Reducing the tuition burden by creating flexibility through investment and planning decisions.
Did you hear about the banker that was arrested for embezzling $100,000 to pay for his child’s college tuition? The arresting officer also had a child in college. As the banker was being led away to jail, the police officer asked, “Where were you going to get the rest of the money?”
Whether you’re in your 20’s or have children in their 20’s, you may think that tuition planning would be fairly straightforward. Earn more, save more. But it is not that simple to plan effectively. Like all tax law, there is only permanency until there is change. All tax laws are temporary, especially when Congress turns over.
As of January 1, 2017, one of the most beneficial tuition-related deductions has expired. The Tuition and Fees Deduction was an “above the line” deduction, which reduced Adjusted Gross Income, a crucial measure for many phase-outs. The expiration of this deduction effectively increased the cost of college education at a time when tuition rates have been outpacing inflation. We mention this, not because we think the Tuition and Fees Deduction will return, but because it coincides with a Marcum theme – flexibility. Like all forms of planning, tuition planning comes with a need to remain flexible and adapt to ever-changing tax law and educational reform, especially within the current, divisive political climate. Federal tax reform is a hot topic, but tuition planning is often reformed at the state level as well, where budget concerns are abundant. In this article, we’ll discuss some ways to reduce the tuition burden, while keeping you aware of the flexibility gained or lost based on your decisions.
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 having already completed more than four years of post- secondary education, 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 or higher ($130,000 for married couples filing jointly).
For the 2017 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, but both are set to expire at the end of 2017. However, due to certain income limitations, these credits may 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, which may be used for the first four years of post- secondary education. This tax credit is based on the amount of qualified educational expense (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 of 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 basically all income) is $90,000 or higher ($180,000 for married couples filing jointly).
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. Unlike Section 529 Plans discussed next, withdrawals can be used to pay for qualified elementary and secondary school expenses and must be disbursed before the beneficiary is 30 years old or the funds are transferred to another eligible family member younger than 30. There is a relatively small $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 a taxpayer to either prepay or contribute to an account that is 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, and
- Savings plans.
Although contributions to 529 plans are not tax deductible for federal purposes, the major benefit of either plan is that earnings grow tax-free, and there is no income limitation. In addition, many states offer incentives for 529 plans; therefore, taxpayers 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, according to the investment option selected by the account owner. Some 529 plan investments are guaranteed to keep up with inflation. Prepaid tuition plans serve as an interesting investment vehicle that serves as a means to gamble that college tuition will outpace market gains, but reduce flexibility because it is often difficult to use the funds for out-of-state universities. They also come with state budget risks. 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 within 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, and related parties, as well as federal education loans. Although all of 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 borrowing would be a home equity loan, since up to $100,000 of interest attributable to home equity indebtedness is allowable as an itemized deduction. Plus, a qualified borrower can also certify the loan as an education loan, as long as the loan was for the sole purpose of paying higher education costs. By doing so, 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). Interest paid |on a personal loan certified as an education loan and on Federal education loans is also eligible as a deduction for AGI, up to the $2,500 limit, but any excess will not be allowable as an itemized deduction. Any interest paid on a loan from a pension plan, life insurance policy, or related-party loan will not be tax deductible at all. In order to claim a deduction, married taxpayers must file joint returns, and no deduction is allowed for individuals who may be claimed as dependents.
Student loans are often paid back via Income Driven Repayment (IDR) Plans. There are 4 types: Pay As You Earn Repayment Plan (PAYE), Revised Pay As You Earn Repayment Plan (RePAYE), Income Based Repayment Plan (IBR), and Income Contingent Repayment Plan (ICR Plan). One way to avoid paying back the full amount borrowed is via the Public Service Loan Forgiveness (PSLF) program. The PSLF offers the potential to have student loans (only Direct Loans) forgiven after making 120 qualifying monthly payments under a qualifying repayment plan while working full- time for a qualifying employer. Ordinarily, any amount of debt forgiven would be included in taxable income, but not in this case! If you go the PSLF route, complete and submit the certification form as soon as possible. You should consider submitting it annually and certainly if you change employers. Due to income testing, consider a shift in which a spouse pays for large deductions, such as retirement plans. Also remember that the current administration or a future administration could end PSLF before your 120 payments are made. In many cases, married filing jointly will result in greater student loan repayments, but a lesser tax burden. Married filing separately can have punitive tax brackets, and you can lose various tax benefits, credits, and deductions (such as the American Opportunity Tax Credit, the Lifetime Learning Credit, and the Student Loan Interest deduction to name a few education related benefits). Not always thought of by a non-tax professional, but married filing separately does not equal two single taxpayers combined. Although not seriously recommended, in some circumstances, a marriage penalty may influence a taxpayer to consider a divorce for financial purposes!
Another option for a taxpayer with a lurking tuition bill is to take a distribution from an IRA prior to reaching the age of 59 ½. A taxpayer can take this distribution from the IRA if it is to pay for qualified education expenses for him or herself or for a spouse, child or grandchild. While the distribution will be taxable, the taxpayer will not be subject to the 10% penalty 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 at least 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
Any relative of a student may make a tuition payment directly to the school with no threshold and not use any exemption. This portion of tuition planning extends not only to universities or higher education, but also to private elementary or secondary schools.
Each taxpayer’s scenario is different, and you should consider consulting with your Marcum tax professional to run the numbers and see what options make sense, based on taxpayer-specific scenarios and various outcomes. When it comes to tuition planning, families should have a diligently planned approach. Tuition planning should incorporate retirement planning, gifting strategies, estate planning, and life choices. But more importantly, with tuition costs continuing to skyrocket, a family needs to also consider a cost benefit analysis to determine whether or not a person should actually attend college. Do not let tax avoidance tactics drive a college decision, but instead, use tuition planning as an important part of the plan to pay for higher education. Many trade unions and civil service jobs require little paid education. They often incorporate paid on the job training. That said, Marcum firmly believes that a good education with an appropriate major course of study at the right price can be invaluable and should be the most important factor in a family’s tuition plan.
jobs require little paid education. They often incorporate paid on the job training. That said, Marcum firmly believes that a good education with an appropriate major course of study at the right price can be invaluable and should be the most important factor in a family’s tuition plan.