Tax Advantages to Consider When Saving for College

Sara F Gonzalez

Article Highlights:

  • Planning for a Child’s Post-Secondary Education 
  • Tax-Advantaged Plans 
  • Tax-Free Earnings 
  • Coverdell Accounts 
  • Qualified Tuition Plans 
  • Have Others Contribute 
  • Gift Tax Issues 
  • Tuition Gifts 

"How can I save for my child's post-secondary education in a tax-efficient manner?" is a typical question among parents. The answer is contingent on how much the schooling is estimated to cost and how much time the child has until he or she attends college or begins an apprenticeship program.

The amount of money needed will depend on whether your child will be attending a community college, a community college and then transferring to a university, a university straight away, or an apprentice program. If the child is going to a local college or apprenticeship, you only have to worry about tuition, books, and other class materials, and the child can live at home, whereas a child going to a university, unless it is local, will have to pay for housing and food on top of significantly higher university tuition. Another consideration is whether the student intends to leave school after earning a bachelor's degree or pursue graduate studies in order to receive an advanced degree.

Your child may be eligible for a scholarship or grant when the time comes, but you can't count on it when putting together a college savings plan.

There are two tax-advantaged savings plans available under the federal tax code. Making original contributions to the plan is not a tax deductible event under either scheme. When withdrawn for qualified educational expenditures, growth owing to investment gains, if any, and earnings (dividends and interest) are tax-free. As a result, the earlier each plan is implemented, the better, as it will have more years to develop in value.

Both savings options allow money to be utilized for kindergarten and higher education. These plans, however, allow for tax-free growth, and the more funds utilized for expenses at lower levels of schooling, the fewer tax benefits they provide. Using these savings programs for anything other than post-secondary education should be carefully considered.

Front-loading contributions will result in more tax benefits because there will be a larger amount for which growth and earnings can be compounded. You should also be aware that anyone can contribute to your child's college savings program, not just you. If your child has wealthy grandparents, other relatives, or friends who want to help, they can do so as well.

The Coverdell Education Savings Account and the Qualified Tuition Plan, sometimes known as a Sec. 529 plan, are the two college savings plans now available (529 denotes the section of the tax code that governs it).

Coverdell Education Savings Account — Because this sort of plan only allows for $2,000 in contributions per year, it is often ruled out as a viable option for college savings, unless it is used in conjunction with other methods.

Sec. 529 Plan — This is most likely the best option for your child. State-run Sec. 529 plans allow far higher contributions, and numerous people can each contribute up to the annual gift tax limit without having to record their gifts. For 2021, the maximum is $15,000, and it is updated for inflation on a regular basis; in 2022, the limit will rise to $16,000. A special rule permits donors to make contributions up to five years ahead of time (for a total of $75,000 in 2021 and $80,000 in 2022).

Sec. 529 plans allow taxpayers to save bigger sums of money, limited only by the donor's gift tax concerns and the contribution limits of the targeted plan. There are no restrictions on the number of contributors, nor on their income or age. The maximum amount that can be contributed per beneficiary (intended student) is determined by the estimated cost of a college education and varies by state. Some states set their maximum based on the cost of an in-state four-year education, while others use the cost of the nation's most expensive colleges, including graduate study. The majority have upper limits of over $200,000, with several exceeding $530,000. Additional contributions are generally not permitted once an account reaches that threshold, but this does not prevent the account from growing further.

Taxpayers are not restricted to the 529 plan offered by their home state and can shop around for the plan with the best growth potential and largest maximum contribution.

 When it's time to pay for education, the dividends will be split evenly between earnings and contributions. The earnings portion is tax-free if used to pay for eligible educational expenditures, and the donation portion is never taxable. Furthermore, if utilized for qualified school expenses, the portion of the payout representing the return on the contributions will qualify for the American Opportunity Tax Credit, which can be as high as $2,500 if your income level does not phase it out.

Gifts - In addition to the annual gift tax exclusion, a donor can make gifts (of any amount) that are completely exempt from the gift tax when made directly to an educational institution for tuition. Both college and private primary education fall under this category. These gifts, however, can only be used to cover tuition, not books, supplies, or room and board. For the payments to be exempt from the gift tax, they must be made directly to the educational institution. Reimbursement to the donee is not eligible.

The tuition exclusion is frequently overlooked, but it can be advantageous. For example, a grandparent can use a tuition gift to minimize their estate while also assisting a grandchild in paying for tuition and providing an education credit to the child's parents.

Please contact our office for more information or assistance in planning for a child's higher education.

 

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