Tips to Thrive Financially After College: Taxes, Spending and Financial Planning
The Big Surprise for Recent College Graduates
College students are now graduating with more debt than ever, loan payments can be crippling as they enter an economy where almost everything has increased a lot in cost, like food and gasoline. Graduates right out of college at best start out with modest incomes and have many financial pressures. The most shocking thing that happens to these grads occurs a few weeks after they start their first job, they discover how small their paycheck is after deductions for taxes and benefits.
College Loan Burden
The average amount of total loans per student is $29,400 according to Money.CNN. However, it’s not unusual for students to graduate with $50,000, $75,000 and more in total debt. For struggling graduates, I’d guess they have at least $50,000. A person with this amount probably graduated on time, received some help from parents and relatives, worked some, and qualified for some grants and aid.
Many student loans are based upon a 10 year (120 months) amortization, although the terms and rates can vary quite a bit, and they are usually private or government backed. For this entire article’s example we’ll use a 7% rate, $50,000 single loan with one entity (which is rare), and 10-year term. The payment would be $580.54, using the loan calculator at DinkyTown. The first payment consists of $291.67 of interest and $288.87 going to principal. In comparison, the final payment, number 120 consists of $577.54 to principal and $3.37 of interest.
Mini primer explaining loan types
The most common form of lending is where the payment stays the same, and the amount that goes towards principal and interest changes. Like in the example, the amount the payment that goes towards interest in the early years is much greater than the percentage that goes to reduce the loan principal. Compared to a different kind of loan, an equal principal loan, that has a decreasing payment, but the amount of the payment that goes to principal each year stays the same (these are rare). You may have also heard of a balloon loan, which has level payments like the first type here, but has a large principal payment due at the end of the loan. These are designed to keep payments low and borrowers expect to refinance or receive a windfall in the future to pay the ballon.
Why does this all of this matter to grads with big loan payments now? The answer to this is your interest may be tax-deductible. In the earlier years of loan re-payment, a greater percentage of your payment is made up of interest, giving you a good tax deduction. Tax deductions can mean either a larger tax refund or a larger net take home paycheck, if you pre-plan. We’ll get into this deduction later.
First paycheck shock
Lets assume the recent grad lands a pretty good job, making $50,000 per year. Assuming 70% net take-home (after taxes and benefits are deducted), the monthly income would be $2,917. That seems like a decent amount of money to live on, but assuming that $50,000 student loan, they now have only $2,337 to live on, an almost 20% reduction ($2,917 – 580 = $2,337). $2,337 isn’t a bad income either, but it will not provide the high living the grad dreamed of while a starving college student. After rent, food, transportation and other living expenses, there’s little left at the end of the month to have fun, unless they’re very careful.
Financial mistakes some grads make
When the student graduates, she or he may have some cash to start off to help for business attire and some incidental expenses to get started. Some of the expenses may end up on credit cards. That’s okay if they’re paid off within a few months. However, there could be pressure from co-workers and friends to have fun. Also, while young they might have gotten used to a decent middle or upper class lifestyle, so they could have the expectation to maintain or even improve on that. Therefore, it’s easy to spend more than you make and put the balance on credit cards.
Most student loans payments don’t start until the grad has been out of school for 6 months. It’s easy to forget this impending loan, and build a lifestyle without giving much consideration to loans. This could be very dangerous. One of the biggest mistakes of new grads is to buy a really nice car. Again, they’ve lived a bare bones lifestyle, and can’t wait to get rid of the Junker. It’s so nice to get a new car, that doesn’t leak fluids everywhere, and need constant repairs. However, a big payment comes with the new car, as well as expensive car insurance.
Financial traits of wise college graduates
I’ve coached hundreds of people with financial difficulty, many of them in their 20’s and 30’s, with a lot of student debt. The one’s doing well, are those that:
- Share living expenses, by finding roommates
- Avoid using credit cards, since it’s too easy to overspend
- Pay off any credit card balance from their first few months of post-graduate employment
- Develop a budget they can live on
- Quickly accumulate a savings account, something like $1,000 to help out with emergencies, so that emergencies aren’t charged
- Get by with older cars, or obtain a job and housing close to public transportation
- Study personal finances and investing
- Obtain a long-term financial plan, since it’s great to get into the swing of living with a plan
- Learn from others grads, by regularly reading or subscribing to blogs written by recent grads in similar predicaments, like the ones at Money Manifesto, Empowered Dollar, and Get Rich Slowly
Is all loan interest tax-deductible?
Not much anymore. Back in the tax-deductible interest glory days that ended almost 30 years ago, almost all personal loan interest was deductable. This ended during tax reform in 1986; that’s the last time we saw 50% tax brackets too. There’s always trade-offs. You used to be able to deduct the interest on your auto loan and credit cards too. However loan interest was in the high teens back then too.
Generally speaking, only deductible loan interest that survived tax reform is for those few things that have a high probability of improving the financial condition of people and society. Generally debt is not good, it’s a burdensome drag on income, and should be avoided. However, it might make sense to borrow money, for example to buy seed to plant crops. This is a good example. Assuming a new farmer has little money left over after buying equipment, and needs funds to buy seed. Let’s assume the seed cost for corn seed is $100 per acre, but an acre yields 150 bushels. Assuming the farmer sells his corn for $5 per bushel, his gross income for one acre is $750. Not including other costs like fertilizer, the farmer borrowed $100 for seed and made back a net amount of $650, minus what he paid in interest cost. In this instance borrowing makes sense. This is good for the farmer and society, as long as it rains.
The types of loans where the interest is deducible are like this example, that have good potential for a return greater than the loan cost. Education fits that analogy, since it’s expected the person’s income will be greater than the cost of the education and loans, and greater than if they had not gone to college. Using the same analogy, it can make sense to lend money to fund business, the purchases of someone’s primary residence, and to invest in stock (margin investing). These things have the expectation that the cost to borrow is offset by the increase in capital, generally speaking. These types of loans can be deductible, depending upon IRS guidelines.
Is student loan interest deductible?
Yes some student loan interest is deductible. IRS’s 94 pages of Publication 970, outlines them, but since that document is quite long and complex, we’ll only touch on a few things here.
The maximum deduction that is allowable is $2,500. The loan must have been taken out solely to pay qualified education expenses, for at least half-time in a degree program (but see the document for full details). However, higher income grads might not qualify, since the limit on modified adjusted gross income (MAGI) is $75,000 for singles or heads of households, or $155,000 if married filing a jointly.
Considering the example used in the this article, since the worker made only $50,000 and their income falls below the $75,000 limit, they can fully take advantage of the deduction. Assuming they began re-payment January 1st, their total interest they paid on the $50,000 loan in the first 12 months of payments is about $3,000, therefore then can deduct a large percentage of it. Make sure though that you check out the document or consult a professional tax-preparer for help.
Other tax savings opportunities?
A couple of the other potential areas of tax savings for grads is for business travel and relocation expenses, that an employer doesn’t reimburse the worker for. Not all of these unreimbursed expenses are deductible, see IRS document 529, nor are all relocation expenses, see IRS document 521. Also, ask your employer if they have a cafeteria style benefits programs that allows you to pay for other expenses pre-tax, like for public transportation.
There are a few options for reducing student loan payment amounts
- Graduated payment plan, whereby your loan payment increases automatically each year, and it starts out lower
- Income Based Repayment (IBR) plan, bases the payment on a percentage of your income (e.g., 15%) and other factors
- Loan consolidation, combines loans into one stream and some programs lowers the average interest rate by .25%, however be extremely careful signing up for these, as there are some programs that try to get you into plans with higher interest or move you away from government backed loans that have IBR or loan forgiveness options.
In summary, being smart with spending, wise with taxes and recording keeping, and exploring options for reducing your payments by calling your lender, are some things you can do not only survive post graduation, but financially thrive.
