Student Loan Interest Rates Jump on July 1st

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Interest rate hikes on student loans will take effect on July 1, 2006 as a result of the Deficit Reduction Act of 2005. So, now is the time to assess your student loan portfolio and consider strategies, such as student loan consolidation.

Last month Congress passed the Deficit Reduction Act of 2005, which included a provision dramatically cutting the government's student loan package by $13 billion. This change affects anyone who will take out student loans in the future, as well as those who have outstanding student loans but haven't yet consolidated them.

“Since these cuts reduce subsidies available to student loan lenders, interest rates on student loans are on the rise,” cautions Andrew Schwartz, CPA, founder of the MDTAXES Network, an affiliation of CPAs throughout the country that specializes in tax planning and preparation for healthcare professionals. Effective July 1st, the rate for Stafford Loans jumps from 4.7% to 6.8%, and the fixed rate on PLUS loans increases to 8.5% from as low as 6.1%.

There are quite a few changes to the loan consolidation rules as well. Not only will rates increase substantially on July 1st, you'll no longer be able to include certain types of student loans, such as Direct Loans and FFELPS, when you consolidate.

Student Loan Strategies

“If you currently have outstanding student loan debt, now is the time to assess your student loan portfolio and consider the options available to you through June 30th, including consolidation,” advises Schwartz. A good source of information is Sallie Mae and AAMC.org.

Consolidating generally makes sense for people with student loans. When you consolidate, you reduce the number of loans outstanding and the number of payments you need to make each month, making it easier for you to manage your student loan portfolio. You can also take advantage of desirable options that reward you with a lower interest rate for making your monthly payments automatically and consistently making payments on time.

If you currently have a child in college, make sure to complete the FAFSA annually, and consider taking out a Stafford Loan each year. As long as you submit the FAFSA form, you're generally eligible to borrow $2,625 for your child's freshman year, $3,500 for the sophomore year, and $5,500 for the final two years. Most students are eligible for a Stafford Loan (up to a certain limit) regardless of income, and many qualify for a “subsidized” version of this student loan – meaning the government pays the interest until the student’s graduation.

One positive outcome of the Deficit Reduction Act of 2005 is that the maximum Stafford Loan increases from $2,625 to $3,500 for first-year students and from $3,500 to $4,500 for second-year students, effective July 1, 2007.

Saving For A Child's Education

Do you have a child who will attend college in the future? Rising student loan interest rates provide an extra incentive for you to save more money towards your child's education.

What is the best way to save for a child's education these days? With all the options available to you today, it's important to understand the basics:

529 Plans. With these state sponsored education savings plan, you purchase into a managed investment portfolio based on when your child will attend college. Amounts contributed grow tax-deferred, but since the post-2010 rules have not yet been determined, withdrawals from a 529 Plan to pay for college tuition and fees might end up being taxed at your child’s rate starting in 2011. For 2006, you can contribute up to $12,000 per child into a 529 plan. Or, you can make five years worth of contributions, up to $60,000, all in one year. Just make sure to file a Gift Tax return (Form 709) electing to spread your 529 contributions over five years.

Pre-paid Tuition Programs. If you’re concerned that the cost of college will rise quicker than your investment portfolio, take a look at pre-paid tuition programs. Many states offer these college savings programs on behalf of colleges and universities within their state. Or you can check out the Independent 529 Plan (http://www.independent529plan.com), which is a national pre-paid tuition program representing approximately 250 schools throughout the country.

Coverdell Education Savings Accounts. Formerly known as Education IRAs, you can contribute up to $2,000 per beneficiary per year into an ESA. You’re not allowed to contribute to an ESA if your adjusted gross income exceeds $220,000 ($110,000 if single). Amounts contributed grow tax-free, as long as the money is used for your child's K-12 or college tuition or other allowable education expenses. Unlike 529 Plans, the tax rules for ESAs won’t change in 2010 when the 2001 Tax Act sunsets.

Two Tax Credits. If you're paying for a child's tuition out of your current earnings, don't overlook the Hope Scholarship Credit, which saves you up to $1,500 per year in taxes each of the first two years of college. Another option is the Lifetime Learning Credit, which saves you up to $2,000 in taxes per year. Both of these credits phase out this year once your income exceeds $107,000 if married or $53,000 if single.

U.S. Government Bonds. Another way to save for a child's education is with EE Bonds or I Bonds. Both of these bonds can be purchased at a bank or from TreasuryDirect.gov. I-Bonds are currently yielding 6.73%. As long as your child's name isn't on the bond, the interest isn't taxable to you as long as the total bond proceeds don't exceed the amount spent for tuition and fees. This tax break has a pretty low phase out - $121,850 for married couples and $76,200 for single individuals in 2005.

Employ Your Child. If you have an unincorporated business, you can pay your child up to $5,150 (in 2006), deduct his or her wages, and your child won't pay any income taxes (provided the wages are the only income earned during the year) or social security taxes. You can also contribute up to $4,000 from those wages into a Roth IRA each year, which would be available to pay for your child's college expenses, fund first time homebuyer costs, or grow tax-free over the next fifty years or more.

Higher Rates Are Here To Stay

"It looks like the days of low interest rates on your student loans end on July 1st,“ says Schwartz. "Consolidating your loans by June 30th, and taking advantage of the strategies described above to save for your child's eudcation can help cushion the blow.”

Andrew D. Schwartz, CPA is the editor and a major contributor to http://www.MDTAXES.com, a website that provides income tax and financial planning information geared towards healthcare professionals. Schwartz has provided financial planning advice in interviews with various media, including the Washington Post and Wall Street Journal. He is available for interviews.

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