How to Save $4,000 in Your Graduation Year — Part 1: Taxes

[This is a guest post from Bogleheads investment forum participant Bob’s not my name.]

If you are a college senior or if you graduated this year, pay attention. The year in which you finish college and enter the workforce presents unique tax circumstances. In addition, you may think you are achieving financial independence from your parents at last, but the nanny state has other plans for you. Here are some tips on saving up to $4,000 on taxes and insurance in the year you wear the mortarboard.

Caveat: Everything that follows applies to singles. The federal government hates marriage of all types, and has marshalled an army of tax rules sufficiently intimidating to make lifelong spinsters and bachelors of all but the most ardent lovers. I won’t attempt to explain them here (the rules I mean, not the lovers).

Education credits and deductions: save up to $2,500

In its wisdom, the federal government offers you a parade of education tax credits, each with its own pomp of filigreed rules that depend on your circumstances. Fear not the madding crowd, for there is money to be had here. Your graduation year might be the only year you or your parents get an education credit, since there are income limits that may have excluded your parents (and the government has wisely recognized that nobody needs money when they’re in college).

Critical things to remember:

1. Pay your last tuition bill after January 1. You can’t get a credit in your graduation year if you didn’t pay for college expenses in that calendar year. Wait until January to pay. Even if your tuition payment is due before January 1, the tax benefit will probably trump the late penalty.
2. Don’t let your parents claim you as a dependent. If you’re under 24, were a full time student, and lived with your parents past July 1 they can claim you as a dependent. If they do, that disqualifies you for the education credits. They could still claim one of the credits, but their income might make them ineligible.
3. Don’t live with your parents past July 1. For the Tuition and Fees Deduction, merely creating the possibility of your parents claiming you as a dependent will disqualify you, even if they don’t actually take an exemption for you. In practice this means that if you’re under 24 you mustn’t move back in with your parents after graduation and live with them past July 1.

Which credit to take? Here’s a ranking by dollar value, followed by the Adjusted Gross Income (AGI) phaseout range, your total marginal rate in the phaseout, and some important limitations. AGI is not the same thing as your new salary. It is how much money you will gross in your first calendar year of work (six months of earnings if you start working July 1), minus some important adjustments, which we’ll come back to. This table is a simplified presentation of the options; read IRS Publication 970 for important details.

To calculate the value and the marginal rate I used the federal tax savings plus the state tax savings you would get for a state with an 8% tax rate that uses federal AGI as its starting basis for taxation and does not correct for the federal deduction. Since the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC) are “below the line” credits, they don’t affect your AGI, so there’s no state tax savings under this assumption. Your own state tax rules may yield a different result.

Credit or Deduction	Max Value	AGI Phaseout	Marginal Rate in Phaseout	Limitations
American Opportunity Tax Credit	$2,500	$80,000 – $90,000	58%	Expires after 2012 under existing law. Effectively undergrad only: “must not have completed first four years of postsecondary education before end of prior tax year.” Also, the credit is available for 4 tax years only. Must not be listed as a dependent on another person’s return.
Lifetime Learning Credit	$2,000	$52,000 – $62,000	40%-53%	Must not be listed as a dependent on another person’s return.
Tuition and Fees Deduction	$1,320	$65,000 – $80,000	6600% at the edges of the phaseout	Expired in 2011 but Congress may extend it. Can’t be claimable as a dependent on another person’s return, even if that person doesn’t actually claim the exemption.
Student Loan Interest Deduction	$825	$60,000 – $75,000	38.5%	Must not be listed as a dependent on another person’s return.

Since you can claim only one of the AOTC, LLC, or Tuition and Fees Deduction, the effective marginal rate for the LLC is actually lower than 53% if you qualify for the full value of the Tuition and Fees Deduction and if Congress extends the deduction for 2012, so instead of losing $2,000 you may really just lose $680. Interestingly, the LLC phaseout is inflation adjusted, while the Deduction phaseout is not, so within a year or two they will start to overlap.

At the gross level, though, you can see that being phased out of these tax breaks will give you a marginal tax rate of 40-60%, or even 6600% if your AGI is $1 over a Tuition and Fees Deduction threshold.

How can you shelter your income from such high tax rates? You have to reduce your AGI. Three common items that reduce your AGI are (1) health, dental, and disability insurance premiums, (2) Health Flexible Savings Account (FSA) contributions, and (3) traditional (not Roth!) retirement account contributions – an employer plan like a 401k, or an Individual Retirement Account (IRA). Deductible moving expenses can, too; that’s a complicated topic I’m not going to touch here. I’m also going to defer health insurance and FSA discussion to Part 2.

Let’s talk about 401k and IRA contributions. If the government is going to take half your top earnings, it’s a good idea to deny them that half by putting your top earnings into a traditional 401k and/or IRA.

You can contribute up to $17,000 to your 401k and up to $5,000 to an IRA. If your new employer doesn’t allow you to contribute to their 401k until after you’ve been employed for a year or six months, the IRA is your only choice. The IRA is also distinguished from the 401k in that you can make contributions to it after the end of the calendar year, in fact right up until tax day the following year, typically April 15.

The beauty of this is that you can wait until you prepare your tax return, see what your AGI is precisely, and contribute enough to your IRA to get below a phaseout. Suppose you find your AGI is $65,009. That extra $9 is going to cost you half of your Tuition and Fees Deduction, or $660. If you make a $10 contribution to a traditional IRA, your AGI drops to $64,999 and you save $660 in taxes.

Student Loan interest Deduction: save up to $800

If your AGI in future years is going to be over $60,000 (which is inescapable if your gross income is over about $80,000), your graduation year is the only year you’ll ever be able to claim the full student loan interest deduction.

The system is rigged to dupe you into forgoing this once-in-a-lifetime opportunity: typically, loan payments don’t start until six months after graduation, so you might not have a first required payment until January. It is a very good idea to make a voluntary payment before December 31 so you can get the deduction.

Deductible interest includes loan origination fees and capitalized interest — that means interest that was accruing on unsubsidized loans while you were in school. The maximum deduction is $2,500. You’ll probably have that much capitalized interest if you took out a $4,000 unsubsidized loan each year for four years.

Note also that you can take the Student Loan Interest Deduction in the same year as one of the AOTC, the LLC, and the Tuition and Fees Deduction.