Article Highlights:

  • Sec. 529 plans
  • Coverdell Education Savings Accounts
  • American Opportunity Tax Credit
  • The Lifetime Learning Credit
  • Qualified Education Loan Interest

Figuring out how to pay for your child’s trade school or college education can be challenging, and the earlier you create your plan and begin executing it, the greater your chances are of having the needed money set aside to pay for it.  The government provides a variety of tax incentives to help defray the cost of education. Some require long-term planning to provide the most benefit, while others provide current tax deductions or credits. The benefits generally apply to both vocational schools and colleges.

Tax-Advantaged Savings Plans—There are tax-advantaged plans that allow you to save for the cost of college. Although they provide no tax benefit when contributing to the plans, they do provide tax-free accumulation and withdrawals if the distributions are used for qualified education expenses. The earlier they are established, the more you benefit from these plans.

  • Section 529 Plans—Section 529 plans (named after the section of the IRS Code that created them) are plans established to help families save and pay for college in a tax-advantaged way and are available to everyone, regardless of income. These state-sponsored plans allow you to gift large sums of money for a family member’s college education while maintaining control over the funds. The earnings from these accounts grow tax-deferred and are tax-free, if used to pay for qualified higher education expenses. The accounts can be used as an estate-planning tool as well, providing a means of transferring large amounts of money without gift tax. With all of these tax benefits, 529 plans are an excellent vehicle for college funding. Section 529 plans come in two types, allowing you to either save funds in a tax-free account to be used later for higher education costs or to prepay tuition for qualified universities. For 2017, you can contribute $14,000 without gift tax implications (or $28,000 for married couples who agree to split their gift). The annual amount is subject to inflation adjustment. There is also a special gift provision allowing the donor to prepay five years of Sec. 529 gifts up front without gift tax.

One nice feature of a Sec. 529 plan is that parents, grandparents, a rich uncle, or anyone else, for that matter, can each make annual contributions to the plan, allowing substantial amounts to be contributed each year.

  • Coverdell Education Savings Account—These accounts are actually education trusts that allow nondeductible contributions to be invested for a child’s education. Tax on earnings from these accounts is deferred until the funds are withdrawn, and if used for qualified education purposes, the entire withdrawal can be tax-free. Qualified use of these funds includes elementary and secondary education expenses in addition to post-secondary schools. This is the only one of the educational tax benefits that allows tax-free use of the funds for below post-secondary or college-level expenses. A total of $2,000 per year can be contributed for each beneficiary under the age of 18. The ability to contribute to these plans phases out when the modified adjusted gross income of married taxpayers filing jointly is between $190,000 and $220,000, or between $95,000 and $110,000 for all others.

A Coverdell account is beneficial if there are plans for your child(ren) to attend a private elementary and/or high school.

Education Tax Credits—Two tax credits, the American Opportunity Credit (partially refundable) and the Lifetime Learning Credit (nonrefundable), are available for qualified post-secondary education expenses for a taxpayer, spouse, and eligible dependents. Both credits will reduce one’s tax liability dollar for dollar until the tax reaches zero. The credit is not allowed for taxpayers who file married separate returns.

  • The American Opportunity Credit (AOTC) is a credit of up to $2,500 per student per year that covers the first four years of that student’s qualified post-secondary education. The student must be enrolled in a program leading to a degree, certificate, or other recognized postsecondary educational credential for at least one academic period beginning in that tax year. The credit is 100% of the first $2,000 of qualifying expenses plus 25% of the next $2,000 for a student attending a trade school or college on at least a half-time basis. Forty percent of the American Opportunity Credit is refundable (if the tax liability is reduced to zero). This credit phases out for jointly filing taxpayers with modified adjusted gross income between $160,000 and $180,000, and between $80,000 and $90,000 for others.
  • The Lifetime Learning Credit is a credit of up to 20% of the first $10,000 of qualifying higher education expenses. Unlike the American Opportunity Credit, which is on a per-student basis, this credit covers the whole family, i.e., it is per return, not per student. In addition to post-secondary education, the Lifetime Credit applies to any course of instruction at an eligible institution taken to acquire or improve job skills. For 2017, this credit phases out for jointly filing taxpayers with a modified adjusted gross income between $112,000 and $132,000, and between $56,000 and $66,000 for others. The credit is not allowed for taxpayers who file married separate returns.

The qualifying expenses for these credits are generally limited to tuition. However, student activity fees qualify if they are paid directly to the educational institution for the student’s enrollment or attendance. For the Lifetime Learning Credit, fees for course-related books, supplies, and equipment only qualify if they are paid directly to the school, while for the AOTC, if these types of expenses are needed for a course of study, they qualify whether or not the materials are purchased from the educational institution. Otherwise, eligible expenses paid for with a tax-free scholarship won’t qualify.

You may qualify for either of these credits even if you did not pay the tuition. (However, otherwise eligible expenses paid for with a tax-free scholarship won’t qualify.) The tax law says that if a third party (someone other than the taxpayer or a claimed dependent) makes a payment directly to an eligible educational institution for a student’s qualified tuition and related expenses, the student will be treated as having received the payment from the third party and, in turn, paying the qualified tuition and related expenses. Furthermore, qualified tuition and related expenses paid by a student would be treated as having been paid by the taxpayer if the student is claimed as the taxpayer’s dependent.

Education Loan Interest—You can deduct qualified education loan interest of $2,500 per year in computing your AGI. This is not limited to government student loans and could include home equity loans, credit card debt, etc., if the debt was incurred solely to pay for qualified higher education expenses. For 2017, this deduction phases out for married taxpayers with an AGI between $135,000 and $165,000 and for unmarried taxpayers between $65,000 and $80,000. This deduction is not allowed for taxpayers who file married separate returns.

We all know that a child’s success in life has a great deal to do with the education they receive. It’s never too early to start the planning process for how you’ll finance the higher education of your child(ren). Please call this office if you would like assistance in planning for your children’s future education.