About the author: Lamar Watson, CFP®, is a Fee-Only Financial Advisor in the Washington, D.C. area that works with clients virtually across the country. Lamar's work with his clients focuses on budgeting, employee benefits, paying down debt, buying their first home, and investing. Lamar is the Founder of Dream Financial Planning, a virtual Fiduciary Financial Planning firm specifically designed to help young professionals and minorities take control of their finances and fulfill their dreams. Feel free to schedule a complimentary consultation to learn how we use the DREAM Financial Planning Process ™ to help our clients achieve their goals.
Parents and grandparents of high school students have a wistful feeling about the child they’ve watched grow up, as well as a concern for what lies in their future. It’s only natural to want to help that future scholar navigate the financial hurdles to a great education. That said, you have a few hurdles of your own. It would be good to know how to financially help the child in your life while avoiding any extra tax burdens.
What School Expenses Qualify?
If you’re helping your child fund their education, the IRS offers education credits. These can be claimed for qualified expenses paid with cash, check, credit card, debit card, or with loan money. However, if you are paying with money from a loan, your credit applies only to the year you make the payment.1
These qualified expenses include:2
- Related expenses required for enrollment or attendance
- Expenses covered by the American Opportunity Tax Credit (AOTC)
Bear in mind, the AOTC has phase-out limits for households with a modified adjusted gross income of over $160,000 for married couples filing jointly or $80,000 for single filers. You can still get a partial credit up to the total phase-out limit of $180,000 for couples or $90,000 for those filing as single.2
For those who qualify, the AOTC offers up to a $2,500 credit on items assigned for study, such as:2
These items do not necessarily need to be purchased directly from the school or their bookstore to qualify for the credit, but they must be assigned to the student.
What Expenses Aren’t Qualified?
Expenses for sports, games, hobbies and courses without credit are not qualified. However, there is an exception for these expenses if they are necessary for the student’s degree.1
The following items are not qualified, even in situations where you’re paying the school directly for them:1
- Room and board
- Medical expenses/student health fees
- Personal, living or family expenses (such as meals)
It’s also important to remember that if you’re taking money from a tax-advantaged account, a scholarship or a grant with no tax requirements, you’re disqualified for the amounts used. For instance, if the student in question had a $5,000 scholarship, you’d subtract that amount before taking any deductions.1
As you consider how you'll cover the costs of college, starting with tax-focused saving strategies can help. Here are several college savings vehicles with important tax considerations you may want to consider.
529 College Savings Plans
Offered by states and some educational institutions, these plans allow you to save up to $15,000 per year for your child’s college costs without having to file an IRS gift tax return. A married couple can contribute up to $30,000 per year. However, an individual or couple’s annual contribution to a 529 plan cannot exceed the yearly gift tax exclusion set by the IRS.3 You may be able to front-load a 529 plan with up to $75,000 in initial contributions per plan beneficiary - up to five years of gifts in one year - without triggering gift taxes.4 Unlike the tax deductions above, 529s can be used for books, supplies, equipment, room and board, and even computers or tablets and education software.
Investing in a 529 plan can be an effective strategy to save for college. There are, however, some overlooked nuances related to 529 account distributions. And oftentimes, those nuances are not addressed (or even discovered) until after the distribution has occurred and the client is left with an unexpected tax liability.
To make the discussion with clients easier, we have created the “Is The Distribution From My 529 Plan Subject To Federal Income Tax?” flowchart. It covers some of the most common issues you should consider when planning to take a distribution from a 529 account and considers:
- What kinds of expenses are qualified
- The tax impact if the expense is nonqualified
- Considerations if the beneficiary is disabled
- The formula for calculating Adjusted Qualified Education Expense (AQEE)
- The impact of claiming American Opportunity Tax Credit and Lifetime Learning Tax Credit
- The formula for calculating the tax associated with any distribution (if applicable)
Remember, a 529 plan is a college savings plan that allows individuals to save for college on a tax-advantaged basis. State tax treatment of 529 plans is only one factor to consider prior to committing to a savings plan. Also, consider the fees and expenses associated with the particular plan. Whether a state tax deduction is available will depend on your state of residence. State tax laws and treatment may vary. State tax laws may be different than federal tax laws. Earnings on non-qualified distributions will be subject to income tax and a 10 percent federal penalty tax.
If your child doesn’t want to go to college, you can change the beneficiary to another child in your family. You can even roll over distributions from a 529 plan into another 529 plan established for the same beneficiary (or another family member) without tax consequences.3,4
Grandparents can also start a 529 plan or other college savings vehicle. In fact, anyone can set up a 529 plan on behalf of anyone. You can even establish one for yourself.3,4
Single filers with modified adjusted gross incomes (MAGIs) of $95,000 or less and joint filers with MAGIs of $190,000 or less can pour up to $2,000 into these accounts annually.5 If your income is higher than that, phaseouts apply above those MAGI levels. Money saved and invested in a Coverdell ESA can be used for college or K-12 education expenses. They cover the items mentioned above for 529s and can even be extended to tutoring and transportation related to education.5
Contributions to Coverdell ESAs aren’t tax-deductible, but the accounts enjoy tax-deferred growth and withdrawals are tax-free, so long as they are used for qualified education expenses. Contributions may be made until the account beneficiary turns 18. The money must be withdrawn when the beneficiary turns 30 or taxes and penalties may occur.5,6
UGMA & UTMA accounts
These all-purpose savings and investment accounts are often used to save for college. They take the form of a trust. When you put money in the trust, you are making an irrevocable gift to your child. You manage the trust assets until your child reaches the age when the trust terminates (i.e., adulthood). At that point, your child can use the UGMA or UTMA funds to pay for college; however, once that age is reached, your child can also use the money to pay for anything else.7
Using a trust involves a complex set of tax rules and regulations. Before moving forward with a trust, consider working with a professional who is familiar with the rules and regulations.
Imagine your child graduating from college, debt-free. With the right kind of college planning, that may happen. Talk to a financial professional today about these savings methods and others.
Dream Financial Planning Process ™
Whether you're managing student loan debt, starting a family, or considering buying your first home, the DREAM Financial Planning Process™ is tailored to the unique needs of busy professionals in their 30s and 40s. This process focuses more on short-term goals while you grow and evolve in your personal and professional life. So if you're looking for guidance on Financial Planning, optimizing employee benefits, budgeting, student loans, and managing your 401k or investments, we can help.
With uncertainty surrounding the economic stability of our country, it's okay to have fears and anxieties surrounding your own savings and investments. The most productive course of action from here is to reach out to Dream Financial Planning (or whoever your trusted advisor might be) and discuss your options. It's easy to have knee-jerk reactions when it feels like the bottom is falling out, but it is imperative to make decisions using research-backed data and a level head. If you'd like a Complimentary Review and risk assessment of your investment portfolio, feel free to send me an e-mail.
In the August Newsletter, I explore how you should invest money for your short-term goals after you've established an emergency fund. I also discuss how a Financial Advisor can help you avoid emotional decision-making with U.S. News and World Report and how to know if your Financial Advisor is the right fit for you. There are also blog posts where I outline how to complete a mid-year financial check-up and 5 college planning mistakes to avoid.
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