Congress, through the years, has provided a variety of tax incentives to help defray the cost of education. Some require long-term planning to become beneficial, while others provide current tax deductions or credits.
- Section 529 Plans – Section 529 Plans (named after the section of the IRS Code that created them) are plans established to help families save and pay for college in a tax-advantaged way and are available to everyone, regardless of income. These state-sponsored plans allow you to gift large sums of money for a family member’s college education while maintaining control of the funds. The earnings from these accounts grow tax-deferred and are tax-free, if used to pay for qualified higher education expenses. They can be used as an estate-planning tool as well, providing a means to transfer large amounts of money without gift tax. With all these tax benefits, 529 Plans are an excellent vehicle for college funding. Section 529 Plans come in two types, allowing you to either save funds in a tax-free account to be used later for higher education costs, or to prepay tuition for qualified universities. For 2016 and 2017, you can contribute $14,000 ($28,000 for married couples who agree to split their gift) a year without gift tax implications. The annual amount is subject to inflation-adjustment, so call for the limit for other years. There is also a special gift provision allowing the donor to prepay five years of gifts up front without gift tax. No income tax deduction is allowed for the amount contributed.
- Coverdell Education Savings Account – These accounts are actually education trusts that allow nondeductible contributions to be invested for a child’s education. Tax on earnings from these accounts is deferred until the funds are withdrawn, and if used for qualified education purposes, the entire withdrawal can be tax-free. Qualified use of these funds includes elementary and secondary education expenses in addition to post-secondary schools (colleges). A total of $2,000 per year can be contributed for each beneficiary under the age of 18. The ability to contribute to these plans phases out when modified adjusted gross income is between $190,000 and $220,000 for married taxpayers filing jointly and between $95,000 and $110,000 for all others.
- Education Tax Credits – Two tax credits, the American Opportunity Credit (partially refundable) and the Lifetime Learning Credit (nonrefundable), are available for qualified post-secondary education expenses for a taxpayer, spouse and eligible dependents. Both credits will reduce one’s tax liability dollar for dollar until the tax reaches zero. The credit is not allowed for taxpayers who file Married Separate returns.
The American Opportunity Credit is a credit of up to $2,500 per student per year, covering the first four years of qualified post-secondary education. The credit is 100% of the first $2,000 of qualifying expenses plus 25% of the next $2,000 for a student attending college on at least a half-time basis. 40% of the American Opportunity credit is refundable (if the tax liability is reduced to zero). The Lifetime Learning Credit is a credit of up to 20% of the first $10,000 of qualifying higher education expenses. Unlike the American Opportunity Credit, which is on a per-student basis, this credit is per taxpayer. In addition to post-secondary education, the Lifetime Credit applies to any course of instruction at an eligible institution taken to acquire or improve job skills. Qualifying expenses for these credits is generally limited to tuition. However, student activity fees and fees for course-related books, supplies and equipment qualify if they are required for enrollment or meaningful attendance in a course of study, whether or not the course materials are purchased from the institution.
You may qualify for this credit even if you did not pay the tuition. If a third party (someone other than the taxpayer or a claimed dependent) makes a payment directly to an eligible educational institution for a student’s qualified tuition and related expenses, the student would be treated as receiving the payment from the third party, and, in turn, paying the qualified tuition and related expenses. Furthermore, qualified tuition and related expenses paid by a student would be treated as paid by the taxpayer if the student is a claimed dependent of the taxpayer.
- Education Loan Interest – You can deduct qualified interest of $2,500 per year in computing AGI. This is not limited to government student loans and could be home equity loans, credit card debt, etc., provided the debt was incurred solely to pay qualified higher education expenses. For 2017 this deduction phases out for married taxpayers with an AGI between $135,000 and $165,000 and for unmarried taxpayers between $65,000 and $80,000. The phase out range is inflation adjusted annually, so please call for limits other than those shown for 2017