Are your kids nearing the time to enter college? If you’re like many parents, you may not have saved enough to finance the higher education of your offspring. Now it’s too late to benefit to any significant degree from a Section 529 plan or other college savings vehicle.
Strategy: Don’t panic. As the clock ticks down, you may be able to turn to other sources, without paying a small fortune in taxes. Here are five alternatives for procrastinators to consider.
1. Tap into your home equity. Generally, you can deduct the interest on the first $100,000 of home equity debt, no matter how you use the proceeds. However, you can’t deduct interest on loans in excess of the value of your home after subtracting other mortgage debt.
Caution: The loan is secured by your home, so use this technique judiciously. Also, if you’re subject to the alternative minimum tax (AMT), interest paid on the home equity loan isn’t deductible.
Note that you may qualify for a home equity loan on a vacation home as well as a principal residence.
2. Borrow from your 401(k) or other qualified retirement plan. Usually, this is preferable to taking outright distributions. Then you can pay yourself back later—with interest—to replenish your account. (Reminder: Saving for retirement is still the primary purpose.)
Generally, you can borrow 50% of your vested account balance up to $50,000 without any tax repercussions.
3. Withdraw funds from a traditional IRA. Normally, IRA distributions are fully taxable at ordinary income rates. However, if you’re under age 59½, you don’t have to pay the usual 10% penalty tax (on top of the income tax) if you use the money to pay for higher-education expenses.
To the extent that a distribution represents a return of nondeductible IRA contributions, that portion is always exempt from any income tax or penalty tax. If you have multiple IRAs, the computation depends on the amounts contributed to all the IRAs and the combined balance of all the IRAs, not just the one you’re withdrawing from.
4. Withdraw funds from a Roth IRA. Alternatively, you might take distributions from a Roth IRA. Qualified distributions are completely exempt from tax regardless of the use of the funds. A “qualified distribution” is one made from a Roth in existence at least five years that is paid after you’ve reached age 59½, on account of death or disability or to pay first-time homebuyer expenses (up to a lifetime limit of $10,000).
Even if you don’t qualify for 100% tax-free distributions, Roth IRA distributions are treated as coming first from Roth IRA contributions, then traditional IRA conversions and finally taxable earnings. Withdrawals from contributions are income-tax-free and usually penalty-tax-free.
5. Borrow from a family member. If needed, you may arrange a loan from your parents or other relative. The tax rules for intrafamily loans are complex, but you can generally avoid “imputed interest” if the loan amount doesn’t exceed $100,000 and the loan is payable on demand. Fall-back position: You can arrange a low-interest or no-interest loan for less than $10,000 without any tax worries.
Make sure any intrafamily loan is formalized in a loan document stating the interest rate. Otherwise, the IRS might challenge the setup as a disguised gift.
Tip: We’re not advising you to siphon away money being saved for retirement or to jeopardize your financial affairs in any way. But you do have some last-resort options when a tuition bill suddenly becomes due.
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