A Parent’s Guide to Surviving College Tuition Through Tax Benefits
5 min read
August 30, 2016 • Block Advisors
Has your child gone from toddler to high school graduate overnight? As a parent, you have worked your whole life to ensure your child is set up for a life of success, which includes the proper financial planning for their college education. But, did you understand, while putting money into your piggy bank, the education benefits on your income tax return? Probably not. Many parents overlook the financial benefits of paying for college.
So, build your child’s college savings… Here are five tax benefits to improve your overall tax situation and help save for college:
1. American Opportunity Credit (AOC)
This year, you have the potential to claim up to $2,500 for qualified education expenses paid for your college student through the American Opportunity Credit. Unlike tax deductions, tax credits directly reduce the tax itself. This one is a hidden gem: if your credit is more than your tax, the excess up to $1,000 will be refunded to you. You can claim the AOC for each eligible student in your family.
The AOC is income-based, so your allowable credit may be limited by the amount of your adjusted gross income.
2. Lifetime Learning Credit (LLC)
Another tax credit available to help offset the costs of higher education is the Lifetime Learning Credit. For this tax year, you may be able to claim up to $2,000 for qualified education expenses. The LLC has fewer restrictions than the AOC but only one credit is allowed per tax return, according to the IRS. Like the AOC, the LLC is a tax credit which directly reduces your tax. Your allowable LLC is limited by the amount of your adjusted gross income..
An additional word to the wise: the LLC is a nonrefundable credit, so if the credit is more than your tax, the excess won’t be refunded to you.
For more information on the Lifetime Learning Credit, visit the IRS website.
3. Tuition & Fees Deduction
The tuition and fees deduction can reduce the amount of your income subject to tax by up to $4,000, according to the IRS. This deduction is claimed as an adjustment to income, so you can claim it even if you don’t itemize deductions on your Schedule A (Form 1040).
Many parents who do not qualify for the AOC or LLC use this deduction.
For more information on it, visit the IRS website.
4. Coverdell Education Savings Accounts
A Coverdell Education Savings Account (Coverdell ESA) is a trust or custodial account created solely to pay for qualified education expenses for a designated beneficiary. (The beneficiary must be under 18 years old or have special needs for the account to receive contributions.) Many people are drawn to this type of account because distributions for qualified expenses are tax-free.
Coverdell ESAs are set up to include the cost of qualified higher education, and qualifying elementary and secondary education institutions as well. Common costs covered include:
- Extended day programs
- Room and board expenses
- School uniforms
- Expenses related to enrollment at a private, public or religious school
You can contribute to these accounts for the previous tax year until the filing deadline, which is typically on Tax Day (April 18 this year). Another caveat: If the beneficiary reaches age 30, the account must be distributed. However, it can be rolled over for certain family members. And, while these plans are tax-free, they require a little more effort to create and administer. For example, there must be a governing document that satisfies 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. Other restrictions are as follows:
- 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 percent additional tax.
- A portion of distributions for non-qualified expenses or to schools that are not qualified educational institutions are taxable and may be subject to a 10 percent penalty.
BONUS 1: Education Savings Bond Program
The Education Savings Bond Program allows you to exclude from gross income all or a portion of the interest earned on the redemption of qualified U.S. savings bonds. (A qualified bond is a Series EE bond issued after 1989 or a Series I bond.)
If the requirements are met, the bond interest is not taxable when the bond is redeemed. To qualify for this exclusion, you must:
- Pay qualified education expenses for yourself, your spouse, or your dependent(s).
- Be eligible based on modified adjusted gross income. Otherwise, you could be affected by a partial or complete phase-out.
- Not file as married filing separately. The bond must be issued in your name or in the name of you and your spouse (as co-owners).
- Be at least 24 years old before the bond’s issue date.
Bond amounts that are cashed and exceed qualified educational expenses are taxable.
BONUS 2: Education Exception to Additional Tax on Early IRA Distributions
You can take an early IRA distribution to cover higher education expenses for you, your spouse, your children, or grandchildren without incurring the 10 percent additional tax.
While there are many credits and deductions available once your child has left for college, it is best to meet with your Tax Advisor to determine how to maximize your tax benefits for the upcoming tax season. While the parents have saved their whole lives for education, there may be light at the end of the tunnel for tax benefits to maximize savings on their tax return.
Set up an appointment at you local Block Advisors office today.