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.
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 $147,250 if married or $93,150 if single (in 2017).
If you prefer to invest in mutual funds to save for a child's college education, 529 Plans and Coverdell Education Savings Accounts (ESAs) are options. 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 $100,000 to $350,000 per year per donor into a 529 plan depending on the state.
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.
For 2017, the amount of your ESA interest exclusion is gradually reduced if your MAGI is between $78,150 and $93,150 ($117,250 and $147,250 if you file a joint return). You cannot exclude any interest if your MAGI is $93,150 or more ($147,250 or more if you file jointly). 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.
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 must be $66,000 or less or $132,000 or less if you file jointly. If your MAGI is between $56,000 and $66,000 (between $112,000 and $132,000 if filing jointly), you receive a reduced amount of the credit. If your MAGI is over $66,000 ($132,000 for joint filers), you cannot claim the credit.
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 2017. It is reduced to $2,000 for single filers with an MAGI of $65,000 to $80,000 ($130,000 to $160,000 for married couples filing jointly) and eliminated for single filers with an 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, phases out for married couples who earn over $165,000 and for single individuals who earn above $80,000 in 2018.
The Bottom Line
With 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 is important not to overlook how each of these strategies might impact the financial aid package your family ultimately receives.