Before University – Schedule
In general, consider gifting your income-generating assets to your child. Income earned from these assets would be subject to a lower tax rate than yours. However, with the enactment of the child tax, your child’s unearned income of more than $2,100 is taxed in the parent’s marginal bracket.
Investing in bonds can be one way to plan for your child’s future. There are several types of bond investments available in the market today. Tax-exempt bonds or tax-exempt bond mutual funds pay interest tax-free.
Another type of bond to consider is Series EE bonds. This type of bond has two interesting features. Interest is only taxed when the bond is exchanged for cash. Additionally, interest earned may be tax-exempt if the bond is issued in the parent’s name and the proceeds are used for qualified college expenses such as tuition, fees, etc. The tax exemption for Series EE bonds is reduced when the parent’s income exceeds certain levels.
An additional option is to invest in a 529 Plan (Qualified Tuition Program). Parents have two options with a 529 Plan. They can prepay for their child’s tuition by purchasing tuition credits at current cost for future use, or they can contribute to an investment account that is established specifically for higher education. Contributions are not tax deductible, however they do qualify for the $14,000 annual gift tax exclusion. In the event that their contribution is greater than $14,000, parents can choose to treat the contribution as if it were made over 5 years. Accumulated income grows tax-free until it is distributed from the account. Distribution income used for qualified college expenses is tax-free, but if distribution income is used for other purposes, the withdrawal becomes taxable plus a 10% tax penalty on the amount of the withdrawal.
Finally, Coverdell Education Savings Accounts (Coverdell ESA) may be the option you are looking for. Set up this account and have the ability to contribute up to $2,000 a year for your child under age 18 (the age limit is different for children with disabilities). The contribution is not tax deductible; Income earned from the account is not taxable and will be tax free if used for qualified college expenses. If your child chooses not to pursue a college education, the money must be claimed before age 30, the earnings are taxable and subject to a 10% federal tax penalty. Unused funds from an account holder over the age of 30 can be transferred tax-free to the Coverdell ESA account of a sibling under the age of 30.
While in college – Payment
Thinking, “I’m too late. My son is about to enroll in college and there are no funds set aside.” There are also ways to save taxes by paying for college expenses.
The American Opportunity Tax Credit is a tax credit of $2,500 per child for the first 4 years of their education. Qualified expenses include tuition, fees, and books. 40% or $1,000 of this credit may be refundable.
For students pursuing high school and graduate school, lifetime learning credit may be available. The amount of this credit is limited to $2,000 per family and is calculated at the rate of 20% of expenses up to $10,000 in qualified expenses.
These tax credits are designed to gradually decrease or even disappear when income exceeds certain levels. This may result in credit not being available.
Scholarships should be the first option to pay for a student’s education. This will reduce education costs since they are generally tax free. The scholarship is taxable when considered as compensation.
When employers pay tuition for an employee’s child, the employee generally pays tax on the value of the payments. There is an exception to this rule, when the focus of education is different from the employer’s work, for tax purposes it is a scholarship and tax free.
Gifting is an option before and after the student starts college. For example, the student’s grandparents want to give away money to pay for their grandchild’s college costs. A single grandparent can give a student up to $14,000 without paying gift tax. Married grandparents can give the student up to $28,000 without paying gift tax. It should be noted that tuition paid directly to the educational institution is subject to an unlimited exclusion of gift tax.
Some parents consider having the student get a loan instead. As a general rule, interest on student loans is not deductible; however, up to $2,500 in interest is deductible when loan proceeds pay for higher education.
Parents and students can also choose to withdraw money from their retirement plans. Recipients of retirement plan funds are exempt from a 10% early distribution penalty when withdrawals pay for college costs. The withdrawal may be taxable depending on the type of retirement plan.
There are several ways to plan for your child’s educational cost, but not all of the items discussed apply to everyone and can be used at the same time. Not sure which option is best for you or would like to learn more about tax planning for your child’s future? This article is an example for illustrative purposes only and is intended as a general resource, not a recommendation.
