If you are helping your child navigate the college application process, you may feel like reaching for indigestion medicine when you review the costs of tuition and room and board. It wouldn't be a surprising reaction given that public and private college costs have been rising for a long time.
However, before you despair of ever affording your children's college education, it may help to understand two important facts. First, the expenses at most colleges and universities are generally less than the quoted prices. Second, there are various ways to lessen the financial burden of attending college, including scholarships, grants, and work-study programs. In addition, one key step you can take as a parent is to look into the various federal tax breaks that are available for both saving and paying for college.
Here's a look at these tax breaks:
Section 529 Plans
Section 529 plans are a tax-smart way to save for a child's college education. The money in a Section 529 plan grows on a tax-deferred basis, and distributions for qualified educational expenses are free of federal income tax. (Many states offer Section 529 plan tax benefits for their residents as well.)
Most Section 529 plans are state sponsored. They come in two varieties: prepaid tuition plans and college savings plans. You can fund a plan by investing a lump sum or by making regular contributions. You can contribute to a Section 529 plan regardless of your annual income or age. Moreover, if you don't like some of the features of your state's plan, you can participate in another state's plan.
You could choose to open a 529 plan account and begin making contributions to it when your child (or grandchild, since grandparents can also open 529 plan accounts) is first born or very young, investing your contributions in one or more of the selection of investment options offered by the company that manages the plan. By investing sooner -- and thanks to the power of compounding -- a significant sum potentially may be available to pay college expenses by the time that child enters college.
One other attractive feature of a Section 529 plan is that you retain control of the money in the account even after your child reaches age 18. In addition, you have the flexibility to name another qualifying family member as the beneficiary of the account if your child does not attend college or does not deplete the funds in the account, and you won't lose tax benefits.
Coverdell Education Savings Accounts
Coverdell Education Savings Accounts (ESAs) are another tax-savvy way to set money aside for a child's educational expenses. These accounts allow for a maximum annual contribution of $2,000 per child. However, the contribution amount depends on the annual income of taxpayer. For example, annual contributions are capped at $2,000 for joint filers with a modified adjusted gross income (MAGI) up to $190,000 and are gradually reduced for a MAGI between $190,000 and $220,000. Taxpayers whose MAGI is greater than $220,000 are ineligible to contribute to a Coverdell ESA.
Contributions are not tax deductible, but any income or capital gains earned by the account will accumulate tax deferred (at the federal level), which gives the money in the account an opportunity to compound faster. Withdrawals can be taken out tax free for qualified education expenses, such as tuition, room and board, and books. Just be aware that if you withdraw money from a Coverdell account for non-education purposes, you may have to pay federal income taxes and a 10% penalty on the earnings portion of the withdrawal.
Education Credits
A tax credit is more valuable than a tax deduction in that a credit reduces your tax bill on a dollar-for-dollar basis. An education credit helps with the cost of higher education by reducing the amount of tax owed on your tax return. There are two education credits available: The American Opportunity Tax Credit and the Lifetime Learning Credit.
The American Opportunity Tax Credit (AOTC). This credit is worth up to $2,500 and is available to help pay for tuition, enrollment fees, and required course materials for the first four years of your child's post-high school education. The credit equals 100% of the first $2,000 of qualifying expenses plus 25% of the next $2,000. If the credit is greater than the amount of tax you owe, the tax law allows for a refund of 40% off the remaining credit. Just be aware that there are income caps on eligibility for this credit.
The Lifetime Learning Credit (LLC). This credit reduces your tax bill on a dollar-for-dollar basis for part of the tuition, fees, and other qualifying expenses you pay for yourself, your spouse, or a dependent for a post-high school education. The credit can be worth up to $2,000 a year. To qualify for the credit, you must have made qualifying tuition and fee payments to a post-high school institution during the year. There is an annual income cap on eligibility for the LLC credit -- the credit phases out for single taxpayers with MAGI between $80,000 and $90,000 and for married couples with MAGI between $160,000 and $180,000.
You should understand that you cannot claim the AOTC in the same year that you claim the LLC. IRS regulations only allow one tax credit per student per year. Since the AOTC is more valuable than the LLC, find out whether you qualify for the AOTC before applying for the LLC.
Consult Your Tax Professional
Your tax professional can answer any specific questions you may have and provide assistance if you are uncertain about the various rules that apply in your situation.
Source/Disclaimer:
Investing in Section 529 plans involves risk, including loss of principal. Before you invest in a Section 529 plan, request the plan's official statement and read it carefully. The official statement contains more complete information, including investment objectives, charges, expenses, and the risks of investing in a Section 529 plan, which you should carefully consider before investing. You should also consider whether your home state or your beneficiary's home state offers any state tax or other benefits that are only available for investments in such state's Section 529 plan. Section 529 plans are not guaranteed by any state or federal agency. By investing in a Section 529 plan outside of the state in which you pay taxes, you may lose the tax benefits offered by that state's plan. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary.
