Education Planning & Tax Benefits

There are a number of tax saving options and strategies to help you save for college expenses. Below is an overview of some of the most important options available to you. For additional information, please view the IRS’ Q&A on education credits and IRS Publication 970 – Tax Benefits for Education.

Tuition Tax Credits

There are tax credits available for qualified expenses (such as tuition, course-related books, supplies, and equipment) that are needed for attending college courses. The American Opportunity Tax Credit (AOTC) allows eligible taxpayers to receive up to $2,500 in tax savings (a portion of the credit can also be refunded to you if you don’t have a tax liability). There are income limits that apply to claiming this credit. For taxpayers using the single filing status, the amount of the credit is reduced if your income (modified AGI) is greater than $80k. For taxpayers using the married filing jointly filing status, the amount of the credit is reduced if your income (modified AGI) is greater than $160k.

Scholarships & Grants

There are a number of scholarships available to students for a range of different criteria. The amount of scholarships received will reduce the amount of educational costs eligible for tax credits, but it’s better to not pay for the educational costs rather than receiving a tax break for only a portion of these costs.

529 College Saving Plans

529 College Saving Plans allow taxpayers to save for college costs over a number of years. There are various state and private 529 plans available. Some 529 plans allow you to prepay for courses at today’s prices and some others allow you to invest in the 529 plan to save for educational costs you incur in later years. 529 plans can be used for tuition, room & board, books, supplies, and required equipment. If 529 plans are used for something other than qualified educational costs, or if you withdraw more from the plan that you incurred in qualified educational costs, you can face a penalty and income taxes on a portion of the amount withdrawn. Amounts withdrawn from 529 College Saving Plans cannot be used for the same educational costs used for the tuition tax credit when excluding the earnings on amounts withdrawn from taxable income (see details below on combining strategies).

529 Plans – Tax-Free Growth

Some 529 plans allow you to invest is stocks, mutual funds, and/or index funds in the plan. A major tax benefit of these plans is the earnings grow tax-free. If you were to save for college expenses by investing outside of a 529 plan you would owe income taxes on gains from stock sales, dividends, and capital gain distributions. When the funds are used for qualified educational costs such as tuition, room & board, books, supplies, and required equipment, you can avoid owing penalties and income taxes on the amount withdrawn. As with all investing, it’s best to start early to maximize the growth of investments.

529 Plans Tax Deductions

Some states allow you to deduct contributions to their own state’s 529 plans. For example, if you are a Maryland resident, you can contribute to a Maryland 529 plan and receive a tax deduction on your Maryland tax return for the contributions. This can result in immediate tax savings by saving for educational costs you expect down the road. Combined with the tax-free growth on the investments, you can minimize the financial burden of these costs. States have varying rules about how much of the 529 plan contributions can be deducted each year. Generally, if you contribute more than the allowable deduction for the current year, the excess is carried-forward and can be deducted on the state return in later years. For some states, married taxpayers can benefit from setting up multiple 529 plans, one in each spouses’ name, to deduct a larger portion of the contributions earlier on. For instance, each spouse contributing $2k, rather than one spouse contributing $4k.

Combining Strategies

It’s generally best to combine these strategies as applicable. For instance, if your income is expected to be below the income limits that apply to the tuition tax credits, you’ll want to pay for up to $4k of tuition expenses out-of-pocket (meaning not paid from a 529 plan or other educational savings plan) in order to have these costs qualify for the maximum amount of the AOTC. Pulled from the IRS’ Q&A on education credits, “You calculate the AOTC based on 100 percent of the first $2,000 of qualifying expenses, plus 25 percent of the next $2,000, paid during the tax year.” Additional educational costs can be paid using amounts withdrawn from 529 or other education savings plans. Since room & board does not qualify for the tuition tax credits, it is generally a good idea to pay this amount from an education savings plan. I recommend taking out the same amount from education savings plans as used for educational costs during the year (excluding amounts used for the tuition tax credit) to avoid having to pay penalties and income taxes on earnings from education savings plans.

Contact me to discuss this topic in further detail

Please note: the information on this website is intended to provide general advice to start the discussion with your tax professional. The information on this website may not apply to your specific situation. Only an experienced professional with the details of your specific situation can advise you on making the best decision. Contact me or your tax professional to discuss the information on this site to make an informed decision.