This section is provided to assist clients plan for paying for college education and all the issues surrounding it, including tax benefits, aid programs, and educational savings programs. We encourage you to call for an appointment so that we can help you plan for your children’s education.
There are currently two nonrefundable educational tax credits: the American Opportunity and the Lifetime Learning Credits. Both credits will reduce a taxpayer’s tax liability dollar for dollar until the tax reaches zero with any excess of the tax liability being lost. Taxpayers who file married separate returns may not claim this credit.
American Opportunity Credit
This credit is available for four years of college, and the maximum credit per student is $2,500. The credit will be based on 100% of the first $2,000, and 25% of the next $2,000, of tuition, fees, and course material expenses paid during the tax year. 40% of the credit is refundable as long as the student is over between 18-24 years of age, is a full-time student, and is not self-supporting.
Lifetime Learning Credit
The Lifetime Learning Credit covers up to 20% of the first $10,000 of qualifying educational expenses for undergraduate, graduate, or certificate level courses (must be at least part-time student) or any course at an eligible institution to acquire or improve job skills of the student (no time requirement).
Gift and Estate Tax Considerations
Contributions to Section 529 Plans are subject to the gift tax rules. Under these rules, you may give up to the annual limit to another individual (double for a married couple) without having to pay gift taxes and without reducing your lifetime gift and estate tax exclusion.
Individuals are also allowed to make five years’ worth of gifts to a Section 529 Plan in a single year, but no additional gift could be given to the beneficiary of the plan for that five year period.
Section 529 Plans are an ideal estate-planning tool for wealthy grandparents as large contribution to 529 Plans can reduce their taxable estate much quicker than the current annual gift exclusion. Another benefit is that the assets remain in the individual’s control even though they leave their estate.
How Much Can Be Contributed?
There are no income or age limitations on Section 529 Plans. There are contribution limits, though most are quite high, in excess of $200,000. The maximum amount that can be contributed per beneficiary will vary between state plans as it is based on the projected cost of a college education.
Most programs have a minimum contribution which is fairly reasonable, and many have payroll or automatic withdrawal programs. Contributions to a 529 college savings plan must be made in cash and consist of after-tax money.
Qualified State Tuition Programs
A qualified state tuition program is one run by a state that allows individuals to make contributions to an account established for the higher education of a designated beneficiary’s.
There is no limit on annual contributions to a Qualified State Tuition program, but contributions are considered gifts to the beneficiary, making the annual gift exclusion amount the practical annual limit per contributor. However, a donor who makes total contributions exceeding the annual gift limit may choose to take the contributions into account over a five-year period, allowing the donor to contribute as much as $50,000 adjusted for inflation in one year and still avoid the gift tax. They will need to file a gift tax return and make a five-year election on the return.
The distributions of earnings from these programs can be excluded from income if used for qualified education expenses, which is a major benefit.
Qualified Tuition Programs
Qualified tuition plans (or Section 529 Plans) are intended to help families save and pay for college in a tax-advantaged way and are available to everyone, regardless of income. These plans allow individuals to gift large sums of money for a family member’s college education while maintaining control of the funds. Earnings from these accounts grow tax-deferred and are tax-free as long as they are used to pay for qualified higher education expenses. These accounts may also be used as an estate-planning tool, providing a way to transfer large amounts of money while avoiding the gift tax. These tax benefits make 529 plans an excellent vehicle for college funding.
Types of Plans
There are two kinds of Section 529 Plans. One allows you to prepay tuition for qualified universities and the other allows you to either save funds in a tax-free account to be used later for higher education costs.
College Savings Plans
You may contribute after-tax dollars to these state-sponsored accounts to be invested in some sort of savings vehicle. Many College Savings Plans use more aggressive investments when a child is quite young and move to more conservative investments as the child approaches college age. As with any investment, there are no guarantees of growth, and although the government sponsors them, the plans are subject to all the normal investment risks. And although the state sponsors these plans, funds may be applied to whichever school your child chooses to attend.
Prepaid Tuition Plans
As the name implies, a Prepaid Tuition Plan allows parents to pay for college education at today’s tuition rates. This eliminated parent’s worries about the future increase of tuition rates and offers assurance that the child will be able to afford college when that time comes. Many of these plans guarantee that you will only be covered if your child chooses to go to a public in-state institution.
You want to ensure the hard-earned money you save for your children’s college education actually ends up being used for college. 529 Plans are an attractive option because they allow you to keep control of the account whereas other popular accounts the UGMA/UTMAs become the child’s property once he or she reaches the age of maturity (usually 18 or 21). Money does not come out of the account without permission from the account owner, and if the designated beneficiary chooses not to go to college, the account owner may change the beneficiary to someone else.
The account owner with control over the funds doesn’t necessarily have to be the primary donor; a grandparent could make a large donation but name the child’s parent as the account owner. If the designated beneficiary of the plan decides not to go to school, then the account owner can simply change the beneficiary to someone else in the family.
There is no tax deduction for contributions to a Section 529 plan, but taxes on the earnings are tax-deferred while they are held in the account and tax-free when withdrawn to pay for qualified education expenses. This enables parents to accumulate money for college at a much faster rate than would be possible if they were required to pay tax on the investment gains and earnings.
If the earnings are withdrawn but not used for qualified expenses, the earnings are be subject to both regular taxes and a 10% penalty.
Tax Breaks for Higher Education
Congress has enacted many tax breaks to provide taxpayers options for tax-favored financing of their education and the education of their family members. Below we discuss some of these tax benefits. Qualified State Tuition Programs A qualified state tuition program is one run by a state that allows individuals to make contributions to an account established for the higher education of a designated beneficiary’s. There is no limit on annual contributions to a Qualified State Tuition program, but contributions are considered gifts to the beneficiary, making the annual gift exclusion amount the practical annual limit per contributor. However, a donor who makes total contributions exceeding the annual gift limit may choose to take the contributions into account over a five-year period, allowing the donor to contribute as much as $50,000 adjusted for inflation in one year and still avoid the gift tax. They will need to file a gift tax return and make a five-year election on the return. The distributions of earnings from these programs can be excluded from income if used for qualified education expenses, which is a major benefit. Penalty-Free IRA Withdrawals When funds are withdrawn from an IRA before a taxpayer reaches age 59-1/2, a 10% early withdrawal penalty is usually applied. However, if the funds are used to pay qualified higher education expenses, that penalty is waived. Qualified higher education expenses include tuition, room, board, fees, books, supplies, and equipment. Deduction For Interest Interest paid on student loans for tuition, room and board, and other expenses relative to higher education is deductible even if the taxpayer uses the standard deduction. Education Tax Credits There are only two nonrefundable tax credits: the American Opportunity Tax Credit and the Lifetime Learning Credit. Both credits reduce a taxpayer’s tax liability dollar for dollar until the tax reaches zero and cannot be used in conjunction with one another. Please call us to find out more about these credits as the rules may change from year to year. Above-the Line Education Deduction A deduction from gross income, up to a maximum of $4,000, is permitted for higher education tuition expenses provided that the taxpayer’s income is $65,000 ($130,000 on a joint return) or less. This deduction is only allowed in years when education credits are not claimed.
Using Home Equity to Fund Education
Many parents of college aged children have considered utilizing the equity in their home to help pay for college expenses. There are two questions you should consider if you are planning on this action. First, should the first trust deed be refinanced, or should a second trust deed line of credit be secured? Second, will the interest be deductible?
The answer to the first questions will depend on several factors, including how much it will cost to refinance, how favorable the interest rate is on your current mortgage, how long you will remain in the home, and how much you need to borrow. If your interest rate is near the prevailing rate for new mortgages, it would be better to obtain a second loan or line of credit. If you are planning on selling your home soon, the cost of refinancing the first mortgage is probably not wise, but if you are planning on staying in your home and your current mortgage is more than 2 points higher than the prevailing rates, refinancing is probably worth the extra cost.