Tax Considerations When Going Back to School
Four years ago, I left the workforce and moved to London, Ontario, to complete an MBA. The decision was a trade-off that involved several known factors (e.g., cost of tuition, time off work) and unknown factors (e.g., what I’d learn, people I’d meet, the job I’d get afterwards). As most do, I completed a financial assessment to see if it was worth it for me to go back to school from a pure number’s perspective. However, I’ve since realized that I did this calculation differently than most. After many conversations with prospective students, I wanted to share the thought process I used in case it can help you with your decision.
Assumptions I used for the financial assessment
Tuition: $50,000
Time off work: 18 months
Current salary: $70,000
Expected increase in salary: $20,000 (based on a median starting salary of $90,000)
I’ve left off living expenses assuming they’d be similar if working or at school. If your expenses would change while at school, you can add or subtract the difference.
The standard grad school calculation
Most people look at this scenario and decide the up-front cost is $70,000 times 1.5 years (the opportunity cost of not working) plus $50,000 tuition. This would result in a total cost of $155,000.
They would then likely compare this up-front cost to the increase in salary of $20,000 and decide the degree would pay for itself in 8 years.
Several unknown factors that could impact the financial benefits of a degree include:
Is your salary likely to increase over 18 months if you don’t go back to school?
Will the $20,000 increase remain constant over your career? Or could it increase or decrease with time?
Will you be off for only 18 months, or might it take longer to find the right role?
In addition to these minor critiques, it also doesn’t factor in taxes, which, as we’ll see shortly, have a material impact.
The after-tax calculation for Canadians
When I looked at the calculation, I wanted to get a better sense of the cost and value that I’d experience after tax considerations. To do this, there are three important adjustments I included in my calculation.
The tuition you pay will likely qualify for the tuition tax credit which allows you to lower future taxes by ~20% of the tuition you paid.
Your additional income will be taxed at a higher rate than what you’re likely used to today. As a result, you may receive 50% to 70% of the increase after-tax.
Taxes are calculated annually on a calendar basis. However, you’re likely to start a degree midway through the year and to start working again midway through a later year.
To provide an example of point three, when I went back to school, the class started in March. I continued to work at my job in January and February because I’d be able to keep almost the entire income I’d earn. In those two months, I made $12,000 and paid nearly $0 in tax that year. Also, when I graduated, I started working as soon as I could in June. If my income were the median $90,000, I’d have earned $53,000 over the next seven months. This $53,000 would be taxed at a much lower rate than $90,000 is taxed.
If we use these adjustments and look at the calculation again, the numbers become:
Tuition: $50,000 - $10,000 in tuition tax credit = $40,000
Time off work: 18 months (unchanged)
Current salary: $70,000 - 25% in taxes = $52,500
Expected after-tax increase in salary: $20,000 - 35% in taxes = $13,000
The up-front cost then becomes $52,500 times 1.5 years (the after-tax opportunity cost of not working) plus $40,000 after-tax tuition. This would result in a total cost of $118,750.
This could then be compared to the after-tax increase in salary of $13,000 to arrive at a payback period of 9 years.
Key takeaways
While the two calculations aren’t significantly different in this case, several key ideas surface. If you’re considering going back to school:
It’s important to look at an after-tax calculation if the numbers are a major deciding factor, and you’re on the fence.
If you decide to go back to school, any income you can earn in the calendar year that you start or end your program is attractive because it will be taxed at a lower rate. This will help you save up more for your degree and allow you to start paying off any loans faster once you finish.
It’s critical to take advantage of the tuition tax credit. There are horror stories of people who are unaware and end up losing out on its benefits.
Closing remarks
The decision to go back to school should consider more than just financial trade-offs. There are many reasons to go back to school that won’t show up in your bank account. I made some of my closest friends at school and challenged myself in ways I never could have imagined. However, going back to school can strain existing relationships and require the use of savings and student loans. Based on discussions I’ve had with prospective students and graduates, one of the most important steps when deciding to go back to school is to develop a list of what you want to achieve. You may want to:
Land a specific role or a job at a particular company
Meet new people and expand your network
Put yourself out of your comfort zone for an extended period
Learn new skills for your current job or to transition careers
Whatever your reasons, if you decide additional schooling is likely to get you from where you are today to where you want to be, then it’s important to take intentional steps towards your list of goals.