Saving for a child's college education was once much simpler, more affordable, and there were a lot fewer tax breaks to navigate. Over time, the tax rules have evolved and become 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. Here we take a look at what the tax consequences are for various college savings plans.

Key Takeaways

  • There are numerous opportunities to cut your taxes based on what kind of college savings plan you invest in for your child; however, it's important to keep track of the taxpayers' income, as every plan has limits.
  • Savings plans include the Education Savings Bond Program, which must be in the name of a parent, as well as 529 Plans and Coverdell Education Savings Accounts, both of which allow for mutual fund investing.
  • A tax credit called the Lifetime Learning Credit provides you with a tax savings of up to $2,000 per year, which is equal to 20% of the first $10,000 of any educational expenses you pay each year.
  • Those who work full time while taking classes can have their employer pay a certain portion of their education costs; this is a tax-free benefit.
  • The tuition and fees deduction allows you to deduct a certain amount yearly if your income is below a certain level; the student loan interest deduction allows you to deduct up to a certain amount of interest paid.

Tax-Advantaged College Savings Accounts

The first tax-advantaged college savings opportunity was instituted back in 1990. The Education Savings Bond Program ensured that taxpayers would not pay taxes on interest earned on certain government bonds redeemed to pay for a child's tuition. Currently, Series 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 are not eligible. Plus, you will not benefit from this tax break unless your modified adjusted gross income (MAGI) is less than $153,550 if married or $97,350 if single (in 2020).

If you prefer to invest in mutual funds to save for a child's college education, 529 Plans and Coverdell Education Savings Accounts (ESA) are options.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act signed into law by President Donald Trump in December 2019 expands the use of 529 and ESA plans by allowing up to $10,000 to be used for student loan payments. In addition, funds in these plans may be used to cover the costs of an apprenticeship program, if approved by the U.S. Department of Labor.

Both 529 Plans and Coverdell Educational Savings Accounts 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. 529 plan beneficiaries can have a maximum account balance between $235,000 and $529,000, depending on the state. 

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

For 2019, the amount of your ESA interest exclusion is gradually reduced if your MAGI is between $95,000 and $110,000 ($120,000 and $220,000 if you file a joint return). You cannot exclude any interest if your MAGI is over the limits. With a 529 Plan, there are no income limitations.

Are you wondering which opportunity makes the most sense for you? It all depends on your specific situation and how much you plan to save for your child's education.

With a number of different tax breaks available, coordinating opportunities to minimize the after-tax cost of sending a child to college is quite a challenge.

Tax Credits for College Tuition

A 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 full credit, your MAGI for 2020 must be $69,000 or less, or $138,000 or less if you file jointly. If your MAGI is between $59,000 and $69,000 (between $118,000 and $138,000 if filing jointly), you receive a reduced amount of the credit. If your MAGI is over $69,000 ($138,000 for joint filers), you cannot claim the credit.

Be careful not to overlook how each of these tax-saving strategies might impact the financial aid package your family ultimately receives.

More Tax Breaks

If 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.

The Tuition and Fees Deduction allows a deduction of up to $4,000 annually in connection with your higher education expenses provided your income was less than $160,000 if married or $80,000 if single for 2020. It is reduced to $2,000 for single filers with a MAGI of $65,000 to $80,000 ($130,000 to $160,000 for married couples filing jointly) and eliminated for single filers with a MAGI over $80,000 (over $160,000 for married couples filing jointly).

Also, consider 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, begins to phase out for married couples who earn over $140,000 ($70,000 for single filers) and completely phases out at $170,000 ($85,000 for single) in 2020.