This is one of the few win-win deals when it comes to taxes. I think most of you will agree that education has positive benefits for the individual, community and society as a whole. And when you can receive tax benefits for pursuing education, what’s not to like?
The tax code includes various incentives that can provide tax benefits for your education as well as that of your spouse or children. But proper planning is needed to determine which incentive is best for your situation and to ensure you maximize your benefits.
Types of education tax incentives
Student loans. These are highly utilized and often make education possible. But we have all heard of the significant student loan debt that has accumulated and the difficulty graduates are having in paying it down. Before you pursue a loan you might want to see if any of the other options mentioned below are suitable for your situation.
If debt is the way you need to go, you might also want to look at home equity loans. Student loans generally have higher interest rates than a home equity loan which may also offer a longer repayment term and lower payments. When deciding between a student loan and home equity loan it is important to keep in mind the following restrictions.
- Student loans must be single-purpose loans—the interest deduction is available even if you do not itemize but is limited to $2,500 per year, and the deduction phases out for joint filers with income (AGI) between $130,000 and $160,000 ($65,000 to $80,000 for unmarried taxpayers).
- 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 that you are taxed by the alternative minimum tax
Gifting low basis assets. This is another commonly used method of financing education. Under this method, appreciated assets (typically stock) are gifted to children who then turn around and sell the stock to pay for their education. This allows the taxpayer to transfer any gain on the stock to the child at a time when the child has little to no income. The benefit to the taxpayer is that the tax on the gain is avoided or taxed at a much lower rate. Unfortunately Congress got wind of this and curtailed income shifting to children by making most full-time students under the age of 24 subject to the “kiddie tax.” This effectively taxes their unearned income at their parents’ tax rates and makes the gifting of appreciated assets to a child less appealing as a way to finance college expenses.
The tax code provides two types of post-secondary education tax credits for taxpayers and their dependents.
- American Opportunity Credit. This tax credit is limited to any four tax years for the first four years of post-secondary education and provides up to $2,500 of credit for each student. The credit is phased out for joint filers with incomes between $160,000 and $180,000 ($80,000 to $90,000 for single filers).
- Lifetime Learning Credit. As the name implies, this tax credit is not limited to the first for years of post-secondary education. However the maximum allowed is lower ($2000) and applies to the family regardless of how many students in the household. The 2015 credit phase out is $110,000–$130,000 for married joint and $55,000–$65,000 for others.
Careful timing of tuition payments under either of these options is critical for maximizing the tax benefit.
Education Savings Programs
The tax code provides two different plans if you are interested in setting up a formalized long-term savings program to pay for education expenses for your children.
- Coverdell Education Savings Account. This program allows the taxpayer to make $2,000 annual nondeductible contributions to the plan. Coverdell accounts can be used for kindergarten through post-secondary education and become the property of the child at age of majority. Contributions are phased out for joint filers between $190,000 and $220,000 ($95,000 and $110,000 for others) of income (AGI).
- Qualified Tuition Plan. This program, also referred to as a Sec. 529 plan, generally limits annual nondeductible contributions to the gift tax exemption for the year ($14,000 in 2015). Sec. 529 plans are only for post-secondary education, but the contributor retains control of the funds and there is no phase out of the contribution based on income.
Both plans provide tax-free earnings if used for qualified education expenses.
Educational Savings Bond Interest
Another option for financing education is the use of Series EE or I bonds purchased after 1989. All or part of the interest on these bonds is exempt from tax if qualified higher education expenses are paid in the same year that the bonds are redeemed. The tax benefit is phased out for joint filers with income between $115,750 and $145,750 ($77,200 and $92,200 for unmarried taxpayers, but those using the married filing separately status do not qualify for the exclusion).
If you would like to learn more about these benefits, or to work out a comprehensive plan to take advantage of them, please give me a call.