It is never too early to prepare and go through the process of tax planning for college.
It’s no secret that a college education is expensive. Average annual charges for tuition, fees, and room and board at four-year public colleges and universities stood at $20,770 for in-state students and $36,420 for out-of-state students (this was averages for the 2017-2018 school year.)
Average charges were $46,950 at four-year private colleges and universities.1 Based on historical trends, these costs are likely to increase in the future.
Parents who are intimidated by these figures should realize that the expenses at most colleges and universities are generally less than the quoted prices. There are scholarships, grants, and work-study programs available that can soften the financial impact of a college education.
Parents should take the time to look into the various tax benefits that can help reduce the costs of sending a child to college. Getting an early start on tax planning for college expenses can help reduce some of the anxiety surrounding the whole issue of trying to figure out how to pay for college. Here are some areas worth further investigation.
Parents have several education savings opportunities that come with built-in tax benefits. Section 529 plans have grown in popularity over the years, but Coverdell education savings accounts also offer valuable tax benefits.
Section 529 Savings Plans
Section 529 college savings plans* are specifically designed for educational saving. You can invest a little at a time or contribute a larger lump sum, whatever approach works best for you. You choose how you want your contributions invested; your plan investments are then professionally managed. These plans offer several features that parents may find appealing:
- Investment earnings accumulate tax deferred and won’t be subject to federal income taxes when withdrawn for your child’s qualifying educational expenses. (Excess withdrawals are subject to tax and a potential 10% penalty.)
- Some states offer their residents tax incentives for investing in an in-state plan. For example, Ohio gives up to a $4,000 deduction for each child’s 529 plan contributed to during the year.
- As a parent, you retain control of the money in the account even after the child turns 18.
- If your child does not attend college or deplete the fund, you can change the account beneficiary to another qualifying family member without losing tax benefits.
Coverdell Education Savings Accounts
Annual contributions to these accounts are limited to $2,000 per child. This maximum phases out (is gradually reduced to zero) for taxpayers with modified adjusted gross income (AGI) between $95,000 and $110,000 (between $190,000 and $220,000 for joint filers).
Your contributions accumulate tax deferred at the federal level and earnings are tax-free when used for qualified educational expenses such as tuition, room and board, and books. If you make withdrawals from the account for non-educational expenses, the earnings portion of the withdrawal may be subject to federal income tax and an additional 10% penalty.
Another college planning option may be to discuss if opening a Roth IRA would make the most sense. Roth IRA contributions are post tax and offers special withdrawal rules for higher education.
Similar to other college savings plans, the earnings will grow tax-free and with a Roth you will have more flexibility on how the money is utilized (for example, if your child doesn’t need the money for college you can continue to invest in the Roth for the future).
Roth IRAs do not get tax benefits similar to other college savings plans and you will want to understand how financial aid views a Roth IRA for planning purposes. Roth IRA contributions have income limitations as well that you should know.
It’s best to sit down with your advisors to determine which vehicle makes the most sense for your situation.
Young adults who demonstrate high academic promise or who possess certain desirable skills may receive scholarships that can defray a percentage of the cost of attending college. Scholarships are generally exempt from income tax if the scholarship is not compensation for services and is used for tuition, fees, books, supplies, and similar items (and not for room and board).
Tuition Tax Credits
A tax credit gives you a dollar-for-dollar reduction against the taxes you owe the IRS. The following two education tax credits can help eligible parents alleviate the costs of educating a child.
American Opportunity Tax Credit (AOTC)
This credit is worth up to $2,500 per year for each eligible student in your family. It’s for the payment of tuition, required enrollment fees, and course materials for the first four years of post-secondary education. The credit is allowed for 100% of the first $2,000 of qualifying expenses, plus 25% of the next $2,000. Were the credit to exceed the amount of tax you owe, you may be eligible for a refund of up to 40% of the credit. The available credit is phased out for single taxpayers with modified AGI between $80,000 and $90,000, and for married couples with modified AGI between $160,000 and $180,000.
Lifetime Learning Credit (LLC)
This credit can be as much as $2,000 a year (per tax return) for the payment of tuition and required enrollment fees at an eligible educational institution. It is calculated as 20% of the first $10,000 of expenses. You cannot claim the credit for a student if you are claiming the AOTC for the student that year. Unlike the AOTC, qualified expenses for the LLC do not include academic supplies and no portion of the credit is refundable. The LLC is phased out (in 2018) for single taxpayers with modified AGI between $57,000 and $67,000, and for married couples with modified AGI between $114,000 and $134,000.
Student Loan Interest Deduction
A tax deduction lowers your tax liability by reducing the amount of income on which you pay tax. You can deduct interest on qualified loans you take out to pay for your child’s post-secondary education. The maximum deduction is $2,500 per year, but it phases out for taxpayers who are married filing jointly with AGI between $135,000 and $165,000 (between $65,000 and $80,000 for single filers). The deduction is available even if you don’t itemize deductions on your return.
*Certain 529 plan benefits may not be available unless specific requirements (e.g., residency) are met. There also may be restrictions on the timing of distributions and how they may be used. Before investing, consider the investment objectives, risks, and charges and expenses associated with municipal fund securities. The issuer’s official statement contains more information about municipal fund securities, and you should read it carefully before investing.
College Funds Held in Each Account
|General Savings Accounts||22%|
|Prepaid State Plan||8%|
|Certificate of Deposit||5%|
Don’t put this off until it’s too late. Set up a time to talk with one of our advisors to get started on the right path for tax planning and college.
1 Trends in College Pricing 2017, The College Board, 2017