Saving for a child's college education was once simpler and much more affordable in the past. There were also a lot fewer tax breaks to navigate. Over time, the tax rules have evolved, leading to 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

  • Every college savings plan has its limits and depends on the parents' income level.
  • Parents can invest in bond programs or mutual funds through a 529 Plan or a Coverdell Education Savings Account.
  • The Lifetime Learning Credit is a credit that provides a tax savings of up to $2,000 per year.
  • Full-time employees are eligible for tax-free employer contributions for a certain portion of their educational costs.
  • The tuition and fees deduction allows taxpayers to deduct a certain amount yearly if their income is below a certain level.

Tax-Advantaged College Savings Plans

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. Series EE Bonds and Series I Bonds qualify.

The bond must be in your name or the name of you and your spouse in order to qualify. This means bonds issued in your child's name are not eligible. Plus, you won't benefit from this tax break unless your 2020 modified adjusted gross income (MAGI) is less than $153,550 if married or $97,350 if single.

If you prefer to invest in mutual funds to save for a child's college education, you may also want to consider a 529 Plan or a Coverdell Education Savings Account (ESA). 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. Funds in these plans may also be used to cover the costs of an apprenticeship program, provided the program is 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.  But they aren't the same. Here's how these 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: Distributions from both plans that are used to pay for qualified education expenses are tax-free. But you can also make tax-free withdrawals from an ESA 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.

This may have you wondering which opportunity makes the most sense for you. There isn't a simple answer. 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 married filing jointly—you receive a reduced amount of the credit. If your MAGI is over $69,000 or $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 work 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 or $130,000 to $160,000 for married couples filing jointly. The deduction is eliminated for single filers with a MAGI over $80,000 or over $160,000 for anyone filing jointly.

Don't forget to 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.