Saving For Education
Updated for Tax Years 2010-11

There are four different approaches to saving for education. These are listed in order from the least to the greatest tax benefit:

1. Custodial accounts
2. Coverdell Education Savings Accounts (ESAs)
3. Section 529 prepaid tuition plans
4. Section 529 savings plans

All contributions to these plans are non-deductible. However, only earnings of the custodial account are taxable when withdrawn for qualified education expenses.

In addition to savings plans, there are currently four different kinds of deductions and credits available for higher education costs:

1. American Opportunity credit
2. Lifetime learning credit
3. Higher education expense deduction
4. Student loan interest deduction

Custodial Accounts

These are accounts set up in the student’s name with parent or guardian as custodian. Not only are the earnings fully taxable, but they are taxed at the parents’ rate if they exceed $1,900 for children under age 18 (under age 24 if full-time students and their earned income is less than half their support). This means that if the parents’ tax bracket is up to 28%, or more, that is the rate at which earnings on these accounts are taxed. This is the Kiddie Tax that both California and the IRS impose.

When the child comes of age, usually at 18 (21 in some states), he or she is free to use the money as they please, which may or may not be for education.

Coverdell Education Savings Accounts (a.k.a. Education IRAs)

Joint filers with adjusted gross income less than $190,000 ($95,000 single) can contribute up to $2,000 per year per beneficiary under age 18. Contributions may be made as late as April 15th of the following year.

The earnings are tax-deferred and may be withdrawn tax-free, provided that they are used for education and provided that neither the American Opportunity or Lifetime Learning credits are claimed. Qualified education expense includes grades K through 12, college, public, and private school costs and covers tutoring, computer equipment, room and board, uniforms, and extended day program costs. Grandparents, other family members, corporations and other entities may contribute so long as the child receives no more than $2,000 from all sources combined.

This plan works best if saving starts when the child is very young, to take advantage of the tax-free income benefit. It is also attractive to those who don’t plan to save more than $2,000 per year and who want full control over how funds are invested. Perhaps the biggest benefit is the range of covered expenses.

Section 529 Plans

These have much higher contribution limits than other plans, no phase-outs apply, and generally there are no beneficiary age limits. They are run like mutual fund portfolios, and states offer a choice of risk options. Distributions for education expenses (including room and board) are tax free. There are no age or income restrictions on owners or beneficiaries. Anyone can open an account for a beneficiary, and then anyone can contribute up to $13,000 per year per beneficiary, or even use up to 5 years annual gift exclusions provided that they contribute no more to that beneficiary for 5 years.

For 2010 the definition of qualified expenses is expanded to include computers, computer technology, and internet service.

Leaving assets in the owner’s name eases financial aid qualification. Only 5.6% of parental assets are considered available for education, while 35% of a student’s assets are allocated to education when applying for financial aid. An owner can switch a beneficiary to another family member or their spouse, or even to oneself, if the original beneficiary chooses not to go to college, or if excess funds remain, or if another beneficiary account is short. It is even possible to roll over some plans from state-to-state.

Section 529 Savings Plans offer investment options from which to choose.

529 Prepaid Tuition Plans lock in tuition costs. If you purchase a year of tuition today, it will be worth a year of tuition 20 years from now. This is a low-risk plan that may appeal to those who want to eliminate risk from market drops. By keeping pace with inflation in the plan state, it is a little better than earning interest on a certificate of deposit or a treasury instrument.

www.savingforcollege.com is a good place to compare 529 plans offered by states and educational institutions.

American Opportunity and Lifetime Learning Credits

These credits are available only to the taxpayer paying for the education and for 2010 can be used for books, lab fees, software, and computers, as well as for tuition and fees. The maximum American Opportunity credit for 2010 is $2,500 per student and covers up to 4 years of at least half-time attendance in a degree program. 40% of the credit is refundable. The credit may be used to offset AMT. This credit starts to phase out at adjusted gross income of $160,000 for joint filers and $80,000 singles.

The Lifetime Learning credit is a maximum $2,000 per taxpayer and covers all post-secondary education. Qualified expenses are limited to tuition and fees. This credit starts to phase out at adjusted gross income of $96,000 for joint filers and $48,000 singles.

Education Deductions

Up to $2,500 of student loan interest may be deducted whether or not you itemize deductions. The adjusted gross income phase-outs start at $120,000 for joint filers and $60,000 for singles.

Up to $4,000 college tuition and fees are deductible. Funds from 529s or ESAs can’t be used; nor can the American Opportunity or Lifetime Learning credits be claimed. The adjusted gross income phase-outs start at $130,000 for joint filers and $65,000 for singles.

In Closing

This summary is necessarily brief in order to condense a lot of information into a form more palatable for most people to digest. If some of this information is not clear, please do not hesitate to email or call. Saving for children’s education is an important and often stressful topic for parents today. Hopefully, I can help you decide on the best approach for your family.