By: Investor Solutions
In the first of this two part series, we discussed financial aid and the formulas used to calculate how much aid a student is eligible to receive. Let’s move on to discuss other planning vehicles students and their parents can use to help save for and ultimately subsidize college expenses. Tax deferred accounts and tax credits are excellent tools that can help individuals amass significant tax free funds for payment of educational expenses and/ or reductoin of taxable income.
Tax Deferred Accounts
Coverdell Education Savings Account (CESA)
Formally known as an Education IRA, a Coverdell can be established for payment of qualified elementary, secondary and higher education expenses (including tuition, fees, expenses, and anything related to the child’s education). Educational institutions can include public, private or religious based schools. The maximum allowable non deductible contribution to such a plan is $2,000 per beneficiary per year with contributions phased out for joint filers with MAGI between $190,000 and $220,000 (between $95,000 and $110,000 for single filers). Beneficiaries must be a child under 18 years of age. Distributions from these accounts are excluded from gross income to the extent they do not exceed the qualified education expenses of the beneficiary during the year the distribution is taken. If distributions exceed qualified education expenses during the year, expenses treated as paid pro rata from both principal and interest. The excess earnings are taxable income to the distributee. An additional 10% penalty tax is assessed for distributions not used for education. Amounts remaining in the account after the student has completed his or her studies must be distributed within 30 days after the beneficiary reaches 30 years of age or 30 days after the death of the beneficiary. Funds in a Coverdell may be rolled over to a CESA for a member of the beneficiary’s family. These funds will not be treated as income to the distributee as long as the rollover occurs within 60 days of the distribution.
Section 529 Plans
A Section 529 Qualified Tuition program, which is established and maintained by a state, allows individuals to either set up an account to accumulate savings for college or make contributions to prepay tuition expenses. Either 529 plan can be owned by a parent or grandparent, single individual, UGMA, UTMA or trust. Unlike the CESA which has very small annual contribution limits, an individual can contribute up to $55,000 ($110,000 for a couple) in one year to this type of account gift tax free. The IRS treats this lump sum payment as the equivalent of five gifts over a five year period (or $11,000 per year). As with CESAs, a 10% penalty will be imposed for distributions not used to pay for educational expenses. The owner of the plan can rollover the value of the account to another beneficiary as long as he or she is in the same generation as the current beneficiary. If he or she is not, the rollover will be deemed a taxable gift.
The Hope and Lifetime Learning Credits can be claimed by individuals for tuition expenses incurred in the pursuit of a college, graduate or vocational degree. Both credits are available for the payment of education expenses for a taxpayer, spouse or dependent. The amount of either credit is reduced when Modified Adjusted Gross Income (MAGI) for joint filers is between $87,000 and $107,000 (between $43,000 and $53,000 for single taxpayers).
The Hope Scholarship Credit
The Hope Scholarship Credit is capped at a maximum of $1,500 per student for each of the first two years of post secondary education. In order to claim the credit, the student must attend school at least on a half-time basis. The credit cannot be claimed for expenses paid for with grants or scholarships. It can apply, however, to expenses paid with loans, gifts or the student’s earnings.
The Lifetime Learning Credit
The maximum allowable Lifetime Learning Credit is $2,000 per year. Unlike the Hope credit, the student is not required to attend a minimum number of courses to qualify nor is the student required to be seeking a degree. It can be claimed for individuals who are taking courses merely to acquire or improve job skills. The credit can be used for expenses incurred by either the taxpayer, his or her spouse and dependents. Additionally, the student can claim the credit for an unlimited number of years as long as qualified education expenses are being incurred.
Putting It All Together
We have taken a detailed look at financial aid formulas, tax deferred accounts and tax credits and we hopefully have a clear picture of what all of these are, but how do we apply all of this newly acquired knowledge? This depends on which stage of the process you are in. The following tools are available to you if you are in the:
College Funding Years:
- 2503( c ) Trust
- EE Educational Bonds
- Coverdell Education Savings Account
- 529 Plan (either college savings or prepaid tuition)
College paying years:
- Hope Credit or Lifetime Credit or Coverdell Withdrawal or 529 Plan Distribution (You cannot have a combination of these, it must be one or the other.)
- UGMA/UTMA assets
- 2503 ( c ) assets
Deciding what investment vehicle to use and/or what accounts to draw from to pay for college depends largely on whether or not you will qualify for financial aid. Someone who will potentially qualify should do everything possible to reduce their expected family contribution. Ways of accomplishing this are by diverting savings to tax-deferred retirement accounts rather than taxable accounts, establishing 529 plans in a grandparent’s name and maintaining a high level of equity in your primary residence, among others. Your trusted financial advisor will be able to help you develop a strategy that works for your particular situation.
I know that I have given you a lot of information in these last two articles. I hope, though, that it was useful information that has helped you make better choices regarding saving and paying for college expenses. For more information on these types of vehicles and planning for college go to http://www.savingforcollege.com/.