The Ultimate Guide to Tax Savings for Education
According to the College Board, the average cost of tuition and fees for the 2015–2016 school year is $32,405 for private colleges, $9,410 for in-state, public school tuition, and $23,893 for out-of-state, public university tuition.
With tuition on the rise, many parents choose to plan ahead to save for their child’s college education. Educational savings plans provide not only an opportunity to save money for education, but also potential tax savings.
Many people wonder, “Is it difficult to navigate through the vast amount of potential educational tax savings for education?” There are a variety of options, like 529 Plans, Coverdell Education Savings Accounts (ESAs), Educational Savings Bonds, and penalty-free IRA Distributions. Here are the considerations of each type of tax savings for education and how it will potentially affect your overall financial forecast:
529 Plans: Qualified Tuition Programs
A 529 plan, or Qualified Tuition Program, is a type of savings program where individuals can prepay or save for qualified higher education expenses at eligible educational institutions. Many people enroll and participate in 529 plans for their children or grandchildren for a variety of reasons:
- 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.
The biggest drawback of 529s is this: if there are distributions for non-qualified expenses or to a higher education institution that is not qualified, a portion of the distribution is taxable and may be subject to an additional 10 percent penalty.
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.
Education Savings Bond Program
The Education Savings Bond Program permits qualified taxpayers to exclude from their 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, the taxpayer must:
- Pay qualified education expenses for the taxpayer, the taxpayer’s spouse, or the taxpayer’s dependent.
- 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.
Also, bond amounts that are cashed out and exceed qualified educational expenses are taxable.
Individuals can take an early IRA distribution to cover qualified educational expenses without incurring the 10 percent additional tax.
Bonus Section: College Tuition Tax Deductions for YOU
In a study reported by U.S. News & World Report, former college students said they did not expect to pay off student loans until age 41. And more than 70 percent of bachelor’s degree-earning college graduates have student loans, with an average balance of $28,400 per borrower. So, while you may be planning for your child’s education, you still may owe on yours.
If you do still have student loan payments, you may be able to deduct any interest you pay. Generally, you may deduct $2,500 or the amount of interest you actually paid—whatever the lesser amount is. This benefit may be phased out based on your adjusted gross income. This deduction can help lower your taxes.
Not Sure What Avenue to Pursue? Connect with Experts to Find Additional Tax Savings for Education
If you prepare your taxes with the help of Block Advisors, we’ll guide you to making informed decisions about how education deductions and tax credit can factor into your yearly tax return, as well as your overall financial picture.
For additional resources on tax savings for education, review this resource from the IRS.