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Table of Contents
• When should I start saving for my child's education?
• How much will my child's college education cost?
• How should I invest my child's college fund?
• What is the American Opportunity Tax Credit?
• What is the "kiddie tax?"
• What is a Coverdell Education Savings Account and who is eligible for one?
• If you have insufficient savings for your child's education, what should you do?
• What types of grants are available for college?
• What types of loans are available for college?
• How can I increase the amount of financial aid my child is entitled to?
• How can I save taxes on college savings?
When should I start saving for my child's education?
This depends on how much you think your children's education will cost. The best way is to start saving before they are born. The sooner you begin the less money you will have to put away each year.
Suppose you have one child, age six months, and you estimate that you'll need $120,000 to finance their college education 18 years from now. If you start putting away money immediately, you'll need to save $3,500 per year for 18 years (assuming an after-tax return of 7 percent). On the other hand, if you put off saving until the child is six years old, you'll have to save almost double that amount every year for twelve years.
Another advantage of starting early is that you'll have more flexibility when it comes to the type of investment you'll use. You'll be able to put at least part of your money in equities, which, although riskier in the short-run, are better able to outpace inflation than other investments in the long-run.
How much will my child's college education cost?
How much will your child's education cost? It depends on whether your child attends a private or state school. According to the College Board, for the 2022-23 school year the total expenses - tuition, fees, board, personal expenses, and books and supplies - for the average four-year private college are about $57,570 per year and about $27,940 per year for the average four-year in-state public college. However, these amounts are averages: the tuition, fees, and board for some private colleges can exceed $80,000 per year whereas the costs for a state school can often be kept under $10,000 per year. It should also be noted that in 2022-23 the average amount of grant aid for a full-time undergraduate student was about $8,690 and $24,770 for four-year public and private schools, respectively. More than 75 percent of full-time students at four year colleges and universities receive grant aid to help pay for college.
How should I invest my child's college fund?
As with any investment, you should choose those that will provide you with a good return and that meet your level of risk tolerance. The ones you choose should depend on when you start your savings plan-the mix of investments if you start when your child is a toddler should be different, from those used if you start when your child is age 12.
The following are often recommended as investments for education funds:
Series EE bonds: These are extremely safe investments. They should be held in the parents' names. If the adjusted gross income of you and your spouse at the time of redemption is at or under the amount set by the tax law, the interest on bonds bought after January 1, 1990, is tax-free as long as it is used for tuition or other qualified education costs. If your adjusted gross income is above the threshold amount, the tax break is phased out.
You can exclude from your gross income interest on qualified U.S. savings bonds if you have qualified higher education expenses during the year in which you redeem the bonds. For tax year 2023, the exclusion begins phasing out at $91,850 modified adjusted gross income ($76,000 indexed for inflation) and is eliminated for adjusted gross incomes of more than $106,850. For married taxpayers filing jointly, the tax exclusion begins phasing out at $137,800 and is eliminated for adjusted gross incomes of more than $167,800. The exclusion is unavailable to married filing separately.
U.S. Government bonds: These are also investments that offer a relatively higher return than CDs or Series EE bonds. If you use zero-coupon bonds, you can time the receipt of the proceeds to fall in the year when you need the money. A drawback of such bonds is that a sale before their maturity date could result in a loss on the investment. Further, the accrued interest is taxable even though you don't receive it until maturity.
Certificates of deposit: These are safe, but usually provide a lower return than the rate of inflation. The interest is taxable. These should generally only be used by the most risk-averse investors and for relatively short investment horizons.
Municipal bonds: Assuming the bonds are highly rated, the tax-free interest on them can provide an acceptable return if you're in the higher income tax brackets. Zero-coupon municipals can be timed to fall due when you need the funds and are useful if you begin saving later in the child's life.
Be sure to convert the tax-free return quoted by sellers of such bonds into an equivalent taxable return. Otherwise, the quoted return may be misleading. The formula for converting tax-free returns into taxable returns is as follows:
Divide the tax-free return by 1.00 minus your top tax rate to determine the taxable return equivalent. For example, if the return on municipal bonds is 1 percent and you are in the 32 percent tax bracket, the equivalent taxable return is 2.6 percent (1 percent divided by 68 percent).
Stocks: An appropriate mutual fund or portfolio containing stocks can provide you with a higher yield than bonds at an acceptable risk level. Stock mutual funds can provide superior returns over the long term. Income and balanced funds can meet the investment needs of those who begin saving when the child is older.
What is the American Opportunity Tax Credit?
Income limits. To claim the American Opportunity Tax Credit, your modified adjusted gross income (MAGI) must not exceed $90,000 ($180,000 for joint filers). To claim the Lifetime Learning Credit, MAGI must not exceed $69,000 ($138,000 for joint filers). "Modified AGI" generally means your adjusted gross income. The "modifications" only come into play if you have income earned abroad.
Amount of credit. For most taxpayers, 40 percent of the AOTC is a refundable credit, which means that you can receive up to $1,000 even if you owe no taxes.
Which costs are eligible? Qualifying tuition and related expenses refer to tuition and fees, and course materials required for enrollment or attendance at an eligible education institution. They now include books, supplies, and equipment needed for a course of study whether or not the materials must be purchased from the educational institution as a condition of enrollment or attendance.
"Related" expenses do not include room and board, student activities, athletics (other than courses that are part of a degree program), insurance, equipment, transportation, or any personal, living, or family expenses. Student-activity fees are included in qualified education expenses only if the fees must be paid to the institution as a condition of enrollment or attendance. For expenses paid with borrowed funds, count the expenses when they are paid, not when borrowings are repaid.
The tax law says that you can't claim both a credit and a deduction for the same higher education costs. It also says that if you pay education costs with a tax-free scholarship, Pell grant, or employer-provided educational assistance, you cannot claim a credit for those amounts.
What is the "kiddie tax?"
In the past, parents would invest in the child's name in order to shift income to the lower-bracket child. However, the addition of the "kiddie tax" mostly put an end to that strategy.
In 2023, the amount that can be used to reduce the net unearned income reported on the child's return that is subject to the "kiddie tax" is $1,250. The same $1,250 amount is used to determine whether a parent may elect to include a child's gross income in the parent's gross income and to calculate the "kiddie tax." For example, one of the requirements for the parental election is that a child's gross income for 2023 must be more than $1,250 but less than $12,500.
For 2023, the net unearned income for a child under the age of 19 (or a full-time student under the age of 24) that is not subject to "kiddie tax" is $2,500.
These rules apply to unearned income. If a child has earned income, this amount is always taxed at the child's rate.
What is a Coverdell (Section 530) Education Savings Account and who is eligible for one?
In 2023, you can contribute up to $2,000 each year to a Coverdell education savings account (Section 530 program) for a child under 18. These contributions are not deductible, but they grow tax-free until withdrawn. Contributions for any year can be made through the [unextended] due date for the return for that year. The maximum contribution amount for each child is phased out for modified AGI between $190,000 and $220,000 (joint filers) and $95,000 and $110,000 (single filers). These amounts are not indexed to inflation.
For the $2,000 contribution limit, there is no adjustment for inflation and therefore, the limit is expected to remain at $2,000.
Only cash can be contributed to a Section 530 account and you cannot contribute to the account after the child reaches their 18th birthday.
Anyone can establish and contribute to a Section 530 account, including the child, and you may establish 530s for as many children as you wish. The child need not be a dependent. In fact, he or she need not be related to you, but the amount contributed during the year to each account cannot exceed $2,000. The maximum contribution amount for each child is phased out for modified AGI between $190,000 and $220,000 (joint filers) and $95,000 and $110,000 (single filers). These amounts are not indexed to inflation.
If you have insufficient savings for your child's education when he is close to entering college, what should you do?
Many families find themselves in the same boat. Fortunately, there are ways to generate additional funds both now and when your child is about to enter school:
• You can start saving as much as possible during the remaining years. However, unless your income level is high enough to support an extremely stringent savings plan, you will probably fall short of the amount you need.
• You can take on a part-time job. However, this will raise your income for purposes of determining whether you are eligible for certain types of student aid. In addition, your child may be able to take on part-time or summer jobs.
• You can tap your assets by taking out a home equity loan or a personal loan, selling assets or borrowing from a 401(k) plan.
• You (or your child) can apply for various types of student aid and education loans.
What types of grants are available for college?
Grants. The best type of financial aid because they do not have to be paid back are amounts awarded by governments, schools, and other organizations. Some grants are need-based and others are not.
• The Federal Pell Grant Program offers federal aid based on need.
• Don't assume that middle class families are ineligible for needs-based aid or loans. The assessment of whether a family qualifies as "in need" depends on the cost of the college and the size of the family.
• State education departments may make grants available. Inquiries should be made of the state agency.
Employers may provide subsidies.
• Private organizations may provide scholarships. Inquiries should be made at schools.
• Most schools provide aid and scholarships, both needs-based and non-needs-based.
• Military scholarships are available to those who enlist in the Reserves, National Guard, or Reserve Officers Training Corps. Inquiries should be made at the branch of service.
• Try negotiating with your preferred college for additional financial aid, especially if it offers less than a comparable college.
What types of loans are available for college?
There are various student loan programs available. Some are need-based, and others are not. Here is a summary of loans:
• Stafford loans (formerly guaranteed student loans) are federally guaranteed and subsidized low-interest loans made by local lenders and the federal government. They are needs-based for subsidized loans; however an unsubsidized version is also available.
• Perkins loans are provided by the federal government and administered by schools. They are needs-based. Inquiries should be made at school aid offices.
• Parent loans for undergraduate students (PLUS) and supplemental loans for students are federally guaranteed loans by local lenders to parents, not students. Inquiries should be made at college aid offices.
• Schools themselves may provide student loans. Inquiries should be made at the school.
How can I increase the amount of financial aid my child is entitled to?
Here are some strategies that may increase the amount of aid for which your family is eligible:
Try to avoid putting assets in your child's name. As a general rule, education funds should be kept in the parents' names, since investments in a child's name can impact negatively on aid eligibility. For example, the rules for determining financial aid decrease the amount of aid for which a child is eligible by 35 percent of assets the child owns and by 50 percent of the child's income.
If your child owns $1,000 worth of stock, the amount of aid for which he or she is eligible for is reduced by $350. On the other hand, the amount of aid is reduced by (effectively) only 5.6 percent of your assets and from 22 to 47 percent of your income.
Reduce your income. Income for financial aid purposes is generally determined based upon your previous year's income tax situation. Therefore, in the years immediately prior to and during college, try to reduce your taxable income. Some ways to do this include:
1. Defer capital gains.
2. Sell losing investments.
3. Reduce the income from your business. If you are the owner of your own business, you may be able to reduce your taxable income by taking a lower salary, deferring bonuses, etc.
4. Avoid distributions from retirement plans or IRAs in these years.
5. Pay your federal and state taxes during the year in the form of estimated payments rather than waiting until April 15 of the following year.
6. Since a portion of discretionary assets is included in the family's expected contribution from income, reduce discretionary assets by paying off credit cards and other consumer loans.
7. Take advantage of vehicles which defer income, such as 401(k) plans, other retirement plans or annuities.
Detail any financial hardships. If you have any financial hardships, let the deciding authorities know (via the statement of financial need) exactly what they are if they are not clear from the application. The financial aid officer may be able to assist you in explaining hardships.
Have your child become independent. In this case, your income is not considered in determining how much aid your child will be eligible for. Students are considered independent if they:
1. Are at least 24 years old by the end of the year for which they are applying for aid
2. Are veterans
3. Have dependents other than their spouse
4. Are wards of the court or both parents are deceased
5. Are graduate or professional students
6. Are married and are not claimed as dependents on their parents' returns
How can I save taxes on college savings?
If you decide to invest in your child's name, here are some tax strategies to consider:
• You can shift just enough assets to create $2,500 in 2023 taxable income to an under age 19, child.
• You can buy U.S. Savings Bonds (in the child's name) scheduled to mature after your child reaches age 18.
• You can invest in equities that pay small dividends but have a lot of potential for appreciation. The dividend income earned when your child is under the age of 19 will be minimal with tax relief, and the growth in the stocks will occur over the long term.
• If you own a family business, you can employ your child in the business. Earned income is not subject to the "kiddie tax," and is deductible by the business if the child is performing a legitimate function. Additionally, if your business is a sole proprietorship and your child is younger than 19 years old, then he or she will not pay social security taxes on the income.
Table of Contents
• What types of tax relief are available for costs of my children's higher education?
• What is the education tax credit?
• Do any tax planning considerations apply to the education tax credit?
• Do living expenses while in school qualify for tax relief?
• How does a Coverdell (Section 530) program work?
• How can my family make best use of a Coverdell (Section 530) program?
• What are qualified tuition programs?
• How do Coverdell Section 530 plans and qualified tuition Section 529 plans differ?
• Can my traditional IRA be used for education?
• Can a Roth IRA be used for education?
• What tax deductions are available for college education?
• What tax benefits are available for continuing/adult education for a hobby or a sideline?
• Can I deduct student loan interest?
• If I take a home equity loan to pay education expenses, can I deduct the interest?
• What tax treatment applies if my student loan debt is canceled?
• What's the tax relief for education savings bonds?
• Must I pay tax on my employer's payment or reimbursement of my education expenses?
• Can I take tax deductions from education I pay for that helps me in my work?
What Types of Tax Relief are Available for Costs of my Children's Higher Education?
A wide variety of tax relief is available, but you'll need to choose which credit or deduction to claim or which savings plan to use based on your individual tax situation. You also can't use two different kinds of relief for the same item. For instance, you can't take the higher education credit and tuition fees deduction for the same student for the same year. You also can't take the American Opportunity Tax Credit and the Lifetime Learning Credit for the same student for the same year. There may also be limits based on adjusted gross income.
What is the Education Tax Credit?
Two tax credits are available for education costs - the American Opportunity Tax Credit and the Lifetime Learning Credit. These credits are available only to taxpayers with adjusted gross income below specified amounts, see Income Phase-Outs, below. Both credits were made permanent by the Protecting Americans from Tax Hikes Act of 2015 (PATH).
How Do These Credits Work?
The amount of the credit you can claim is either, $0, $2,000, or $4,000 and depends on (1) how much you pay for qualified tuition and other expenses for students and (2) your adjusted gross income (AGI) for the year.
You must report on Form 8863 the eligible student's name and Social Security number on your return to claim the credit. You subtract the credits from your federal income tax. If the credit reduces your tax below zero, you cannot receive the excess as a refund. If you receive a refund of education costs for which you claimed a credit in a later year, you may have to repay ("recapture") the credit.
If you file married-filing separately, you cannot claim these credits.
Which costs are eligible?
Qualifying tuition and related expenses refer to tuition and fees, and course materials required for enrollment or attendance at an eligible education institution. They now include books, supplies, and equipment needed for a course of study whether or not the materials must be purchased from the educational institution as a condition of enrollment or attendance.
"Related" expenses do not include room and board, student activities, athletics (other than courses that are part of a degree program), insurance, equipment, transportation, or any personal, living, or family expenses. Student-activity fees are included in qualified education expenses only if the fees must be paid to the institution as a condition of enrollment or attendance. For expenses paid with borrowed funds, count the expenses when they are paid, not when borrowings are repaid.
If you pay qualified expenses for a school semester that begins in the first three months of the following year, you can use the prepaid amount in figuring your credit.
You pay $6,500 of tuition in December 2023 for the winter 2023-2024 semester, which begins in January 2024. You can use the $6,500 in figuring your 2023 credit. If you paid in January instead, you would take the credit on your 2024 return.
As future year-end tax planning, this rule gives you a choice of the year to take the credit for academic periods beginning in the first 3 months of the year; pay by December and take the credit this year; pay in January or later and take the credit next year.
If I hire teenagers as babysitters or for yard work, must I withhold and pay tax for them?
When figuring whether you paid an employee $2,800 or more in 2025 ($2,700 or more in 2024) to babysitters or others, you generally don't count wages paid to an employee who is under age 18 at any time during the year.
Eligible students. You, your spouse, or an eligible dependent (someone for whom you can claim a dependency exemption, including children under age 24 who are full-time students) can be an eligible student for whom the credit can apply. If you claim the student as a dependent, qualifying expenses paid by the student are treated as paid by you, and for your credit purposes are added to expenses you paid. A person claimed as another person's dependent can't claim the credit. The student must be enrolled at an eligible education institution (any accredited public, non-profit or private post-secondary institution eligible to participate in student Department of Education aid programs) for at least one academic period (semester, trimester, etc.) during the year.
No "double-dipping." The tax law says that you can't claim both a credit and a deduction for the same higher education costs. It also says that if you pay education costs with a tax-free scholarship, Pell grant, or employer-provided educational assistance, you cannot claim a credit for those amounts.
Income limits. To claim the American Opportunity Tax Credit, for example, your modified adjusted gross income (MAGI) must not exceed $90,000 ($180,000 for joint filers). To claim the Lifetime Learning Credit, MAGI must not exceed $90,000 ($180,000 for joint filers). "Modified AGI" generally means your adjusted gross income. The "modifications" only come into play if you have income earned abroad.
The Lifetime Learning Credit
You may be able to claim a Lifetime Learning Credit of up to $2,000 (20 percent of the first $10,000 of qualified expense) for eligible students (subject to reduction based on your AGI). Only one Lifetime Learning Credit can be taken per tax return, regardless of the number of students in the family.
• The credit can help pay for undergraduate, graduate and professional degree courses, including courses to improve job skills.
• For courses taken to acquire or improve job skills, there are no requirements as to course loads, so that even one or two courses can qualify.
• The number of years for which this credit can be claimed is not limited.
Choosing the Credit. You can't claim both credits for the same person in the same year. But you can claim one credit for one or more family members and the other credit for expenses for one or more others in the same year - for example, an American Opportunity Tax Credit for your child and a Lifetime Learning Credit for yourself.
Electing Not to Take the Credit. There are situations in which the credit is not allowed, or not fully available, if some other education tax benefit is claimed - where the higher education expense deduction is claimed for the same student, see below, or where credit and tax exemption (under a Section 529 or 530 program) are claimed for the same expense. In that case, the taxpayer - or, more likely, the taxpayer's tax adviser - will determine which tax rule offers the greater benefit and if it's not the credit, elect not to take the credit.
Do any tax planning considerations apply to the education tax credit?
For an academic period (quarter, semester, etc.) beginning in the first 3 months of a calendar year, you can pick which year to pay the expense and take the credit. That is, pay in December 2023 and take the credit in 2023 or pay in, say, February 2024 and take the credit in 2024.
Your family may be able to save tax by foregoing the education credit and taking an available exemption for program distributions instead.
Do living expenses while in school qualify for tax relief?
Sometimes. Examples are for relief provided for Coverdell Education Savings Accounts (Section 530 programs), for Qualified Tuition Programs (Section 529), for withdrawals from traditional and Roth IRAs, and for student loans.
How does a Coverdell (Section 530) Education Savings Account work?
An education IRA differs from other IRAs in the following ways:
• No more than $2,000 a year can be contributed to any beneficiary of a single 530 account in any year and contributors are subject to income limits. Modified AGI cannot exceed $110,000 ($220,000 joint filers).
• Contributions aren't deductible and excess contributions are subject to penalty.
• Withdrawals are tax-free to the extent used for qualified education expenses.
• Contributions can't be made after the student reaches age 18, and the account generally must distribute all funds by the student's age 30.
A 530 account may be used for primary and secondary education, including paying for room and board of children in private schools, and for computers and related materials whether or not away from home.
How can my family make best use of a Coverdell (Section 530) program?
There can be a number of Section 530 accounts for any student. Various family members, such as grandparents, aunts, and uncles, and siblings--and persons outside the family--can contribute to separate accounts for a student.
The original student beneficiary for the Section 530 account can be changed to another family member, such as a sibling - for example, where the original beneficiary wins a scholarship or drops out.
Funds can be rolled over tax-free from one family member's Section 530 account to another's for example, to avoid distribution when the first family member reaches age 30.
The education tax credit (where applicable) can be waived in favor of tax-free treatment for Section 530 account distributions.
What are Qualified Tuition Programs (QTPs)?
Also called Section 529 plans, these college savings plans have been established by almost every state and some private colleges. You invest now to cover future college or vocational school expenses, by contributing to a savings account or buying tuition credits redeemable in the future. Investments grow tax-free, and distributions to pay college expenses can also be tax-free. You may choose any state's plan, regardless of where you live. Starting in 2018, funds from 529 plans can be used for up to $10,000 of qualified expenses related to K-12 education as well.
Even if a QTP is used to finance a student's education, the student or the student's parents still may be eligible to claim the American Opportunity Tax Credit or the Lifetime Learning Credit.
How do Coverdell Education Savings Accounts (Section 530) and Qualified Tuition Plans (Section 529) differ?
Section 530 plans limit investment to $2,000 a year per student; 529 plans allow a much larger investment. Section 530 plans allow a wide choice of investments; 529 investment choices are limited and conservative. Section 530 is a single nationwide program, whereas each 529 program is different. Both are available for higher education as well as primary and secondary education.
Can my traditional IRA be used for education?
Yes. The 10 percent penalty on withdrawal under age 59-1/2 won't apply, but ordinary income tax will apply to at least some of the withdrawal.
Can a Roth IRA be used for education?
Yes, generally under the same terms as traditional IRAs. Also, ordinary income tax is somewhat less likely or may be smaller in amount, than with traditional IRAs.
What tax deductions are available for college education?
You can choose to take a tax deduction rather than the college tuition tax credits noted above. A tax deduction is usually taken if income is too high for the tax credits. The tax deduction reduces your amount of income. The tax credits reduce the amount of tax you pay.
A $4,000 above the line deduction for qualified tuition expenses was extended through tax-year 2020, but repealed for 2021 and beyond under the Consolidated Appropriations Act (CAA). In 2020, the deduction was allowed if taxpayer's (modified) adjusted gross income is $80,000 or less ($160,000 or less on a joint return).
A business expense deduction is also allowed without dollar limit, for education that serves the taxpayer's business, including employment. The deduction is also allowed for student loan interest; however, a taxpayer may not take more than one deduction for the same item.
What tax benefits are available for continuing/adult education for a sideline hobby?
If it's not part of a degree or certificate program, and not work-related, the limited deduction (up to $4,000 for qualified tuition and fees) was your only option; however, please note that this deduction expired at the end of 2020 and was repealed for tax years 2021 and beyond. It is possible that in some instances, a sideline interest might qualify for exclusion if paid for under an employer-provided education assistance program.
Can I deduct student loan interest?
Since personal interest is generally non-deductible, deductions must meet several tests:
1. You must be the person liable on the debt and the loan must be for education only (not an open line of credit).
2. Your income can't exceed $180,000 on a joint return or $90,000 for single filers. Married couples filing separately cannot take the deduction.
4. You can't deduct if you're claimed as a dependent.
4. Deduction ceiling is $2,500 (starting in tax year 2013).
If I take a home equity loan to pay education expenses, can I deduct the interest?
For tax years prior to 2018, you could deduct interest form a home equity loan used to pay educational and other non-home improvement-related expenses, not as student loan interest. In this case, there was no income ceiling on your deduction, and certain other student loan limits didn't apply. However, for tax years 2018 through 2025, taxpayers are no longer able to deduct interest on home equity loans taken out for non-home-related purposes.
What tax treatment applies if my student loan debt is canceled?
Usually you're taxed on the unpaid loan balance, but the tax can be waived if the debt is canceled if you worked:
• For a certain period of time,
• In certain professions, and
• For any broad class of employers.
Tax reform legislation passed in 2017 further stipulated that student loan debt forgiveness due to death or permanent and total disability is excluded from income.
What's the tax relief for education savings bonds?
Interest on redemption of Series EE bonds is tax-exempt if you redeem them in a year you have qualified education expenses. Exemption depends on the amount of your income in the year you redeem the bond.
Must I pay tax on my employer's payment or reimbursement of my education expenses?
Maybe not. Starting in 2013, up to $5,250 can be tax-free. Exemption can apply to graduate level courses.
Can I take tax deductions for education I pay for that helps me in my work?
For tax years prior to 2018, the answer was, yes, if it's to maintain or improve skills in your present job, but no, if it was to meet minimum requirements of that job, or to qualify to enter a new business. Furthermore, employee's deductions were subject to the two percent floor on miscellaneous itemized deductions. However, under the Tax Cuts and Jobs Act of 2017 ("tax reform"), for tax years 2018 through 2025, employee business-related deductions (including education expenses) are disallowed. That is, there are no miscellaneous deductions on Schedule A as there were previously. Self-employed individuals are still able to deduct qualifying educational expenses on Schedule C.
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