If you have kids, you already know that education can be expensive. But your dear Uncle Sam has offered up a number of tax deductions and tax credits to help you.
With all that’s been going on in the world, it’s hard to keep up with what’s new—especially in the world of taxes and education. Laws enacted in the last few years, as well as the response to the COVID-19 pandemic, have expanded the definition of education expense tax deduction and tax credit opportunities. Here’s more information about tax-deductible education savings.
There are a number of different tax benefits for education, but they fall into three general categories:
The first thing to know is how education expense tax deductions and tax credits work. Each has its intricacies, especially after recent changes to the tax code. (Here’s a little background on the difference between tax credits and tax deductions.)
A 529 plan is an education savings plan operated by a state or educational institution. It can be used at a qualified college in any state—and now, because of the tax law that went into effect in 2018, may also be used for K-12 tuition. (Some states limit the use of 529s for higher education only, so there could be tax implications if you use them for K-12.) But 529 plans seem to always raise some questions. Here are a few.
What education expenses are tax-deductible?
How do parents (and grandparents) contribute?
Parents and grandparents can each open their own accounts, or grandparents can contribute to an account in the parents’ names. Withdrawals from parent-owned 529 accounts aren’t usually considered part of the parents’ adjusted gross income and shouldn’t affect financial aid eligibility.
Because 529s may now be used for grade school and high school, are Coverdell ESAs still a thing?
Yes. Before the changes with the 529 plans, a way parents could save money in tax-sheltered accounts for K-12 was through the Coverdell, but only up to $2,000 annually. Plus, there’s an income phase-out. For the 2020 tax year, the allowable contribution amount phases out between $95,000 and $110,000 for single filers and $190,000 to $220,000 for joint filers, according to the IRS. So high-income earners are shut out of Coverdell eligibility.
But here’s the thing about 529s and K-12 expenses: The 529 can only be used for K-12 tuition—not books, school uniforms, or laptops for remote learning—up to $10,000 per year per beneficiary.
Coverdells, however, may be used for all qualified education expenses. So if you qualify, the Coverdell might be worth considering. Learn more about 529 plans and Coverdell ESAs here.
What 529 distribution pitfalls should I be aware of?
If money is taken out of a 529 and not used for a qualifying education expense, the IRS will assess a 10% penalty. For example, if you withdraw funds from a 529 to pay tuition but then receive a tuition reimbursement, you generally have 60 days to redeposit the funds into the 529 account. Otherwise, it’s not considered an education expense, and thus you’d be on the hook for the tax penalty.
This became an issue in 2020 amid the COVID-19 pandemic, as many universities offered full or partial tuition reimbursement well after tuition bills were initially paid.
One of the provisions of the SECURE Act, passed at the end of 2019, allows 529 participants to use up to $10,000 from an account to pay off student loans without penalty. Because it’s possible to change beneficiaries fairly easily, if there’s money leftover in the 529 after your children or grandchildren graduate, you could potentially put some of that money toward paying down student loans.
Another consideration, in light of the COVID-19 pandemic, is that federal student loans have been granted a deferral extension (and aren’t accruing interest) through January 31, 2021. If you happen to have a 529 and a student loan deferral, you might consider looking into whether it’s worth tackling some of that debt now because more of the payment would go toward principal instead of interest.
While you’re saving, don’t overlook higher education tax credits. The 2018 tax law preserved the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC). The AOTC is a credit for qualified education expenses paid for an eligible student for the first four years of higher education, up to $2,500 per eligible student.
LLC is for qualified tuition and related expenses paid for eligible higher-education students enrolled in an eligible educational institution, with no limit on the number of years you can claim the credit. It’s worth up to $2,000 per tax return. Because the LLC isn’t limited to the first four years of college, it’s of particular value to students pursuing graduate degrees.
For eligible students, these tax credits are taken by whomever claims the student as a dependent (typically the student, a parent, or guardian). Both credits are phased out above certain income levels. Visit the IRS website to compare the specifics of the LLC and the AOTC.
When considering education tax credits (or any tax credit, really), it’s important to know the difference between a refundable and a nonrefundable credit. According to the IRS:
The LLC is nonrefundable. So although the maximum benefit is $2,000, if that figure exceeds your tax bill for the year, you may not claim the entire amount.
The AOTC is partially refundable. If the AOTC pays your tax down to zero, you can have 40% of the remaining amount of the credit refunded to you, up to $1,000.
Saving for Junior’s schooling can be tough for parents, and with college savings, everything counts. But there are education expense tax deduction and credit opportunities that can ease some of the pain.
Education savings might be one of many goals you have between now and retirement. Need help managing it all? A complimentary goal planning session with a TD Ameritrade Financial Consultant can help you stay on target.
Miranda Marquit is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
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