Financial Abundance

It is expected that taxes will soon rise.  It is also fairly certain that the cost of a college education for our children or grandchildren will continue to rise faster than the annual rate of inflation.  Let’s look at some of the ways that you can save taxes while saving for your children’s or grandchildren’s college education.

You may be aware of the Qualified State Tuition Program, commonly called a Section 529 College Savings Plan.  With the 529 College Savings Plan you can provide a fund for each child.  Contributions are treated as gifts to the person for whom the plan is established and receive the annual gift tax exclusion of $13,000.  A couple may double this gift amount to $26,000.  A unique attribute of the 529 College Savings Plan is the ability to provide up to five times the annual federal gift tax exclusion amount in a single year.  This allows a single gift of up to $130,000 for each child.

529 College Savings Plan contributions are not tax deductible.  However, all interest and appreciation of the plan’s assets grow tax free until withdrawn.   As long as funds are withdrawn to pay for qualified higher education expenses, the withdrawals are also tax free.  If a designated beneficiary does not use their 529 funds, the donor you may change the beneficiary to a different person, including themselves.  However, if withdrawn funds are not used for higher education expenses, a ten percent penalty plus taxes on all of the funds growth and income will be applied to the withdrawal.

The Coverdell Education Savings Account (ESA) is a less know college savings plan.  Tax-wise, the Coverdell ESA behaves the same as a 529 plan.  However, Coverdell ESAs allow only a $2,000 annual contribution for each beneficiary.  On the positive side, a Coverdell ESA can be set up similar to a Roth IRA providing the “responsible party” with virtually unlimited investment options.  As long as the beneficiary has not reached age 30, the “responsible party” for the Coverdell ESA may change the beneficiary to another person under age 30.

When you purchase EE and I Savings Bonds, they may be redeemed tax free when the bond owner, their spouse or other dependents use these funds to pay for college tuition and fees.  However, due to income phase outs restrictions, full deductibility is lost when a couple has taxable earning above $104,900.

You may also withdraw funds from an individual retirement account, before age of 59 ½, to pay for any family member’s qualified post-secondary education expenses.  The proceeds will be treated as a normal IRA withdrawal with the 10% early withdrawal penalty waived.  .

The Hope Scholarship Credit, now called the American Opportunity Tax Credit (AOC), allows a parent to claim up to a $2,500 annual tax credit for a dependent’s college tuition and mandatory fees.  This tax credit will “phase out” for couples earning above $160,000 per year.  Since this is a tax credit, the full amount (up to $2,500) can be deducted from taxes owed.

The Lifetime Learning Credit can help pay for your own, your spouse, or your children’s education.  You may claim a tax credit of twenty percent of up to $10,000 in combined tuition and mandatory fees for anyone (and everyone) in your family.  Like the AOC, the Lifetime Learning Credit is a tax credit, lowering taxes owed up to $2,000.

The Lifetime Learning Credit’s “phase out” begins at $100,000 per year for joint filers.  Since you cannot claim both the AOC and the Lifetime Learning Credit in the same year, if you qualify for the full AOC, you cannot use this credit.  However, the Lifetime Learning Credit can be used for part time students and for courses to improve your job skill, while the AOC only applies to full time college students.

College expenses will continue to rise.  It is more critical than ever for families to begin early planning to meet these high expenses.  As taxes rise, the tax savings from these programs will become an ever more important piece of your child’s or grandchild’s college education planning.