Federal and State tax laws offer credits or deductions to assist taxpayers in meeting the increasing cost of a college education. A review of eligibility for such credits and deductions should be part of any family tax planning. Opportunities are often overlooked. Each individual’s particular facts and circumstances should be considered.
For the 2015 tax year, many individuals will be eligible to take advantage of either the American Opportunity Tax Credit (the former Hope Credit) or the Lifetime Learning credit. Due to certain income limitations, these credits are not be available to all individuals and/or may be phased out. The maximum tax credit available for the American Opportunity Tax Credit is $2,500 per student and may be used for the first four years of post-secondary education. This tax credit is based on the amount of qualified educational expenses (tuition and related expenses) incurred during the year. Qualified educational expenses do not include room and board, transportation, insurance, medical and other personal expenses. If the credit exceeds the computed tax liability, the taxpayer can claim a refund up to 40% of the credit not to exceed $1,000. The credit cannot be claimed if the taxpayer’s Adjusted Gross Income (AGI, or essentially all income) is $90,000 ($180,000 for married couples filing jointly) or greater.
Unlike the American Opportunity Tax Credit, the Lifetime Learning Credit is a per-taxpayer (per-return) credit, limited to $2,000 per year and is nonrefundable. This credit has less restrictive eligibility requirements than the American Opportunity Tax Credit. If a taxpayer is not eligible for the American Opportunity Tax Credit due to the fact that they have more than four years of post-secondary school, the Lifetime Learning Credit can still be claimed. This credit is allowed for undergraduate, graduate and job skills courses. Expenses covered include tuition, books and supplies. Similar to the American Opportunity Tax Credit, room and board, transportation, insurance, medical and other personal expenses are not eligible expenses. The credit is based on 20% of eligible expenses up to a maximum of $10,000. The credit cannot be claimed if the taxpayer’s AGI is $65,000 ($130,000 for married couples filing jointly) or greater.
COVERDELL EDUCATION SAVINGS ACCOUNTS
The Coverdell Educational Savings Account (Coverdell ESA) is a trust that is created solely for the purpose of paying the qualified education expenses of the designated beneficiary of the account. Contributions to a Coverdell ESA are not tax deductible, but the earnings and distributions are tax-free as long as they are used for qualified education expenses. There is a $2,000 contribution limit (again, subject to income limitations) per year, per beneficiary. The contributions must be made in cash and cannot be made after the beneficiary reaches 18 years old, unless the beneficiary has special needs. There is no limitation as to who can contribute to a Coverdell ESA. Therefore, the contributor can be a friend, relative or even the beneficiary. There are rollover and other transfer options available in cases where the original beneficiary changes. These types of accounts can negatively impact the amount of financial aid a student might otherwise be eligible for if the parent or student is the owner of the account. Weigh the financial aid impact against the benefits of being able to make tax-free withdrawals.
SECTION 529 PLANS
Qualified tuition programs (529 Plans) are another instrument available to taxpayers. States are permitted to establish and maintain programs that allow taxpayers to either prepay or contribute to accounts set aside to pay for a student’s qualified education expense at a post-secondary institution. There are two types of Section 529 plans:
- Prepaid tuition plans.
- Savings plans.
The major benefit of either plan is that earnings grow tax-free, and there is no income limitation.
In addition, many states, including New York and Connecticut, offer state incentives for 529 plans; therefore, investors should consider state incentives before selecting a plan. A Section 529 prepaid tuition plan allows families to prepay the higher education costs for a beneficiary at a specified institution. These prepayments are then invested by the 529 plan. Most 529 plan investments are guaranteed to keep up with inflation. The Hope and Lifetime Learning credits can be claimed in the same year the beneficiary takes a tax-free distribution from the 529 plan, as long as the same expenses aren’t used for both benefits. If there are remaining funds in the 529 plan, they can be rolled over tax-free to another 529 plan for the benefit of a member of the beneficiary’s family.
BORROWING FOR TUITION
There are various methods to borrow money in order to finance education costs, including borrowing from home equity, pension plans, life insurance policies, related-parties, and federal education loan programs. Although all these vehicles can be used to pay for education, some loans are more beneficial due to their tax treatment. Generally, the most preferable type of loan is a home equity loan, since up to $100,000 of interest attributable to home equity indebtedness is deductible as an itemized deduction. Plus, the qualified borrower can also certify the loan as an education loan, as long as the loan is for the sole purpose of paying higher education costs. In so doing, the taxpayer may then be eligible to deduct up to $2,500 (subject to AGI phase-outs) as an interest deduction in order to compute AGI. (Any excess interest on the home equity loan would then be eligible to be deducted as an itemized deduction). Federal education loans and interest paid on personal loans certified as education loans are also eligible as deductions for AGI, up to the $2,500 limit, but any excess will not be deducted as an itemized deduction. Any interest paid on loans from a pension plan, life insurance or related-parties loans will not be tax deductible at all. In order to claim the deduction, married taxpayers must file joint returns, and no deduction is allowed for individuals who may be claimed as dependents.
Another option for a taxpayer with a lurking tuition bill is to take a distribution from an IRA before reaching the age of 59 ½. The taxpayer can take this distribution from the IRA if it is to pay for qualified education expenses for the taxpayer, spouse, child or grandchild. While the distribution is taxable, the taxpayer will not be subject to the 10% additional tax for early withdrawal, as long as the distribution is not more than the adjusted qualified education expenses for the year.
Interest earned on qualified U.S. Savings Bonds (Series EE bonds issued after 1989 or Series I Bonds) might not have to be included in income if the proceeds are used to pay for qualified education expenses for the taxpayer, the taxpayer’s spouse or taxpayer’s dependent. The bond must be issued either in the name of the taxpayer or in the name of both the taxpayer and spouse. In addition, the owner must be not more than 24 years old before the bond’s issue date. Savings bonds can now easily be automatically purchased using all or part of your tax refund.
CONTRIBUTIONS FROM RELATIVES
A grandparent or any relative of a student may make a tuition payment directly to the school with no threshold and no exemption. This aspect of tuition planning does not just extend to universities or higher education, but also to private elementary or secondary schools.