As the former President of South Africa and Nobel Peace Prize recipient, Nelson Mandela, once said: "Education is the most powerful weapon which you can use to change the world." And even while obtaining an education is integral to our world, planning for a child’s education can be an exciting, yet daunting task. Thankfully there are some tax-advantaged strategies you can consider:
1. Qualified Tuition Programs/529 plans
2. Coverdell ESA (Education Savings Account)
3. Roth IRA
4. American Opportunity Tax Credit (AOTC) and Lifetime Learning Credit
What is a 529 plan and what are the benefits of utilizing one?
A 529 plan is a tax-advantaged savings plan designed to encourage savings for future college or other post-secondary education expenses. 529 plans, legally known as “qualified tuition plans”, are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code. A major benefit of 529 plans is that anyone is able to make contributions regardless of their annual earnings.
The annual gift exclusion amount or in other words, the annual amount that can be contributed to an individual 529 plan each year without filing a gift tax return reporting is $14,000 per recipient ($28,000 for married contributors). If an account owner’s contribution to a Plan account for a beneficiary in a single year exceeds $14,000 ($28,000 for married contributors), the account owner may elect to treat up to $70,000 of the contributions, or $140,000 for joint filers, as having been made over a period of up to five years for federal gift tax exclusion. There are other benefits as well:
- Contributions to a 529 plan are not deductible, but amounts deposited in the account can grow tax-deferred. If the funds are used for qualified higher education expenses such as tuition, fees, books, supplies, and certain room and board expenses (if student has at least half-time status), they can be distributed income tax-free.
- 529 plans are removed from account owner’s gross estate ultimately minimizing account owner’s estate tax liability upon death. The best news is that account owner does not lose control. This is a truly remarkable benefit when you compare it to the “normal” gift and estate tax laws. The grandparents who are advised to reduce their estate tax exposure through gifting, but cannot stand the thought of irrevocably giving away their assets, can now have their cake and eat it too.
- The beneficiary of a 529 plan can be changed at any time. However, it is important to note that if the newly designated beneficiary is not a qualified family member (this extends to nieces, nephews, first cousins, and even an aunt or uncle) or is in a lower generation than the previous beneficiary, this change can result in negative tax consequences.
- In many states, full or partial deductions are offered for 529 plan contributions. While a majority of states offer these full or partial deductions, Minnesota currently does not. Minnesota residents may choose other states’ plan as the Minnesota Plan does not offer additional tax benefits.
Coverdell ESA (Education Savings Account)
Coverdell ESA is a savings account that consists of nondeductible contributions where the earnings portion will not be taxed if used for qualified education expenses. Each year, a $2,000 contribution can be made per beneficiary. An income threshold applies to this account of $110,000 for single filers and $220,000 for married filers. A unique characteristic of this account is that tax-free distributions can be made for qualified expenses at elementary and secondary schools in addition to four-year undergraduate programs. A caveat of this account is that any remaining account balance must be distributed upon the beneficiary attaining 30 years old, with the remaining amount subject to an additional penalty.
ESA is not as commonly used as the 529 plans because of the lower annual contribution limit and the phase out income limit.
Using a retirement account Roth IRA to save for education expenses has some unique benefits:
- Roth IRAs are more flexible than 529 plans and ESAs. If your children do not go to college or get a scholarship, you can use the funds inside Roth IRA to fund your retirement without paying any taxes and penalties.
- Roth IRAs may provide the same tax-free treatment for distributions. Roth IRA contributions (not earnings) can be distributed at any age, and at any time, 100% tax and penalty free. In addition to Roth IRA contributions, amounts converted to a Roth IRA from an IRA may also be distributed tax and penalty free. Even if you are under age 59.5, Roth IRA conversion amounts can be withdrawn tax and penalty free as long as the conversion took place five years ago or longer. If you wait until age 59.5 and meet the five years rule, then any gains on the conversions can also come out tax and penalty free. Distributions can be used for any purposes, not limited to higher education.
- Roth IRAs are not included as an asset on the FAFSA form. If you want to receive student aid, the filing of a Free Application for Federal Student Aid (FAFSA) is a must. Most assets including 529 plans are included in the calculation of the expected family contribution (EFC). Roth IRAs along with other retirement accounts are not considered assets when determining a family’s EFC.
Annual contribution limit is $5,500 and $6,500 (age 50 or over) in 2016. Roth IRA income limits (for single filers): phase-out starts at $117,000; ineligible at $132,000. Roth IRA income limits (for married filers): phase-out starts at $184,000; ineligible at $194,000. If you cannot directly contribute to a Roth IRA due to income limit, consider converting some IRA money to Roth IRA by paying taxes at current tax rates in order to have more money in your Roth IRA that offers more tax diversification during retirement.
If your income is too high to contribute directly to a Roth IRA, you can still contribute to a traditional IRA and then convert to a Roth IRA. However, you must report these non-deductible contributions on tax returns and calculate whether any conversion amount is taxable if you have pre-tax dollars in the IRA along with the non-deductible contributions. This “backdoor” Roth IRA strategy works better with no tax or a small tax bill if you do not have a large IRA balance with pre-tax dollars. Ask your tax advisor to calculate the amount that is subject to taxes in the year of conversion.
For the parents who are currently paying college expenses, be aware of these tax credits:
American Opportunity Tax Credit- As tax credits can ultimately reduce the taxes you pay, this credit can be utilized for the first 4 years of undergraduate studies. The benefit of this credit is that each student can receive a credit up to an annual limit of $2,500. The credit can be applied towards the first $2,000 of eligible education expenses and 25% of the additional expenses up to the $2,500 limit. Room and board is an excluded expense for this credit. To be eligible, the student must be enrolled at least half-time. In addition, annual incomes of greater than $90,000 for single filers and greater than $180,000 (2016) for married filers are fully phased out and unable to participate.
Lifetime Learning Credit- As the name indicates, this credit can be used for life as long as one's income does not exceed the predetermined threshold (2016) - $65,000 for single filers and $131,000 for married filers. This credit provides for a $2,000 credit for each family, unlike the American Opportunity Tax Credit that can be used for each student. To qualify for this full credit in addition to not exceeding the income threshold, an individual or family must have at least $10,000 of qualified education expenses.
So as you can see, there are many ways to save for college in a tax-efficient way. Everybody’s situation is different and you should always evaluate your options to see what’s best for you and your family. Consult your trusted financial advisor and start saving and investing soon. Obtaining an education is a special gift that can be well worth the cost and preparation, and with diligent planning, one can be better prepared for minimizing the potential burden that education expenses can be in one’s life.