Saving For College?

The parents and grandparents of graduating high school students often look back wistfully at the years they’ve spent watching their child grow up. Sometimes they also find themselves concerned for what lies in that child’s future. Naturally, you want to help your future scholar navigate the financial hurdles to a great education. That being said, you might have a few hurdles of your own. It would be beneficial to know how to financially assist the child in your life while avoiding any extra tax burdens.

Education Credits- What Qualifies?

If you’ve decided to help your child fund their education you should be aware that the IRS offers education credits. These credits can be claimed for qualified expenses paid with cash, check, credit card, debit card or with loan money. Bear in mind, if you are paying with loan money, your credit applies only to the year you make the payment.¹

These qualified expenses include:²

Expenses covered by the American Opportunity Tax Credit (AOTC)
Fees
Related expenses required for enrollment or attendance
Tuition

Be aware, the AOTC has phase-out limits for households with a modified adjusted gross income of over $160,000 for married couples filing jointly ($80,000 for single filers). You can still claim a partial credit up to the total phase-out limit of $180,000 for couples ($90,000 for single filers).²

For those who are able to qualify, the AOTC offers up to a $2,500 credit on items assigned for study, such as:²

Books
Equipment
Supplies

These items do not need to be purchased directly from the school (or the school bookstore) to qualify for the AOTC credit, but the item must be assigned to the student.

What Expenses Don’t Qualify?

Expenses for games, hobbies, sports and any courses without credit are not qualified. However, there could be an exception made for these expenses. The exception comes into play if the expenses are necessary for the student’s degree.¹

The following items are not qualified, even in a situation where you are paying the school directly for the item:¹

Insurance
Medical expenses/student health fees
Personal, living or family expenses (such as meals)
Room and board
Transportation

Keep in mind, if you’re taking money from a tax-advantaged account, a scholarship or a grant with no tax requirements, you’re disqualified for the amounts used. As an example, if the student had a $5,000 scholarship, you’d subtract that amount before taking any deductions.¹

Tax-Advantaged Accounts

As you think about how you can cover the costs of college, starting with tax-focused saving strategies can be helpful. Following are several college savings vehicles with important tax considerations you may want to examine.

529 College Savings Plans

529 Plans are offered by states and some educational institutions. You are allowed to save up to $15,000 per year for your child’s college costs in these plans without having to take the step of filing an IRS gift tax return. Up to $30,000 per year can be contributed by a married couple. Please note, an individual or couple’s annual contribution to a 529 plan cannot exceed the yearly gift tax exclusion set by the IRS.³ You might be able to front-load a 529 plan with up to $75,000 in initial contributions per plan beneficiary - up to five years of gifts in one year - without triggering gift taxes.⁴ Be sure to talk to a tax professional before making that move. Unlike the tax deductions discussed above, 529s are more flexible and can be used for books, supplies, equipment, room and board, and even computers or tablets and education software.

While state tax treatment of 529 plans is a factor to consider, it is not the only thing you should be considering prior to committing to a savings plan. Also, think about the fees and expenses associated with that particular plan. Whether a state tax deduction is available will depend on your state of residence. State treatment and tax laws may vary. Additionally, state tax laws may be different than federal tax laws. Earnings on non-qualified distributions will not only be subject to income tax but also a 10% federal tax penalty.

If your child doesn’t end up going to college, you can change the beneficiary on the 529 plan to another child in your family. You can also roll over distributions from a 529 plan into another 529 plan established for the same beneficiary (or another family member) without tax consequences.^3,4

Grandparents are also able to start a 529 plan or other college savings vehicle. It is not limited to parents. In fact, anyone can set up a 529 plan on behalf of anyone else. You can even establish one for yourself if you choose to.^3,4

Coverdell ESAs

Single filers with MAGIs (modified adjusted gross incomes) of $95,000 or less and joint filers with MAGIs of $190,000 or less can deposit up to $2,000 annually into this type of account.⁵ Phaseouts apply if your income is above those MAGI levels. Money saved and invested in a Coverdell ESA can be used for college or K-12 education expenses. They cover the items mentioned above for 529s and can even be extended to other items related to education such as tutoring and transportation.⁵

Contributions to Coverdell ESAs are not tax-deductible. However, the accounts enjoy tax-deferred growth and withdrawals are tax-free, provided the funds are used for qualified education expenses. Contributions may be made up to the point that the account beneficiary turns 18. The money must be withdrawn when the beneficiary turns 30 or taxes and penalties may apply.^5,6

UGMA & UTMA Accounts

While not specifically designed for college savings, these all-purpose savings and investment accounts are often used to save for college. UGMA and UTMA accounts take the form of a trust. When you put money in the trust, you are making an irrevocable gift to the child. You manage the trust assets until the child reaches the age when the trust terminates (i.e., adulthood). At that point, the child can use the UGMA or UTMA funds to pay for college; however, once that age is reached, the child can also use the money to pay for anything else they choose.⁷

Before moving forward with any type of trust, consider working with a professional who is familiar with all the rules and regulations. Using a trust involves a complex set of tax rules and regulations you likely need help navigating.

Imagine seeing your child graduating from college, completely debt-free. With the right kind of planning and knowledge, that is a real possibility. Be sure to talk to your trusted financial professional today about these savings methods and others.