Back in the old days, saving for a child's college education was much simpler. Not only was sending a child to college more affordable, but there were also a lot fewer tax breaks to navigate through. Over the years, the tax rules have evolved into a confusing array of tax-advantaged college
savings accounts,
tax credits and other tax breaks available to families trying to fund a child's college education. (To learn more about saving for college, see
Invest In Yourself With A College Education,
Don't Forget The Kids: Save For Their Education And Retirement and
Investing In Your Child's Education.)
Tax Advantaged College Savings AccountsThe first tax-advantaged college savings opportunity was instituted back in 1990. The Education Savings Bond Program ensured that tax payers wouldn't pay taxes on interest earned on certain government bonds redeemed to pay for a child's tuition. Currently,
EE Bonds and
I Bonds qualify.
To qualify, the bond must be in your name or the name of you and your spouse, which means bonds issued in your child's name aren't eligible. Plus, you won't benefit from this tax break unless your
adjusted gross income (AGI) is less than $128,400 if
married or $80,600 if
single (in 2007).
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If you'd prefer to invest in mutual funds to save for a child's college education, take a look at
529 Plans and
Coverdell Education Savings Accounts (ESAs). (For more information on these plans, see
Choosing The Right Type Of 529 Plan.) Both plans offer tax-deferred growth as long as the money remains invested. Here's how these two plans differ:
- Maximum Annual Contribution: You can contribute up to $2,000 per year per child into an ESA versus $12,000 per year per donor into a 529 plan. Want to put away even more money? 529 plans allow you to front-load five years of contributions - up to $60,000 - all in one year.
- Tax-Free Distributions: While distributions from both plans that are used to pay for qualified education expenses are tax free, you can also withdraw money from an ESA, tax-free, to pay for private kindergarten, elementary school and high school.
- Income Limitation: Earn more than $220,000 if married ($110,000 if single), and you're not eligible to contribute to an ESA that year. With a 529 Plan, there are no income limitations.
Wondering which opportunity makes the most sense for you? It all depends on your specific situation and how much you're looking to put away for your child's education.
Tax Credits For College TuitionBack in 1997, Congress enacted two tax credits to help people pay for a college education. The Hope Credit applies only to the first two years of post-secondary education and currently provides for a tax savings of up to$1,650 annually. This credit is equal to 100% of the first $1,100 spent on tuition, fees and other eligible expenses and 50% of the next $1,100 spent.
A second tax credit, known as the
Lifetime Learning Credit, is equal to 20% of the first $10,000 of qualified educational expenses incurred each year, providing you with a tax savings of up to $2,000 per year.
Like many other provisions, there is an income threshold for these tax breaks as well. For 2006, single individuals who earn more than $55,000 and married couples who earn more than $110,000 aren't eligible.
More Tax BreaksIf you're working full time while taking classes, the government allows your employer to pay up to $5,250 toward your education each year, including tuition, books, supplies and equipment. Under the current rules, this tax-free benefit applies to undergraduate and graduate level classes.
Through 2007, there was also the Tuition and Fees Deduction, allowing you to claim a
deduction of up to $4,000 annually in connection with your higher education expenses, provided your income was less than $130,000 if married or $65,000 if single for 2007. If your income exceeded that threshold but fell below $160,000 ($80,000 if you're single), you could still deduct $2,000. You didn't need to
itemize to claim this deduction, but you had to choose between taking either the Tuition and Fees Deduction or one of the education credits described above. This deduction is scheduled to expire after the 2007 tax year. (Find out more about tax deductions in
Tax Tips For The Individual Investor,
Money Saving Year-End Tax Tips and
Which is better for tax deductions, itemization or a standard deduction?)
And don't forget about the student loan interest deduction. Each year, you can deduct up to $2,500 of student loan interest paid. This deduction, which is also available to non-
itemizers, phases out for married couples who earn between $110,000 and $140,000, and for single individuals who earn between $55,000 and $70,000 in 2007.
College Savings CoordinationWith all these different tax breaks, coordinating these opportunities to minimize the after-tax cost of sending a child to college is quite a challenge. Plus, it's important not to overlook how each of these strategies might impact the financial aid package your family ultimately receives.
