Taxes & Education funding

Taxes and Education

There are investment programs and tax credits that give people benefits while trying to fund higher education. This section will attempt to explain some of the difference in the programs and tax credits so that you can determine which, if any, seem to meet your needs.

Tax Advantages & Issues

These 8 different items are the main investment technique and credits that people can use to realize some tax benefit. Each has its on pro and con; we will attempt to clarify them:

Qualified Tuition Plans (529s)
Coverdell Education Saving Accounts
Hope Scholarship Credit
Lifetime Learning Credit
US Savings Bonds (EE series and I series)
Uniformed Gift to Minors (UGMA)
Traditional IRA
Roth IRA

Qualified Tuition Plans (529s)

Qualified Tuition Plans are commonly called 529s. This is because congress enacted them under section 529 of the Internal Revenue Code. This act created tax exemption on investment vehicles created, sponsored and maintained by a state. Each of the 50 states has 529 plans. The plans can be used to pay higher educational expenses for institutions accredited for:

Associate degrees
Bachelor’s degrees
Graduate degrees
Other post secondary professional degrees

The Advantage of them:

Money grows tax deferred
When money is taken out you do not have to pay income tax on it
Many states allow you to deduct contributions from their income tax
The creator of them (i.e. the parent) can own them and change the beneficiary.

There are two typically types available: Prepaid Plans & Savings Plans

Prepaid plans are where the parent locks the cost of tuition in today’s dollars, for future use, and begins making payment on it now. To us, these plans seem a little more risky. We are not a fan of leaving our outcome in the hand of others. This plans are only valid if they are still funded when your child makes withdraws. The Financial Swami is not here to tell you which plan is better or worse. The answer to that depends on each family's situation: how long you have until your child will need the money and what may happen to the fund financially between now and then.

Savings plans are plans where contributions are made into the plan and the tax benefits allow compounding interest to grow faster. These plans are used to grow the amount of money to cover the cost of tuition in the future. These plans do not lock in a tuition rate, they offer tax growth benefits and the flexibly.

When the child begins college, money can be withdrawn from the 529's without penalty if the withdraw is for higher education. Under these plans higher education expenses are defined as: Tuition, books, fees, equipment & supplies, certain room & board.

If withdraws are made for purposes other than higher education expenses the owner of the 529 will be subject to income tax on the growth and a 10% penalty. The penalty does not apply if the beneficiary receives a scholarship, becomes disabled or passes away.

Coverdell Education Saving Accounts

Coverdell ESAs are another investment vehicle in which contributions can grow tax free. Withdrawal from them is also tax free. A Coverdell is set up in the name of a child that is under the age of 18. They are not in the name of a parent like 529s. This can be an issue for some. Since the child owns the investment, they can cash them out and never use the money for school (they would have a 10% penalty, but most children say "what's 10% when I just put 90% of somebody else's money in my pocket"). Contributions can only be made into a Coverdell until the child reaches 18 years of age. The funds must be used by the time the child reach 30 or there are taxes and penalties. If the child doesn't go to school, than the Coverdell can be transferred to another family member. There is $2000 per year contribution limits. A Coverdell can be used on a wider range of schooling: public, private or religious school that provide elementary through high school education and academic tutoring.

Hope Scholarship Credit

The Hope Scholarship is a Tax credit available to the dependent, the taxpayer of the dependent, or the dependents spouse. The credit is only available for the first two years the student is in higher education. The student had to be enrolled at least 1/2 time. The maximum tax credit for 2008 was $1,800 per student. There is an income limit to qualify for the credit.

How you file your Taxes

AGI phase-out range

Individual filers

$48,000-$58,000

Married filing jointly

$96,000 - $116,000

Lifetime Learning Credit

The Life Time Learning Credit is similar to the hope credit except that it can be used for undergraduate and graduate education. The tax relief is 20% on the education expenses up to a $2,000 limit. The credit is per family not per student. That means if you have 2 children in school, your tax credit is still capped at $2,000. Also, a student can not claim both a Hope & a Lifetime Learning Credit in the same year. However, a family can claim a Life Learning Credit for one child and a Hope Credit for another child. This scenario would yield an additional $200 versus filing a Hope Credit for both. The Lifetime Learning Credit is also subject to the same adjusted gross income limit as the Hope Credit (see above chart).

US Saving Bonds (EE and I)

Series EE and Series I saving bonds are another way to save for higher education with tax benefits. The bond must be purchased in the parent name. The parent must also be over the age of 24 on the issue date on the bond. If these two criteria are met, than the bonds may be cashed with zero federal income tax on the interest earned as long as it is used for higher education during that year.

Uniform Gift to Minors Act (UGMA)

UGMA's are accounts in the child's name (meaning they own it) in which the parents can gift money to them. The benefit of the account is that as long as the child is under 18, interest earned of less that $1,800 is not taxed. If more than $1,800 is earned in interest, it is taxed at the parents' tax rate. If the child is between 18 and 24, than interest earned is taxed at the child's tax rate. There is a "kiddie tax" that is used if the child fails to reach a taxable income range. There is an issue parents should think about when considering using an UGMA. The asset is in the child's name. That means it effects the student's qualification for financial aid. It also means that the child has access to the money and can withdraw it and spend it on things other than schooling.

Traditional IRA

If money is withdrawn from a Traditional IRA and is used to pay higher education for the IRA owner, spouse, child or grand child, than the 10% early withdrawal penalty is waved. The withdrawals will still be subject to the taxpayer's Federal income tax rate.

Roth IRA

Well, if you read the difference between Traditional IRA and Roth IRA under our saving for retirement, you are fully aware that Roth IRAs are funded with post tax dollars. Rather than having a tax deduction for your contribution, like a Traditional IRA, you use post tax dollars and have a tax free distribution (your interest in tax free). And just like the Traditional IRA, if the distribution is used for higher education, the 10% penalty is waived. That means money from a Roth IRA may be used for higher education with zero taxes. These investment vehicles may even be better than Coverdell's because there is not a 30 year age limit. No mandatory age limit for distribution means that what ever isn't used may still be used for retirement. The Financial Swami was created to bring awareness to the issues, not to replace the professional. If this raises your interest, then you really need to contact a professional planner so that they can assess you total condition and make create the road map of how much to contribute to what investment vehicles and when to switch back to maximize your tax advantage while not jeopardizing your retirement.

Visit our Site Map