Reduce the Cost of College Thru Proper Tax Planning
SHORTER DAYS AND COOLER temperatures mean summer is coming to an end. Football season is kicking off, and millions of students across America are heading back to school. While some are already dreaming of a white Christmas, others are poring over their budgets trying to figure out how to pay for college.
For many, the cost of higher education can be offset by federal income tax credits. Like seemingly everything else in the tax code, tax breaks are complicated and require advance planning and coordination by students and parents alike. Here’s what families with college-bound students need to know about filing taxes.
Federal income tax credits can offset the costs of higher education by up to $2,500 per student per year. Of course, the student, expenses and educational institution all must meet certain criteria. Here are a few definitions:
Qualified education expenses can include tuition, books, fees and some other costs required for enrollment or attendance at an eligible educational institution. The costs of being away from home, such as room, board and transportation are not allowable expenses for the purposes of these credits.
Get familiar with education tax credits. There are two main education credits, the American Opportunity Tax Credit, commonly called the AOTC, and the Lifetime Learning Credit. Most students paying qualified education expenses at an eligible educational institution will be able to apply for one of these credits.
Tax Planning – Family and Education Related Opportunities
The increasing costs of higher education have made education planning an important aspect of personal financial planning. Frequently, education planning does not receive proper attention because cash outlays may not be incurred for many years and are low on the priority list. Often, families have made mental commitments to a certain standard of education for their children but have done little planning for when the tuition bill arrives. This tendency to postpone the issue may eliminate several effective education funding strategies that offer opportunities for tax reduction and financial gain when implemented early.
Many of the strategies discussed include shifting income or assets to children. For clients who may be eligible for college financial aid, this strategy can have a negative impact on the amount of such aid, since a greater percentage of a child’s income and assets is considered in financial aid formulas than if such income and assets were attributable to the parents. However, high-income families may be eligible for little, if any, financial aid, so strategies that maximize the family’s available college funds may be the best overall plan.
Some Possible Opportunities:
- Employing a child in the family business,
- Gifting appreciated property to a child,
- Using trusts, partnerships, & S-corporations to shift income to children
- Funding for future college costs using 529 savings accounts, Roth and/or traditional IRA accounts, and U.S. Savings Bonds.
Choose a College Wisely
The decision to attend a particular college has major ramifications on the total cost of education. For example, a high school student in Texas might attend a smaller public university such as Midwestern University (estimated total cost of $7,952 per year), a large public university, such as the University of Texas at Austin (approximately $26,400 annually), or a private school such as Southern Methodist University (estimated annual cost of $57,755).
While these estimates do not take financial aid into consideration, they do reflect the disparity between different educational environments. All three schools are fully accredited and all three schools regularly send graduates on to advanced degree programs, such as law or medical school.
Careers that require advanced degrees may depend less on the choice of undergraduate college and more on the mastery of standardized tests, such as:
- Graduate Record Examination (GRE)
- Graduate Management Admission Test (GMAT)
- Law School Admission Test (LSAT)
- Medical College Admission Test (MCAT)
Tapping Tax-Free College Savings
You can take tax-free distributions for qualified education expenses from your child’s 529 college savings plan or Coverdell Education Savings Account. You can use tax-free withdrawals from Coverdell ESAs and 529 college savings plans in the same year as the Hope or Lifetime Learning credits as long as you don’t use them for the same expenses. (See 529 Plan FAQs)
Tax-Free Savings Bond Interest
Interest earned on EE or I savings bonds issued after 1989 is tax free if the bond is used for college tuition and fee. For 2014, the tax break starts to phase out at a modified adjusted gross income of $113,950 for married taxpayers filing jointly and at $76,000 for single filers. The break disappears completely when adjusted gross income is $143,950 for couples filing jointly and $91,100 for single filers. The tax-free provision cannot be combined with other educational tax breaks so, for example, expenses paid with tax-free interest don’t count when figuring the American Opportunity or Lifetime Learning credit.
An overview of the American opportunity tax credit
The AOTC can produce a tax benefit for an individual taxpayer by creating a combination of nonrefundable and refundable tax credits totaling as much as $2,500. Under Sec. 25A, these credits are available to a taxpayer who is an eligible student or who claims a dependent who is an eligible student. Eligible students include persons who are seeking a postsecondary degree, certificate, or other recognized postsecondary educational credential and are enrolled at least part time at a qualified educational institution. They must also have not completed their first four years of postsecondary education, not claimed the credit for more than four tax years, and not have a felony drug conviction at the end of the tax year.
The credits are calculated based on required tuition, fees, and course materials (together called qualified educational expenses, or QEE) paid for by cash, check, credit card, or debit card or through loans. When the expenses are for a dependent child, the credit can be claimed on the parents’ return if the parents, the child, or a third party is paying the QEE.4 The first $2,000 in QEE create a $2,000 credit, and the next $2,000 create a credit equal to 25% of QEE in excess of the first $2,000. In total, $4,000 in QEE can result in a $2,500 credit, of which the first $1,500 is nonrefundable and the remaining amount, up to $1,000, is refundable