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College Tax Credits & Educational Savings Plans: A Quick Reminder for Parents and Grandparents

Parents and grandparents of high school students have a wistful feeling about the child they’ve watched grow up, as well as a concern for what lies in their future. It’s only natural to want to help that future scholar navigate the financial hurdles to a great education. That said, you may have a few hurdles of your own. It would be good to know how to financially help the child in your life while avoiding any extra tax burdens. 

What School Expenses Qualify?

If you’re helping your child fund their education, the IRS offers education credits. These can be claimed for qualified expenses paid with cash, check, credit card, debit card or with loan money. However, if you are paying with money from a loan, your credit applies only to the year you make the payment.1

These qualified expenses include:2

  • Tuition
  • Fees
  • Related expenses required for enrollment or attendance
  • Expenses covered by the American Opportunity Tax Credit (AOTC)

Bear in mind, the AOTC has phase-out limits for households with a modified adjusted gross income of over $160,000 for married couples filing jointly or $80,000 for single filers. You can still get a partial credit up to the total phase-out limit of $180,000 for couples or $90,000 for those filing as single.2

For those who qualify, the AOTC offers up to a $2,500 credit on items assigned for study, such as:2  

  • Books
  • Supplies
  • Equipment

These items do not necessarily need to be purchased directly from the school or their bookstore to qualify for the credit, but they must be assigned to the student.

While the AOTC is only available for undergraduate expenses, the Lifetime Learning Credit (LLC) can help offset graduate school expenses. However, the LLC has lower income phase-out limits than the AOTC, and the maximum credit amount is lower. See here for a comparison chart of the two tax credits.

What Expenses Aren’t Qualified for the AOTC or LLC?

Expenses for sports, games, hobbies and courses without credit are not qualified. However, there is an exception for these expenses if they are necessary for the student’s degree.1

The following items are not qualified, even in situations where you’re paying the school directly for them:1  

  • Room and board
  • Insurance
  • Medical expenses/student health fees
  • Transportation
  • Personal, living or family expenses (such as meals)

It’s also important to remember that if you’re taking money from a tax-advantaged account, a scholarship or a grant with no tax requirements, you’re disqualified for the amounts used. For instance, if the student in question had a $5,000 scholarship, you’d subtract that amount before taking any deductions.1 

Tax-Advantaged Accounts

As you consider how you'll cover the costs of college, starting with tax-focused saving strategies can help. Here are several college savings vehicles with important tax considerations you may want to consider. These accounts can also be used for certain K-12 expenses up to specified limits.

529 College Savings Plans

Offered by states and some educational institutions, these plans (called “qualified tuition plans” by the IRS) allow you to save up to $15,000 per year ($30,000 for a married couple) for your child’s college costs without having to file an IRS gift tax return.3 You may be able to front-load a 529 plan with up to $75,000 ($150,000 for a married couple) in initial contributions per plan beneficiary – up to five years of gifts in one year – without utilizing any of your estate tax unified credit (assuming no additional gifts to the beneficiary during that period), but you would need to file a gift tax return for the year of the contribution (and up to four subsequent years, depending on the amount of the contribution).4 

Qualified expenses for 529 distributions have fewer limitations than qualified expenses for the AOTC and LLC. 529s may be used for books, supplies, equipment, room and board, and even computers or tablets and education software. 529 distributions can even be used for K-12 tuition up to $10,000 per year per child (although not all states have yet conformed to this federal law, which took effect in 2018). Additionally, up to $10,000 can be withdrawn one-time to pay eligible federal student loans (however, again, not all states have conformed).

Remember, a 529 plan is an educational savings plan that allows individuals to save for education costs on a tax-advantaged basis. State tax treatment of 529 plans is only one factor to consider prior to committing to a savings plan. Also, consider the fees and expenses associated with the particular plan. Whether a state tax deduction is available will depend on your state of residence. State tax laws and treatment may vary, and state tax laws may be different than federal tax laws. Earnings on non-qualified distributions will be subject to income tax and a 10 percent federal penalty tax (as well as potential recapture of state tax deductions or credits in certain states).   

If your child doesn’t end up incurring enough qualified educational expenses to deplete the 529 account, you can change the beneficiary to another child in your family. You can even roll over distributions from a 529 plan into another 529 plan established for the same beneficiary (or another family member) without tax consequences.3,4

Grandparents can also start a 529 plan or other college savings vehicle (and doing so can be advantageous for financial aid purposes in certain situations, depending on the beneficiary’s family’s financial situation). In fact, anyone can set up a 529 plan on behalf of anyone. You can even establish one for yourself.3,4

Coverdell Educational Savings Accounts (ESAs)

Single filers with modified adjusted gross incomes (MAGIs) of $95,000 or less and joint filers with MAGIs of $190,000 or less can pour up to $2,000 into these accounts annually.5 If your income is higher than that, phaseouts apply. 

Money saved and invested in a Coverdell ESA can be used for college or K-12 education expenses. They cover the items mentioned above for 529s and can even be extended to tutoring and certain transportation expenses related to education.5

Contributions to Coverdell ESAs aren’t tax-deductible, but the accounts enjoy tax-deferred growth and withdrawals are tax-free, so long as they are used for qualified education expenses. Contributions may be made until the account beneficiary turns 18. The money must be withdrawn when the beneficiary turns 30 or taxes and penalties may occur.5,6

UGMA, UTMA, and Educational Trust Accounts

These all-purpose savings and investment accounts are often used to save for college. They take the form of a custodial account or trust. When you put money in the trust, you are making an irrevocable gift to your child. You manage the trust assets until your child reaches the age when the trust terminates (i.e., adulthood, as defined by your state’s UGMA/UTMA laws or otherwise as defined by the trust document). At that point, your child can use the funds to pay for college; however, once that age is reached, your child can also use the UGMA/UTMA money to pay for anything else (a trust may be more restrictive). Before reaching the age of maturity, distributions can also be used for any purpose.7

Using a trust involves a complex set of tax rules and regulations. Before moving forward with a trust, consider working with a professional who is familiar with the rules and regulations.

Imagine your child graduating from college, debt-free. With the right kind of college planning, that may happen. Strategic Financial Planning is available to talk with you about these savings methods and others.

  1. https://www.irs.gov/credits-deductions/individuals/qualified-ed-expenses
  2. https://www.irs.gov/credits-deductions/individuals/aotc
  3. https://www.irs.gov/taxtopics/tc313
  4. https://www.finra.org/investors/learn-to-invest/types-investments/saving-for-education/529-savings-plans
  5. https://www.irs.gov/taxtopics/tc310
  6. https://www.thebalance.com/beginners-guide-to-coverdell-esas-4060459
  7. https://finaid.org/savings/ugma/

This content is developed from sources believed to be providing accurate information, and provided by Strategic Financial Planning, Inc. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered legal or tax advice.