As you get closer to college, the question of how to pay for it transitions from “how to save for it” to “how to pay the bills for it.” Many families have some savings and supplement that with cash flow and borrowing. The question is always, when do you use savings versus cash flow versus borrowing?
Part of the answer of course depends on how much you’ve saved, especially relative to the your student’s total cost of attendance. Many families think it’s best to use up the savings and only resort to cash flow and borrowing once the savings are fully depleted. However, this is often less advantageous than it seems. Here’s why:
Most families are eligible for either the Lifetime Learning Credit or the American Opportunity Tax Credit. Each of these tax credits is potentially worth thousands of dollars, but each has an annual cap and each is subject to the IRS’ “No Double Benefit Allowed” rule. No double benefit means you cannot take a tax credit for an expense that was paid by money that received another tax benefit. So, you can’t pay for all of your expenses using money from a 529 account and then also get a tax credit, because the 529 plan money already received tax benefits. Similarly, student loans and parent PLUS loans are considered tax benefits. Assuming you qualify for one or the other tax credit, and you will be spending some cash flow on college over your student’s four years, you should pay as much as possible that’s credit-eligible each year. (Your tax preparer can provide guidance on whether you’re eligible for the tax credits and if so, which is most beneficial.)
Loans are somewhat similar. While it’s true that parents can borrow up to the full cost of college with PLUS loans, those aren’t necessarily the best loans to take. Direct student loans have lower fees and interest rates than do PLUS loans, but there’s a cap to the amount you can borrow each year. Student loans have the added benefit that your student is more likely to be eligible for the tax deduction for student loan interest than are you, since the income phaseout is fairly low. (Regardless of who makes the loan payments, the named borrower is the only person eligible for the tax deduction.) If you’re planning to borrow $20,000 total over the course of your student’s college years, you might do better taking out $5,000 in direct student loans each year, rather than waiting until the final year(s) to borrow a larger sum via a PLUS loan.
Of course, everyone’s situation is different so you’ll want to map out your annual resources and cash flow before getting too far down any one path, payments-wise.