Back-to-campus tax planning tips
Posted On: 8-29-2014 | Posted By: Rosemary Jacobson, CPA, EA
As your college-aged children head back to campus, it’s a good time to think about some of the tax planning opportunities related to education expenses. There are plenty of tax incentives available to help lessen the burden of paying for college, and we want to make sure you are aware of them and can take advantage of any that apply to your situation.
First let’s look at the credits that are available. The American Opportunity Credit is available for the first four years of an undergraduate degree (must be at least half-time enrollment) and is worth up to $2,500 per student. Expenses that qualify for this credit are tuition, fees, books, supplies and equipment. A credit directly reduces your tax liability, so a $2,500 credit could potentially mean $2,500 less income tax that you pay. As a parent, you must claim your student as a dependent in order to claim the credit. However, the credit is also available for yourself or your spouse.
The Lifetime Learning Credit is, not surprisingly, available for an unlimited number of years for post-secondary education even if enrolled in non-degree courses or on a less than half-time basis. The same expenses that qualified for the American Opportunity Credit qualify for this one, but the maximum Lifetime Learning Credit is $2,000 annually per taxpayer, not per student. The credit is calculated as 20% of your qualified education expenses, so it would take $10,000 of expenses to reach the maximum credit of $2,000. Both the American Opportunity Credit and the Lifetime Learning Credit phase out when your Adjusted Gross Income (AGI) exceeds certain limits.
If you’re past the college years and are now paying back the loans, there is an annual deduction of up to $2,500 available for the interest paid on education loans. A deduction reduces your taxable income, not your tax, so the savings are a little more watered down but can still be a valuable tool in reducing your tax bill. Deductions have the added advantage of reducing the income reported on your state tax return as well as the federal return. Like the credits, this deduction phases out when your AGI exceeds certain limits.
If you find it necessary to take an early distribution on an IRA to pay for education expenses, you can avoid the 10% early withdrawal penalty on the amount of the distribution that is spent on education, and for this one you can include the cost of room and board as well as the education expenses mentioned above. Your distribution may still be taxable, but this can help you avoid the additional 10% penalty that is imposed on early distributions.
Lastly, if you are thinking ahead and setting money aside for future education expenses, there are some incentives for that, too. You can contribute up to $2,000 annually per child under age 18 to an Education Savings Account (ESA). This can be done for as many children as you want and they do not have to be your own – it can be done for grandchildren, nieces, nephews, friends or anyone else! However, it’s important to remember that total contributions to all ESAs set up for any one beneficiary are limited to $2,000 per year. Although the contributions are not deductible, the earnings in the account are tax-free if they are disbursed for qualified educational expenses and like the credits, the allowable contributions are subject to Adjusted Gross Income phase-outs. However, the income limits are slightly higher than those for the education credits. These ESA contributions can actually be used not only for undergraduate or graduate programs but also for K-through-12 expenses, including the cost of private schools.
One other education savings plan is a state-sponsored Qualified Tuition Program (QTP), also known as a 529 Plan. Like the ESA, contributions to a QTP are non-deductible for federal taxes and earnings are tax free. However, there is not an annual contribution limit – the only limitation is that contributions can’t be more than is necessary to cover the beneficiary’s qualified education expenses (as determined by the plan). Although these contributions are considered a gift, it is possible to make a contribution that exceeds the annual gift tax exclusion ($14,000 for 2016). You can contribute up to $70,000 and use the annual gift exclusion ratably over five years, provided you make no other gifts to the beneficiary. Contributions to a qualified 529 Plan may also qualify for a deduction on your state tax return. There is an AGI phase-out for the ESA contributions but not for the QTPs. Although there are some variations in how these plans are administered, they are essentially a tool that allows you to save for college expenses and shelter the earnings on those funds from being taxable.
We understand what a daunting task it is paying for a college education and our goal is to help you take advantage of every opportunity that’s available to minimize that cost. Give us a call at (573) 442-6171 or (573) 635-6196 if you would like to discuss any of these opportunities in more detail.