Whether your loved one is just beginning his or her educational journey or they are planning to enroll in college in the next year or two, it’s never too early to begin the planning process to fund those future college costs – or to pay for those current or imminent college bills. We have outlined several approaches that seek to take maximum advantage of tax benefits to minimize those expenses. Please note that these suggestions are strictly related to tax benefits. You may have non-tax-related concerns that make these suggestions irrelevant. Please do not hesitate to contact your tax advisor to learn more.
Education savings accounts are a popular way to save money over the long-term for education expenses.
Qualified tuition programs (529 plans)
A qualified tuition program (also 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 are not deductible on federal taxes, but some states do allow a deduction. Be sure to check with your tax adviser to learn more.
The contributions are treated as taxable gifts to the child, but they are eligible for the annual gift tax exclusion ($16,000 for 2022 and 2023). A donor who contributes more than the annual exclusion limit for the year can elect to treat the gift as if it were spread out evenly over a five-year period.
The earnings on the contributions accumulate tax-free until the college costs are paid from the funds. Distributions from qualified tuition programs are tax-free to the extent the funds are used to pay “qualified higher education expenses”—which can include up to $10,000 in expenses for tuition for an elementary or secondary public, private, or religious school. Distributions of earnings that aren’t used for “qualified higher education expenses” will be subject to income tax plus a 10% penalty tax.
Coverdell education savings accounts
You can establish Coverdell ESAs (formerly called education IRAs) and make cash 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.
Organizations, such as corporations and trusts, can also contribute regardless of their adjusted gross income. Contributors must contribute by the due date of their tax return (not including extensions). There’s no limit to the number of accounts that can be established for a particular beneficiary; however, the total contribution to all accounts on behalf of a beneficiary in any year can’t exceed $2,000.
Although the contributions aren’t deductible, income in the account isn’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. The requirement that the child or member of the child’s family not have reached 30 doesn’t apply to an individual with special needs.
The above are just some of the tax-favored ways to build up a college fund for your children. If you wish to discuss any of them, or other alternatives, please call.