college costs force me to work 5-7 years longer before retiring?
Like many of our clients, these questions probably never crossed your mind. This is usually due to the fact that you’re looking at your college finances from a short-term perspective. Regardless of how much income you earn though, the high cost of college is definitely going to affect long-term financial objectives that are important to you.
The solution is to approach your college plan backwards. In other words, you must insure that your retirement plan is solid first, and then work backwards on your college financial plan. After all, you can’t borrow money for your retirement. Part of this planning process involves cash flow planning. There are many cash flow strategies that can 1) increase income, 2) decrease taxes, or 3) decrease expenses in order to maximize your ability to fund college and retirement at the same time. Here’s an example of cash flow savings that even most financial professionals miss:
Education Tax Credits vs. Tuition & Fees Deduction
The Hope Credit allows a family to claim a federal tax credit of up to $1,800 for their students’ first two years of postsecondary education. The Lifetime Learning Credit allows the family to claim a federal tax credit of up to $2,000 per tax year for the taxpayer, taxpayer’s spouse, or any eligible dependents for an unlimited number of tax years. The Tuition & Fees Deduction (now scheduled to expire for the 2008 tax year) is a federal tax deduction that families can claim for up to $4,000 in qualified postsecondary education expenses.
The Hope Credit, the Lifetime Learning Credit and the Tuition & Fees Deduction are all based on family income parameters and families must choose which credit or deduction is best to claim. This is normally an easy decision because when you’re dealing with federal taxes it’s almost always more beneficial to claim a tax credit than a tax deduction. But when you add state taxes to the formula you may get a surprise.
Since the Tuition & Fees Deduction reduces your federal adjusted gross income it will also reduce your state tax liability. However, the Hope and Lifetime Learning Credits have no effect on your state taxes. Therefore, when you add up both your federal and state taxes due, the result may prove that it is more beneficial to take the Tuition & Fees Deduction than the Hope or Lifetime Learning Credit, especially in states with higher tax rates.
Does this sound confusing and complicated? That’s because it is! Very few financial professionals understand how these education tax credits and deductions work. Even many tax preparers miss this savings because their tax software does not compare federal taxes and state taxes together. Yet the cash flow savings could be in the hundreds of dollars.
There are hundreds of little-known cash flow strategies available to families and they can add up to significant money over the long term. The question is, if you try to do your own financial plan, will you overlook these opportunities?