The ABCs of tax-saving education
The tax code provides myriad incentives to encourage education. This means you have plenty of opportunities to save on your tax bill while giving your children and grandchildren the best education possible. But it also means you have to consider your options carefully to make sure you use the tax preferences that will best help your bottom line.
There are generally two ways the tax code offers savings on education. First, there are deductions and credits for education expenses, including the American Opportunity credit, the Lifetime Learning credit, the tuition and fees deduction, and the student loan interest deduction. The second and often better opportunity is a tax-preferred savings account, which comes in the form of either a 529 plan or Coverdell education savings account (ESA).
Unfortunately, all of these tax incentives — except 529 savings plans — phase out based on adjusted gross income (AGI). (See chart 8 for the various phaseout thresholds.) Regardless of your approach, making payments directly to educational institutions can help you save in gift taxes. (See Tax planning opportunity 12 for more information.)
Deductions and credits
The American Opportunity credit was added by the 2009 economic stimulus bill and temporarily replaces the Hope Scholarship credit for 2009 and 2010. The new credit is more generous and has a higher AGI phaseout than the Hope Scholarship credit. It is equal to 100 percent of the first $2,000 of tuition and 25 percent of the next $2,000, for a total credit of up to $2,500. It is also 40 percent refundable and allowed against the alternative minimum tax (AMT). The credit is only available for the first two years of college education (not room, board or books), and it covers only tuition and certain fees at colleges, universities or vocational or technical schools.
The Lifetime Learning credit can be used anytime during the college years as well as for graduate education. But it is less generous. It provides a credit of up to 20 percent of qualified college tuition and fees up to $10,000, for a maximum credit of $2,000. For 2009 and 2010, it also phases out at much lower income threshold than the American Opportunity credit. (See chart 8.)
Bear in mind that you cannot use both credits in the same year for the same student. If your AGI is too high to claim either credit, consider letting your child take the credit. But neither you nor the child will be able to claim the child as an exemption.
The maximum tuition and fees deduction is either $2,000 or $4,000, depending on your AGI. If you have children who are out of college and paying back student loans, remind them they may be eligible for the student loan interest deduction.
Section 529 savings plans
Section 529 savings plans allow taxpayers to save in special accounts and make tax-free distributions to pay for tuition, fees, books, supplies and equipment required for college enrollment. The economic stimulus bill passed in February 2009 clarified that computer technology, computer equipment and internet access are allowed as qualified expenses for 529 plans in 2009 and 2010.
529 plans come in two forms, prepaid tuition plans and college savings plans. Prepaid tuition plans allow you to “buy” tuition at current levels on behalf of a designated child. They can be offered by states or private educational institutions, and if your contract is for four full years of tuition, tuition is guaranteed when your child attends regardless of the cost at that time. Your state may also offer tax benefits for investments in the state qualified tuition programs.
College savings plans can only be offered by states and can be used to pay a student’s qualifying tuition at any eligible educational institution. They offer more flexibility in choosing schools and more certainty on benefits. If the student doesn’t use all of the account funds, the excess can be rolled over into the plan for another student.
529 plans have many benefits
- The plan assets grow tax-deferred, and distributions used to pay qualified higher education expenses are tax-free.
- Contributions aren’t deductible for federal tax purposes, but some states offer state tax benefits.
- There are no income limits for contributing and the plans typically offer much higher contribution limits than ESAs (set by state or private institution sponsors).
- There is generally no beneficiary age limit for contributions or distributions.
But there are disadvantages
- You don’t have direct control over investment decisions and the investments may not earn as high a return as they could earn elsewhere. (But you can roll over into a different 529 plan if you’re unhappy with one plan’s performance.)
- There is also a risk the child may not attend college and there may not be another qualifying beneficiary in the family.
Contributions to a 529 plan are subject to gift tax, so contributions over the annual gift tax exclusion ($13,000 in 2009) will use up your $1 million lifetime gift tax exemption (or be subject to gift tax). But there are opportunities to boost the account without creating gift tax headaches. (See Tax planning opportunity 13.)
Coverdell ESAs
Coverdell ESAs are similar to 529 plans. The plan assets grow tax-deferred and distributions used to pay qualified higher education expenses are income tax-free for federal tax purposes and may be tax free for state tax purposes. Contributions are also not deductible.
ESAs have two distinct advantages over 529 plans
- They can be used to pay for elementary and secondary school expenses.
- You control how the account is invested.
However, they also have disadvantages
- They are not available for some high-income taxpayers due to the AGI phaseout. (Consider allowing others, such as grandparents, to contribute to an ESA if your AGI is above the phaseout threshold.)
- The annual contribution limit is only $2,000 per beneficiary.
- Contributions generally cannot be made after the beneficiary reaches 18.
- Any balance left in the account when the beneficiary turns 30 will be distributed subject to tax.
- Another family member under 30 has to be named the beneficiary to avoid a mandatory distribution and maintain the account’s tax-advantaged status.
- As with 529 plans, there is always a risk the child will not attend college and there is no other qualified beneficiary.
Watch out for the kiddie tax
Be careful with an alternative technique that was popular in past years: transferring assets to children to pay for education with an account under the Uniform Gift to Minors Act (UGTA) or Uniform Transfer to Minors Act (UTGA).
These accounts allow you to irrevocably transfer cash, stocks or bonds to a minor while maintaining control over the assets until the age at which the account terminates (age 18 or 21 in most states). The transfer qualifies for the annual gift tax exclusion, but the expanding “kiddie tax” could limit any tax benefits. The kiddie tax was recently expanded to apply to children up to the age of 23 if they are full-time students (unless they provide over half of their own support from earned income). For those subject to the kiddie tax, unearned income beyond $1,900 in 2009 will be taxed at their parents’ marginal rate.
