Tax Code Incentives That Help Pay For College: Part 1
With the beginning of the college academic year, it seems a fitting time to discuss various tax aspects of sending your kids to college. We began this in my last column, August 20, where I discussed the possible consequences to claiming your student as a dependent on your tax return. Continuing the college theme, this is the first of a two-part series on how the tax code attempts to help families and individuals meet the ever increasing cost of higher education.
If you are a parent with college-bound children, you no doubt are concerned with setting up a financial plan to fund future college costs. If your children are already college age, your goal is to pay for current or imminent college bills. I'd like to address both of these concerns by suggesting several approaches that seek to take maximum advantage of tax benefits to minimize your expenses. (Please note that the following suggestions are strictly related to tax benefits. You may have non-tax-related concerns that make the suggestions inappropriate.)
Planning for college expenses. Here are a few ways the tax law can assist you in planning for college costs.
Savings bonds. It is possible to invest in U.S. savings bonds and take advantage of tax-free interest when the bonds are used to pay for college tuition. Here's how the rules work: The bond must be issued to an individual at least 24 years old. That is, the bond will be issued to you, rather than to your child who will be attending college. It can be owned jointly by you and your spouse, but not jointly with anyone else (such as your child).
Only Series EE and Series I U.S. savings bonds qualify—these are the bonds bought at a discount that accrue earnings over time. For the interest to be excludable, the proceeds from the bond must be used for “qualified higher education costs” for any individual who is your dependent (see August 20th edition of The Sun-Times for my article on who qualifies as your dependent) or for you or your spouse. Costs which qualify are for tuition or fees at a college or graduate school. Nursing schools and some vocational schools may also qualify. Room and board costs do not qualify.
Qualified tuition programs. A qualified tuition program (known as a 529 plan) allows you to buy tuition credits for a child or make contributions to an account set up to meet a child's future higher education expenses. Qualified tuition programs can be established by state governments or by private education institutions.
Contributions to these programs aren't deductible for federal purposes. However, Arkansas does allow a deduction for contributions made to its state sponsored plan, The Gift Plan. Contributions are treated as taxable gifts to the child but they are eligible for the annual gift tax exclusion ($13,000 for 2010), and a donor who contributes more than the annual exclusion limit for the year can elect to treat the gifts as if they were spread out over a 5-year period.
The earnings on the contributions accumulate tax-free until the college costs are paid from the funds. And distributions from qualified tuition programs are tax-free to the extent the funds are used to pay qualified higher education expenses. As an incentive to only use these funds for education, distributions of earnings that aren't used for qualified higher education expenses are subject to income tax plus a 10% penalty tax.
Another advantage, plan accounts can be transferred to other family members.
Coverdell education savings accounts. You can establish Coverdell ESAs and make contributions of up to $2,000 for each child under age 18. (This age limitation doesn't apply to a beneficiary with special needs, defined as an individual who because of a physical, mental or emotional condition, including learning disability, requires additional time to complete his or her education.)
The right to make these contributions begins to phase out once your AGI is over $190,000 on a joint return ($95,000 for singles). If the income limitation is a problem, the child can make a contribution to his or her own account.
Although the contributions aren't deductible, funds in the account aren't taxed, and distributions are tax-free if spent on qualified education expenses. If the child doesn't attend college, the money must be withdrawn when the child turns 30, and any earnings will be subject to tax and penalty, but unused funds can be transferred tax-free to a Coverdell ESA of another member of the child's family who hasn't reached age 30. (These requirements that the child or member of the child's family not have reached 30 do not apply to an individual with special needs.)
Next time, we’ll address how the tax law attempts to assist us to actually pay for college.
