The cost of a college education is higher year after year, with no relief to increases in sight. The annual cost at an Ivy League school is over $60,000 a year; even state schools for in‑state students is over $20,000 in some locations. How can you manage to pay all or even some of the cost for yourself, your spouse, or your child? It isn’t easy, but tax incentives can help. Here are some tax‑advantaged strategies for education savings.

529 Plans

There are two types of state plans that can be used to save for higher education:

Tuition plan. Contributions pay a fixed amount of state school tuition (depending on the amount of contributions and the projected tuition).

Savings plan. Contributions are invested and available to pay qualified expenses on a tax‑free basis.

There are no income limits on contributors. The amount you add to the plan is up to you. However, states impose account limits, so no contributions can be made when the value of the account reaches a set limit (e.g., $350,000 per beneficiary in California’s plan; $375,000 in New York’s plan; $394,000 in Florida’s plan).

While contributions are not tax deductible for federal income tax purposes, the earnings are tax deferred and become tax free when withdrawn to cover tuition, fees, and other qualified expenses. There may be state‑level tax breaks for contributions. What’s more, there is asset protection for 529 plans, preventing them from being obtained by creditors in the case of an account owner’s personal bankruptcy.

For financial aid purposes, the account is treated as a parental asset. This means only 5.64% of the account’s value is included in the financial aid formula (a child’s assets are included at 20% but the plan is not considered to be the child’s asset).

Coverdell ESAs

You can contribute annually up to $2,000 on behalf of anyone who is under age 18 or is a special needs beneficiary (although income limits on contributors apply). The contributions can be invested to grow for the benefit of the child.

They can be used to pay an array of education expenses on a tax‑free basis. Qualified expenses for higher education include tuition and fees; books, supplies, and equipment; room and board if the student is enrolled at least half time; and expenses for special needs services.

The downside: Accounts that are not used up the time the beneficiary attains age 30, become taxable to the beneficiary. However, the account beneficiary can be changed to a relative who is younger. Also, there is no age limit on accounts of those with special needs.

U.S. Savings Bonds

If you own U.S. savings bonds – C series EE or I – you can cash them in to pay for higher education expenses and won’t be taxed on the accumulated interest. To obtain tax‑free treatment for the interest, your income must be below set limits that adjust annually for inflation and the funds must be used for qualified expenses (tuition and fees or contributions to 529 plans and Coverdell ESAs).

The advantage to using savings bonds is that if funds are not needed for your child’s education (e.g., your child obtains a scholarship), you don’t have to cash the bonds in. These bonds continue to accrue interest for 30 years. And you can use them for any purpose in the future.

IRAs

While IRAs are intended primarily for your retirement, the funds can be tapped penalty‑free to pay for higher education for you, your spouse, or your child. There is no dollar limit on how much you can withdraw as long as the funds are used for tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. Withdrawals to pay expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance are also penalty free.

The downside to tapping IRA funds is twofold. First, the withdrawal is includible in gross income. Thus, while not subject to a penalty, the funds are taxable. Second, you diminish your retirement savings, which may not easily be replaced.

Conclusion

The sooner you begin to save for your projected education needs, the more you=re likely to have. Take advantage of tax incentives to help you meet your goals.

by:  J.K. Lasser

Edited and posted by Harold Goedde CPA, CMA, Ph.D. (taxation and accounting)