Saving for College While Reducing Your Tax Bill
July 24, 2015 : Ashlee Crowl – The Tax InstituteLeer en español
Editor’s Note: If you are saving for college, here’s what you need to know about educational savings plans and your taxes.
As the cost of education rises, many parents are considering ways to be more prepared for the expense when the time comes. Saving for college early not only provides financial peace of mind, it also has tax benefits now and in future years.
College savings plans like IRAs, 529 plans and Coverdell Education Savings Accounts (ESAs) provide tax benefits while saving money. But how to choose which is best for you? Here is a rundown of your options and the tax benefits, or drawbacks, of each.
It is important to note all of these plans are for qualifying educational expenses at eligible educational institutions. Qualifying expenses usually include tuition, fees, tutoring, required books and supplies. It may cover some room and board expenses, but it varies so check it out first. Eligible educational institutions generally include colleges, universities or vocational schools that are eligible to receive student aid from the Department of Education.
Qualified Tuition Programs
You have probably heard of 529 plans. These are qualified tuition programs that allow individuals to prepay or save for qualified higher education expenses at eligible educational institutions.
- The earnings on your contributions grow tax-free. When they are distributed for eligible educational expenses, the earnings are excluded from the student’s taxable income.
- Some states allow contributions to these plans to be excluded from the adjusted gross income for calculating your state tax bill or allow a tax deduction for contributions.
- Grandparents can transfer substantial amounts to their grandchildren’s 529 plans without paying gift tax. This is a great tool, but it requires some financial planning to maximize the tax benefit.
- If there are distributions for nonqualified expenses or to schools that are not qualified educational institutions, the distribution may be subject to a 10% penalty.
Coverdell Education Savings Accounts
These are trust or custodial accounts created to pay for the qualified educational expenses of a specific beneficiary. The beneficiary must be under age 18 or have special needs for the account to receive contributions. Coverdell ESAs can cover costs of qualified higher education but also for qualified elementary and secondary education expenses such as tuition, fees, extended day programs, equipment, room and board expenses, uniforms and other expenses related to enrollment at a private, public or religious school.
- Individuals can contribute to these accounts for the previous tax year until the filing deadline (typically, April 15 unless extended). So you can designate contributions for the 2015 tax year until April 18, 2016.
- If the beneficiary reaches age 30, the account must be distributed. However, it can be rolled over for certain family members.
- Distributions for qualified expenses are tax-free.
- These plans require a little more effort to create and administer. There must be a governing document that satisfies various requirements such as requiring an IRS-approved bank or entity to serve as the trustee or custodian, and that the account will only accept certain kinds of contributions.
- Contributions to each beneficiary are limited to $2,000 per year, even if there are multiple ESAs for a beneficiary.
- There are limitations on how much one can contribute based on adjusted gross income. Any excess contributions are subject to a 6% additional tax.
- Distributions for nonqualified expenses or to schools that are not qualified educational institutions, may be subject to a 10% early distribution penalty on any earnings.
Education Savings Bond Program
You may be able to cash in qualified U.S. savings bonds without including the interest earned on the bond in taxable income. As always, there are some requirements:
- You have to pay qualified educational expenses for yourself, your spouse or your dependent.
- You must be eligible based on modified adjusted gross income. Otherwise, you could be affected by a partial or complete phase-out.
- You may not file using as married filing separately. The bond must be issued in your name or in the name of you and your spouse (as co-owners). The owner must be at least 24 years old before the bond’s issue date.
- If the requirements are met, the bond interest is not taxable when the bond is redeemed.
- Interest rates and the level of risk vary, so individuals may need to be cautious about their investment.
- Bond amounts that are cashed out and exceed educational expenses are taxable.
Individuals can take an early IRA distribution to cover qualified educational expenses without incurring the 10% additional tax. This treatment applies to education expenses of the IRA’s owner, their spouse or any child, stepchild or grandchild. The distribution amounts may be included in gross income based on the kind of IRA and the amount that has been invested and taxed. There are phase-out amounts based on your adjusted gross income.
All of these options are great savings tools to help you maximize your tax benefit and save for college.
Also keep in mind that there are tax credits to help offset educational costs. These credits can be used in conjunction with these savings plans. With a little planning, you can use educational savings plans to pay for school smarter and offset taxes.