Smart Strategies to Save and Pay for College

With the rising cost of higher education, finding effective ways to save and pay for college has become a top concern for many American families. Fortunately, the U.S. tax code offers several tools and strategies that can help ease the financial burden. Below is an overview of some of the most beneficial tax breaks and planning options for funding your child’s or grandchild’s education.

529 Plans: A Tax-Advantaged Way to Save for College

A 529 plan allows you to either prepay tuition or contribute to an investment account designated for future higher education expenses. These plans are established by state governments or private institutions.

While contributions aren’t tax-deductible, they are considered taxable gifts to its beneficiary. Also, they qualify for the annual gift tax exclusion, which is currently set at $19,000 per recipient. If you contribute more than this amount, you can elect to treat the excess as if it were spread out over five years. This means a grandparent (or anyone else) can contribute up to $95,000 ($19,000 × 5) per beneficiary in one year without incurring gift tax.

Earnings on a 529 plan investment grows tax-free, and withdrawals are also tax-free when used for “qualified higher education expenses.” These expenses include tuition, fees, books, and even up to $10,000 in tuition for elementary or secondary school. However, if withdrawals are used for nonqualified expenses, the earnings portion is subject to income tax and a 10% penalty.

Coverdell Education Savings Accounts (ESAs)

A Coverdell ESA allows you to save up to $2,000 annually per child under age 18. This age limit doesn’t apply to beneficiaries with special needs.

Contributions aren’t tax-deductible, but the account’s earnings grow tax-free. Withdrawals are also tax-free if used for qualified education expenses. However, if the child doesn’t attend college, funds must be withdrawn by the time they turn 30, and any earnings will be subject to taxes and penalties. Alternatively, unused funds can be transferred tax-free to another family member’s ESA, if they are under 30. Special note: This age limit does not apply to individuals with special needs.

It’s important to note that income limits apply. Contribution eligibility starts to phase out for married couples with an adjusted gross income (AGI) over $190,000 ($95,000 for singles). These thresholds have not been adjusted for inflation in recent years. If parents earn too much to contribute, the child may contribute to their own account instead.

U.S. Savings Bonds: A Secure Way to Fund College

U.S. savings bonds offer two tax advantages when used for education:

• Interest doesn’t need to be reported for federal tax purposes until the bonds are redeemed.

• Interest on “qualified” Series EE and Series I bonds may be exempt from federal tax if used for qualified college expenses.

To qualify for the tax exemption, the bonds must be purchased in the parent’s name (not the child’s) or jointly with a spouse. Additionally, the proceeds must be used for tuition and fees—expenses such as room and board do not qualify. If only a portion of the bond proceeds is used for education, only that portion of the interest is exempt. The exemption is phased out at higher income levels.

Education Tax Credits: Reduce Your Tax Burden

In addition to savings accounts, tax credits can provide financial relief when paying for college expenses. See below.

• American Opportunity Tax Credit (AOTC): This credit offers up to $2,500 per eligible student per year for the first four years of undergraduate study. It is subject to income limits and is partially refundable (up to $1,000), meaning you could receive a refund even if you owe no tax.

• Lifetime Learning Credit (LLC): This credit provides up to $2,000 per tax return (20% of up to $10,000 in qualified education expenses). Unlike the AOTC, there is no limit on the number of years you can claim the LLC, making it beneficial for graduate studies and professional development courses. However, it is also subject to income limits.

Disclaimer: You can’t claim both the AOTC and the LLC for the same student in the same year, but you can claim each credit for different students in the same household if eligibility requirements are met.

Plan Ahead for Maximum Benefit

These are just a few of the tax-efficient ways to save and pay for college. By understanding and utilizing these strategies, you can better manage education costs and maximize available tax benefits. Contact us to discuss the best approach based on your unique financial situation.