Parents, other individuals, and even entities such as corporations and non-profits can set up an Education Savings Account (ESA) to save for a child’s higher education expenses. Contributions are not deductible but distributions for qualified education expenses are tax-free. The annual contribution limit is $2000 per beneficiary. Contributions must be made by the beneficiary's 18th birthday.
Expenses for attending grades K-12 at public or private schools, or working toward a degree or a recognized credential qualify. Classes to improve or acquire job skills do not. Any amounts withdrawn that are not used for qualified expenses or that are in excess of qualified expenses are taxed and subject to a 10% penalty tax.
Except for special needs students, any money left in the account when the beneficiary reaches age 30 will be taxed and assessed a 10% penalty tax. Avoid this penalty by rolling the money into an ESA for a younger family member or changing the beneficiary on the existing account.
Tuition programs allow taxpayers to either prepay or save for tuition. Distributions used to pay qualified expenses are tax-free. Nonqualified withdrawals are subject to regular income tax plus a 10% penalty (see IRS Publication 970 for exceptions). The types of educational programs whose expenses qualify are not as clearly defined as for other tax breaks. Expenses for working toward a degree qualify. Classes for a recognized credential appear to qualify, but classes to improve or acquire job skills apparently do not.
The beneficiary can be changed to another member of the original beneficiary’s family. Funds can also be rolled over from one plan to another, either using the same beneficiary (limited to one rollover in twelve months) or with a different beneficiary (no limits).
Gift taxes may be owed if more than $14,000 ($28,000 for a married couple; 2013, indexed for inflation) is contributed per year for a single beneficiary. However, a contribution can be treated as if made over up to 5 years, allowing single contributions of up to $70,000 ($140,000 for a married couple; 2013, as indexed) without gift tax consequences.
Two types of plans fall under this category. Prepaid tuition programs and savings plans.
Prepaid tuition plans: States as well as public and private educational institutions offer prepaid tuition program. You can purchase part or all of your child’s future education. The value of the account should increase at the same rate as tuition. Check the prepaid plan to see what flexibility you have if the student attends an out-of-state school or a private college, and whether the state guarantees the future benefits. Most plans require either the investor or the student to be a state resident.
College Illinois! is the prepaid tuition plan offered by the state of Illinois.
Savings plans: Only states can offer 529 savings plans. There are no state residency requirements, so you can invest in any state’s plan. You choose an investment mix or an age-based option, and you have limited opportunities to switch. Investment performance will determine the value of the account. Plans sold through brokers may charge loads (sales commissions) and have higher annual expenses than plans sold directly to investors. Compare plans at www.savingforcollege.com.
Illinois has three 529 savings plans. Bright Directions is a broker-sold program. Bright Start has both a direct-sold version and a broker-sold version.
Interest from US savings bonds may be excludable from income if used to pay for higher education expenses of family members. The bond owner must have bought the bond after reaching age 24 and must be the sole owner or joint owner with spouse. The interest deduction applies in the year the bond is redeemed. Married taxpayers must file jointly. This deduction applies to both EE savings bonds purchased after 1989 and I-bonds, which offer inflation-adjusted interest payments.
The American Opportunity credit can be used for each of the first four years of college. The credit is a maximum of $2500 per student: 100% of the first $2000 and 25% of the next $2000 of qualifying expenses. Forty percent of the credit is refundable (refunded even if you owe no tax), unless the student has investment income that is taxed at the parent’s rate. Expenses for working toward a degree or recognized credential qualify, but classes to improve or acquire job skills do not.
In 2018, the American Opportunity credit will revert to the Hope credit, which can only be used for the first two years of post-secondary education. The credit of up to $1800 per student is calculated as 100% of the first $1200 of tuition and fees plus 50% of the next $1200 (as indexed for inflation). The credit is used to reduce your income taxes, but it is not refundable if the credit reduces your taxes to less than zero.
To qualify for the American Opportunity or Hope credit, a student cannot have been convicted of a federal or state felony involving the possession or distribution of a controlled substance.
The Lifetime Learning Credit allows a wide range of students and educational programs to qualify, including adults taking a single class to acquire or improve job skills. This tax credit can be as much as $2000 per tax return, calculated as 20% of tuition and fees up to $10,000. The credit reduces the tax you owe but it is not refundable if the credit reduces your taxes to less than zero. Married taxpayers must file jointly to claim the credit.
Employers may offer financial assistance for employee’s education of up to $5250 per year that is not reported as income, whether or not the classes are job-related. The exclusion applies to both graduate and undergraduate classes.
The early withdrawal penalty tax (10%) for IRA account owners under age 59 ½ does not apply if the distribution is used to pay qualified higher education expenses of the taxpayer, spouse, or child or grandchild of the taxpayer or the taxpayer's spouse. However, income taxes are not waived. Whether you owe income tax on the distribution depends on the type of account and other factors.
Traditional IRA. Income tax is due on the distribution, except any portion that is attributable to non-deductible contributions.
Roth IRA. Account balances contain both contributions and the earnings on those contributions. Withdrawals are treated as being taken first from contributions. There is no tax on withdrawals of contributions from a Roth IRA, so you will never owe any tax unless your distributions exceed the total of your contributions.
There is also no income tax on qualified distributions of earnings, which must meet two criteria: the account owner must have had a Roth IRA for at least five years and be either age 59½ or older, disabled, or deceased.
Taxpayers can deduct interest on qualified higher education loans as an above-the-line deduction, meaning that even those who do not itemize can to take the deduction.
Qualified higher education loans are debts incurred to pay qualified higher education expenses for the taxpayer, the taxpayer’s spouse, or any dependent of the taxpayer as of the time the debt was incurred. Loans for classes to improve or acquire skills do not qualify. The loan must be for expenses that were paid or incurred within a reasonable period of time before or after the debt is incurred. Married taxpayers must file jointly to claim the deduction.