|From private preschool classes to college tuition, educating your family can be expensive. You can help lower the out-of-pocket costs by planning ahead with tax-advantaged education savings tools.
The Tax Cuts and Jobs Act (TCJA) retains most education-related tax breaks — and it even makes one saving plan more flexible.
Liberalized Rules for Section 529 Plans
For years, Section 529 plans have been a popular vehicle for saving for higher education. All states offer at least one type of 529 plan and some educational institutions also offer them. Anyone (not just parents) can establish a Section 529 prepaid tuition plan account or a Section 529 college savings plan account for account beneficiaries (usually children or grandchildren).
Prepaid tuition plans generally allow you to pay for tuition (usually not room and board) at today’s rates for a student who will attend college in the future. However, some prepaid plans are only available to residents of the states that sponsor them.
Alternatively, college savings plans are basically investment accounts that donors can contribute to over time. College savings plans are by far more popular than tuition plans.
Under prior and current law, distributions from a Sec. 529 plan were exempt from federal income tax and sometimes from state income tax as long as they were used to pay for qualifying higher education costs at an eligible institution. This includes tuition, room and board, books and even computers.
In a nutshell, these accounts allow you to take federal-income-tax-free distributions to cover qualified education expenses incurred by the account beneficiary. There are no income limits on the tax-free distribution privilege. Even billionaires can qualify. But it is important to keep in mind that there other options, as well.
Under the TCJA, the tax-free distribution privilege has been expanded to cover withdrawals of up to $10,000 per year to cover tuition at a public, private or religious elementary or secondary school. This change goes into effect in 2018 and it’s permanent.
However, because Sec. 529 plans are operated by the states, some plans may choose to ignore this change by not allowing distributions to cover tuition to attend religious elementary or secondary schools.
Another TCJA change benefits people who want to make a large contribution to jump-start a Sec. 529 account. For 2018, if you contribute more than $75,000 (or $150,000 if you’re married and make a joint contribution with your spouse), it will use up part of your unified federal gift and estate tax exemption. However, this may be of little concern, because the TCJA increased the exemption to $11.18 million if you’re single or effectively $22.36 million if you’re married. These amounts will be increased for inflation in 2019 through 2025, but the exemptions are scheduled to return to the pre-TCJA amounts in 2026.
Coverdell Education Savings Accounts (CESAs)
Similar to Sec. 529 plans, CESA contributions aren’t deductible but grow tax-deferred, and distributions for qualified education expenses are tax-free. The TCJA doesn’t change the rules for CESAs. As before the TCJA, annual contributions to CESAs are still limited to $2,000 per beneficiary. Tax-free withdrawals can still be taken to pay for the beneficiary’s postsecondary tuition, fees, books, supplies, and room and board.
Taxpayers can also take tax-free CESA payouts to cover elementary and secondary school (K-12) costs. Eligible expenses include tuition and fees to attend private and religious schools — plus room and board, uniform, and transportation costs. Taxpayers can also withdraw CESA money tax-free to pay out-of-pocket costs to attend public K-12 schools. Eligible expenses include:
It’s important to start contributions early if you want to take full advantage of this break. That’s because contributions generally can’t be made after the account beneficiary reaches age 18.
If you have several children or grandchildren, you can set up separate CESAs for them and contribute up to $2,000 annually to each account. You have until April 15 of the following year (adjusted for weekends and holidays) to make your annual CESA contribution for the current year. For example, you have until April, 15, 2019, to make a contribution for the 2018 tax year.
The downside? Your ability to contribute to a CESA is phased out between MAGI of $95,000 to $110,000 for singles and $190,000 to $220,000 for married filing joint status. However, if the parents’ MAGI is too high to allow contributions, any other person can contribute to the account. For example, a child’s grandparents could make contributions.
Other Ways to Lower College Costs
Colleges offer millions of dollars of scholarships and grants every year. If you or your child is fortunate enough to receive a scholarship or fellowship for higher education (undergraduate and graduate), there may be tax issues to consider. According to the IRS, scholarship and fellowship money is tax-free if you’re a degree candidate at an eligible institution and the funds are designated for tuition and related expenses (including books and supplies) or they’re unrestricted and aren’t specifically designated for some other purpose — like room and board.
When paying for college, other tax-savvy options to consider include:
Savings bond interest. You may be able to cash in qualified U.S. savings bonds and exclude some (or all) of the interest on the bonds from federal income tax if the funds are used for educational purposes. To qualify, you must use them to pay qualified education expenses for yourself, your spouse or a dependent for whom you claim an exemption on your tax return. This benefit is also phased out based on MAGI.
IRA penalty exception. Generally, you can’t take a distribution from a traditional IRA before age 59 1/2 without incurring a 10% penalty. One exception applies to distributions used for qualified education expenses. Although you won’t incur a penalty, you’ll still have to pay income tax on the taxable portion of distributions from traditional IRAs. You can also withdraw annual Roth IRA contributions without any tax or penalty.
Ask a Pro
An education opens the door to a brighter future for your children and other family members. Discuss education savings tools with your tax and financial advisors. By planning ahead, you’ll help minimize your family’s financial stress.