Better for Taxes to Fund College with Loans?

Dear Dr. Don,

Our only child is starting college this fall. My wife and I have saved enough money to pay for our daughter's college education. Would there be any tax advantage if we take out a loan for her tuition and use the money we save for school to pay the loan back?

Thank you,

- Joe Junior

Dear Joe,

I get questions similar to this from homeowners trying to decide whether to use their portfolio funds to pay down a mortgage.

One option would have you keep your money invested. Your daughter takes out Federal Direct Student Loans while you obtain PLUS loans, possibly as well as private student loans. You would need to fill out FAFSA, or Free Application for Federal Student Aid, forms.

If your portfolio is held in a taxable brokerage account, you could borrow through a margin loan to fund the college costs instead of student loans. Parents sometimes also consider home equity lines or loans to fund these costs.

As long as your portfolio has an after-tax yield higher than the effective interest rate on the loans, you're better off staying invested versus selling off the portfolio to fund college expenses.

Instead of paying the college expenses as they occur, you'd take money out of the portfolio to make the loan payments.

I'd suggest that you talk to your tax professional about the tax deductibility of the student loan interest expense and compare that with the other types of loans you're considering.

If your college funds are invested in a tax-advantaged Section 529 plan, then the issues are different. To retain the tax benefit, you need to use distributions only for qualified education expenses. In general that doesn't include student loan payments. In the case of the 529 funds, you'd need to pay those directly toward qualified expenses, such as tuition.

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