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The annual costs to send a student through an average 4-year institution has doubled since 2000 to more than $25,000. (Source- National Center for Education Statistics)
There are many ways families can plan for these expenses. 529 and Coverdell accounts provide parents an opportunity to save money tax deferred, savings bonds can be used tax-free for education expenses, and there are billions of dollars in federal student aid available.
But there are options available for families to save hundreds or thousands of dollars a year on taxes– which don’t require a decade of planning and accumulating assets. Careful planning can reduce your total cost in paying for college, regardless of your income. Here are a few places to start:
These tax strategies can save you thousands a year! Stick around for the end of the article to find out about strategies high-income families should also consider.
The American Opportunity Credit is a tax credit of up to $2,500 for each dependent you are paying higher education expenses for.
For the expenses to qualify the student must:
The tax credit can only be claimed for expenses incurred during your, or your dependent’s, undergrad years. Expenses paid for Masters, Ph.Ds, or from those who have returned to school for a second degree are not eligible for the American Opportunity Credit.
The full credit is available for those with a modified adjusted gross income of $160,000 or less if married filing jointly, $80,000 if single.
A partial credit is available for those with modified adjusted gross income between $160,000 and $180,000 if married filing jointly, or between $80,000 and $90,000 if single.
The following expenses are eligible for the American Opportunity Credit:
The amount of credit you are eligible for under the American Opportunity Credit is calculated by:
For example, if you have $3,500 in eligible expenses, you can claim a credit of $2,375 (100% of the first $2,000, plus 25% of the remaining $1,500).
In order to claim the full $2,500 American Opportunity Tax Credit, you would need to have at least $4,000 in eligible education expenses.
If available to you, the American Opportunity Credit is often the most beneficial in terms of tax breaks. However, if you do not qualify, there are other options.
The Lifetime Learning Credit is a tax credit of up to $2,000 for those with qualified education expenses.
Unlike the American Opportunity Credit, you are able to claim the Lifetime Learning Credit any year you incur qualified education expenses. This credit can be used to help offset costs during grad school, additional semesters required for a degree, or additional degrees obtained in the future. The credit is also available for those not in school full time, or with prior felony drug convictions.
You cannot claim the Lifetime Learning Credit during any year in which you also claim the American Opportunity Tax Credit.
The full credit is available for those with a modified adjusted gross income of $111,000 or less if married filing jointly, $55,000 if single.
A partial credit is available for those with modified adjusted gross income between $111,000 and $131,000 if married filing jointly, or between $55,000 and $65,000 if single.
The amount of credit you are eligible for under the Lifetime Learning Credit is calculated by taking 20% of your first $10,000 in qualified expenses.
For example, if you are married, have a household income of $100,000 and have $7,500 in eligible expenses, you can claim a credit of $1,500 (20% of $7,500).
To claim the full $2,000 Lifetime Learning Credit, you would need to have at least $10,000 in eligible expenses.
The student loan interest deduction is a tax deduction of up to $2,500 available for those paying on their student loans.
The full deduction is available for those with a modified adjusted gross income of $130,000 or less if married, $65,000 if single. A reduced benefit is available for those with incomes between $130,001 and less than $160,000 if married, or between $65,001 and $80,000 if single.
You are ineligible for the student loan interest deduction if your modified adjusted gross income is $160,000 or greater if married, $80,000 if single.
The amount of income you are eligible to deduct under the Student Loan Interest Deduction is the lesser of:
You are allowed to claim a tax deduction of up to $4,000 for tuition and fees paid at an eligible institution that is not covered by other tax-free methods, such as tuition pad for with tax-free savings bonds, Coverdell or other qualified tuition programs, or scholarships and grants.
The full deduction is available for those with a modified adjusted gross income of $130,000 or less if married, $65,000 if single. A reduced benefit is available for those with incomes between $130,001 and less than $160,000 if married, or between $65,001 and $80,000 if single.
You are ineligible for the deduction if your modified adjusted gross income is greater than $160,000, or $80,000 if single.
The amount of income you are eligible to deduct under the tuition and fee deduction is the lesser of:
In addition to your savings in a 529 plan being able to grow tax free, a portion of your contribution may also give you a break on your state income tax.
For residents of Iowa, each spouse can deduct up to $3,239 per year for each child for 529 contributions.
For example, a married couple with 3 children can deduct up to $19,434 in income from their state taxes. If this couple was in Iowa’s top income tax bracket (8.98% tax rate), this deduction is worth $1,745.
For households with high income, which may exclude them from the proceeding tax breaks, there are other options.
A UTMA account is a type of trust account which involves parents or grandparents gifting assets to a minor, which they can use for education expenses later.
Gains on investments within UTMA accounts are not given any special tax treatment. At the time the investments are sold the child will be subject to capital gains taxes on the investments in the account. Because of the kiddie tax laws, the child will likely be subject to their parents’ tax rate.
So where is the benefit with using a UTMA account?
If income from the UTMA account can cover 50% of a student’s expenses, that child is eligible to be designated independent on their taxes, making them eligible for tax credits like the American Opportunity Credit, Lifetime Learning Credit and more.
To see the benefit, let’s compare the effects of a family with a high $418,000 gross taxable income, with a student that is enrolled in a college that costs $50,000 per year:
If the parents planned and funded their child’s UTMA accounts ahead of time (complying with gift tax rules of course), the student will have assets to cover at least 50% of their expenses as they enter college.
Let’s say the student withdraws $28,000 in long term capital gains from the UTMA account to cover at least 50% of their tuition for the year. The student is now eligible to claim the personal exemption ($4,050) for themselves. Since the student passes the IRS’ support test, they are also eligible for the full standard deduction ($6,300) as well.
In addition, the student is also eligible to claim the America Opportunity Credit ($2,500) since their income is low enough to make them eligible.
What does this mean for the student’s year-end tax return?
They will have $28,000 in long term capital gains.
The personal exemption reduces that by $4,050 and the standard deduction by $6,300.
Leaving the student with net taxable income of $17,650.
Because of kiddie tax rules, the child will be taxed at their parent’s tax rate, which would be 15% in this case because the income is from long term capital gains.
The child will owe $2,647, which is almost entirely offset by the American Opportunity Tax Credit of $2,500.
Leaving the child owing the IRS just $147.
Had the family decided to forgo planning, keep the assets in their name, and just pay the 15% long term capital gains, they would be subject to $3,614 in taxes ($28,000 * 15% tax rate – partial personal exemption of $586).
Over 4 years this strategy would save the family $3,467 ($3,614 – $147) per year, and $13,868 over the student’s 4 years at college!
If you have not set up a UTMA account, simply gifting appreciated assets, such as stocks, can have a similar tax saving benefit for parents as planning ahead with a UTMA account. However, you may be restricted by the limit on gifts of $14,000 per parent per year (you can give more, but you’ll have to report it and potentially pay taxes in the future).
If you can gift assets in value greater than 50% of your child’s expenses, your child passes the IRS’ support test, and is eligible to claim the personal exemption and standard deduction as well as likely being able to apply for the American Opportunity Credit or Lifetime Learning Credit.
Like our example above, even with the effect of the kiddie tax on the child’s unearned income from the gifted assets, they are still able to reduce their large tax burden by being able to qualify for credits and exemptions that the parents would not be eligible for.
Want to learn more about tax planning opportunities? Set up a free discovery meeting today!