Reap the Tax Benefits of Education Planning

Article Highlights:

• Education Financing 
• American Opportunity Credit 
• Lifetime Learning Credit 
• Coverdell Education Savings Account 
• Qualified Tuition Programs (Sec 529 Plans) 
• Savings Bond Program 

The tax code includes a number of incentives that, with proper planning, can provide tax benefits while you, your spouse, or your children are being educated.

Education Financing: A major planning issue is how to finance your children’s college education. Those with substantial savings simply pay the expenses as they go, while some parents, sometimes with the help of the children’s grandparents, begin setting aside money far in advance of the education need, perhaps utilizing a Coverdell account or Sec. 529 plan.

Other parents or their student-children will need to borrow the funds, obtain financial aid, or be lucky enough to qualify for a scholarship. Although student loans provide one ready source of financing, the interest rates are generally higher than a home equity loan, which can also provide a longer term and lower payments. When choosing between a home equity loan or a student loan, keep in mind the following limitations: (1) Interest on home equity debt is deductible only if you itemize and then only on the first $100,000 of debt, and not at all to the extent you are taxed by the alternative minimum tax; and (2) student loans must be single-purpose loans; the interest deduction is limited to $2,500 per year, and the deduction phases out for joint filers with income (MAGI) between $130,000 and $160,000 ($65,000 to $80,000 for unmarried taxpayers, and no deduction if filing married separate).

Education Tax Credits: The tax code also provides tax credits for post-secondary education tuition paid during the year for the taxpayer and dependents. There are two types of credits: the American Opportunity Credit, which is available through 2017 and is limited to the first four years of post-secondary education, and the Lifetime Learning Credit which provides credit for years after the first four years of post-secondary schooling and can be used for graduate studies.

The American Opportunity Credit, in many cases, offers greater tax savings than other existing education tax breaks! Here are some key features of the credit:

• Tuition, related fees, books, and other required course materials generally qualify. The credit is equal to 100 percent of the first $2,000 of education expenses and 25 percent of the next $2,000. This means the full $2,500 credit may be available to a taxpayer who pays $4,000 or more in qualified expenses for an eligible student. 
   
• The full credit is available for taxpayers whose modified adjusted gross income (MAGI) is $80,000 or less (for married couples filing a joint return, the limit is $160,000 or less). The credit phases out for taxpayers with incomes above these levels. These income limits are higher than those for the Lifetime Learning Credit. 
   
• Forty percent of the American Opportunity Credit is refundable. This means that even people who owe no tax can get an annual payment of the credit of up to $1,000 for each eligible student. Other existing education-related credits and deductions do not provide a benefit to people who owe no tax. The refundable portion of the credit is not available to any student whose investment income is taxed at the parent’s rate, commonly referred to as the “kiddie tax.” 

The Lifetime Learning Credit provides up to $2,000 of credit for each family each year. The Lifetime Learning Credit is phased out for joint filers with incomes (MAGI) for 2014 between $108,000 and $128,000 ($54,000 to $64,000 for single filers) and is not allowed at all for married individuals filing separately.

Careful planning for the timing of tuition payments can provide substantial tax benefits. Taxpayers are allowed to prepay the first three months of the subsequent year’s tuition in advance, thereby allowing them to spread the payment and maximize the credits.

Tax-Favored Savings Programs: For those who wish to establish a long-term savings program to provide funds to educate their children, the tax code provides two plans. The first is a Coverdell Education Savings Account, which allows the taxpayer to make $2,000 annual nondeductible contributions to the plan. The second plan is the Qualified Tuition Plan, more frequently referred to as a “Sec. 529 plan,” with annual contributions generally limited to the gift tax exemption amount for the year ($14,000 in 2014). However, the law allows up to five years of a contributor’s contributions to be made to a Sec. 529 in a year without gift tax implications, allowing substantial up-front contributions.

Both plans provide tax-free earnings if they are used for qualified education expenses. When choosing between a Coverdell or Sec. 529 plan, keep the following in mind: (1) Coverdell accounts can be used for kindergarten through post-secondary education and become the property of the child at the age of majority, and contributions phase out for joint filers with income (MAGI) between $190,000 and $220,000 ($95,000 and $110,000 for others); and (2) Sec. 529 plans are only for post-secondary education, but the contributor retains control of the funds.

Savings Bond Program: There is also an education-related exclusion of savings bond interest for Series EE or I Bonds purchased by an individual over the age of 24. All or part of the interest on these bonds is exempt from tax if qualified higher education expenses are paid in the same year the bonds are redeemed. As with other benefits, this one also has a phase-out limitation for joint filers with income (MAGI) between $113,950 and $143,950 (between $76,000 and $91,000 for unmarried taxpayers, but those using the married separate status do not qualify for the exclusion). The income ranges shown are for 2014. 

If you would like to work out a comprehensive plan to take advantage of these benefits, please give this office a call.

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