Saving For Education
Last Updated 12/03/07
Unless otherwise noted, phase-outs are stated per 2007 rates
There are four different approaches to saving for education. These are listed in order from the least to the greatest tax benefit:
All contributions to these plans are non-deductible. However, only earnings of the custodial account are taxable when withdrawn for qualified education expenses.
In addition to savings plans, there are currently four different kinds of deductions and credits available for higher education costs:
Custodial Accounts
These are accounts set up in the student’s name with parent or guardian as custodian. Not only are the earnings fully taxable, but they are taxed at the parents’ rate if they exceed $1,700 for children under age 18. This means that if the parents’ tax bracket is up to 28%, or more, that is the rate at which earnings on these accounts are taxed. This is the Kiddie Tax that both California and the IRS impose. Kiddie tax gets worse in 2008: kids under age 19 will be hit, as will full-time students under age 24 if their earned income is less than half their support.
When the child comes of age, usually at 18 (21 in some states), he or she is free to use the money as they please, which may or may not be for education.
Coverdell Education Savings Accounts (a.k.a. Education IRAs)
Joint filers with adjusted gross income less than $220,000 ($110,000 single) can contribute up to $2,000 per year per beneficiary under age 18. Contributions may be made as late as April 15th of the following year.
The earnings may be withdrawn tax-free, provided that they are used for education and provided that neither the Hope or Lifetime Learning credits are claimed. Qualified education expense includes grades K through 12, college, public, and private school costs and covers tutoring, computer equipment, room and board, uniforms, and extended day program costs. Grandparents, other family members, corporations and other entities may contribute so long as the child receives no more than $2,000 from all sources combined.
This plan works best if saving starts when the child is very young, to take advantage of the tax-free income benefit. It is also attractive to those who don’t plan to save more than $2,000 per year and who want full control over how funds are invested.
Prepaid Tuition Plans
These plans lock in tuition costs. If you purchase a year of tuition today, it will be worth a year of tuition 20 years from now. This is a low-risk plan that may appeal to those who want to eliminate risk from market drops. By keeping pace with inflation in the plan state, it is a little better than earning interest on a certificate of deposit or a treasury instrument.
The major drawbacks to these plans are the negative impact on financial aid in some states, and the limitation of choice in investment options and in schools. They are worth looking at, though, as they are becoming more flexible all the time in order to compete with the 529 plans.
These plans are not subject to income phase-out limits.
Section 529 Plans
These are almost too good to be true. They are run like mutual fund portfolios, and states offer a choice of risk options. Distributions for education expenses (including room and board) are tax free. There are no age or income restrictions on owners or beneficiaries. Anyone can open an account for a beneficiary, and then anyone can contribute up to $12,000 per year per beneficiary, or even use up to 5 years annual gift exclusions ( $60,000 in 2006) provided that they contribute no more to that beneficiary for 5 years.
Leaving assets in the owner’s name eases financial aid qualification. Only 5.6% of parental assets are considered available for education, while 35% of a student’s assets are allocated to education when applying for financial aid. An owner can switch a beneficiary to another family member or their spouse, or even to oneself, if the original beneficiary chooses not to go to college, or if excess funds remain, or if another beneficiary account is short. It is even possible to roll over some plans from state-to-state.
www.savingforcollege.com is a good place to compare state 529 plans.
Hope and Lifetime Learning Credits
These credits are available only to the taxpayer paying for the education and can be used for tuition and fees only. The Hope credit is a maximum $1,500 per student and applies to the first 2 years of at least half-time attendance in a degree program. The Lifetime Learning credit is a maximum $2,000 per taxpayer and covers all post-secondary education. These credits start to phase out at adjusted gross income of $94,000 for joint filers and $47,000 singles.
Education Deductions
Up to $2,500 of student loan interest may be deducted whether or not you itemize deductions. The adjusted gross income phase-out ranges are $110,000-$140,000 for joint filers and $55,000 - $70,000 for singles.
Up to $4,000 college costs are deductible. Funds from 529s or ESAs can’t be used; nor can the Hope or Lifetime credits be claimed. The adjusted gross income phase-out ranges are $130,000-$160,000 for joint filers and $65,000 - $80,000 for singles.
In Closing
This summary is necessarily brief in order to condense a lot of information into a form more palatable for most people to digest. If some of this information is not clear, please do not hesitate to email or call. Saving for children’s education is an important and often stressful topic for parents today. Hopefully, I can help you decide on the best approach for your family.