For most students, the price of higher education is steep and getting steeper. Annual increases in the cost of higher education have consistently outpaced the overall rate of inflation, and the Scholarship Workshop projects the average in-state cost of the 2016/2017 academic year will be over $33,000 at a public university and nearly $72,000 for a private college. Costs are not limited to undergraduate school, as more and more graduates go on to postgraduate studies. In the 2015/2016 school year, colleges and universities are expected to award 802,000 master’s degrees and 179,000 doctoral degrees, according to the National Center for Education Statistics.
Students and their families must be proactive in finding ways to pay for higher education. This includes maximizing the myriad tax incentives that support saving for education costs and paying them on a tax-advantaged basis. At present there are more than a dozen tax incentives tied to education, as well as various other financial strategies, including scholarships, loans, and work-study programs.
Higher Education Savings Plans
Needless to say, the earlier that families begin saving for higher education, the more options are available to them, and the easier it will be to save enough. Because there are so many options, it is vital to coordinate their use by relying on those providing the greatest benefit.
Internal Revenue Code (IRC) section 529 allows for a variety of educational savings plans. Such plans include those offered by states and prepaid tuition plans from states or a consortium of private institutions. Each plan has its own rules governing contribution limits, fees, and investment options. There are no income limits on eligibility to make contributions. In addition, parents or grandparents who want to contribute a sizeable amount in a lump sum can use a special rule that permits a gift-tax-free contribution of up to five times the annual gift tax amount [$70,000 for 2016; see IRC section 529(c)(2)(B)]. Whichever type of 529 plan is used, there is no federal tax deduction for contributions; however, earnings grow tax deferred and are tax-free if withdrawn to pay for qualified higher education costs. The majority of states and the District of Columbia provide state-level tax breaks for contributions; a list of state income tax deductions and credits can be found at http://www.savingforcollege.com/.
The Protecting Americans from Tax Hikes Act of 2015 (PATH Act) made some changes to federal tax rules for 529 plans. Several years ago, distributions from 529 plans to pay for computers, software, and Internet access qualified as taxfree. This favorable rule had expired but has been permanently reinstated, retroactive to the start of 2015. In addition, when a student receives a scholarship, distributions previously taken from 529 plans to pay for tuition now covered by the scholarship can now be redeposited penalty-free if made within 60 days of receiving the refund.
Contributors can add up to $2,000 annually to a Coverdell education savings account (ESA; IRC section 530). Like 529 plans, contributions are not deductible for federal income tax purposes, but earnings grow tax deferred and can be used to pay not only for higher education costs, but also for primary and secondary schools. The designated beneficiary must be under age 18 or a special needs beneficiary. In addition, the contributor cannot have modified adjusted gross income (MAGI) above a set limit, which phases out and is not adjusted annually for inflation ($95,000–$110,000 for singles and $190,000–$220,000 for joint filers). Finally, the balance of the account must be distributed within 30 days after the earlier of the beneficiary reaching age 30 (unless he or she is a special needs beneficiary) or the beneficiary’s death. While this plan likely will not provide meaningful savings for higher education, it is worthy of consideration for primary or secondary school.
U.S. savings bonds.
IRC section 135 allows parents to save for higher education by buying U.S. savings bonds (series EE and I). There is no tax break for the purchase of the bonds, but interest may be partially or fully tax-free when the bonds are redeemed to pay higher education costs. The owner of the bond must be at least 24 years old on the first day of the month in which the bond is purchased; therefore, bonds given to a child will not entitle the owner to an exclusion when the bonds are redeemed. The owner’s MAGI cannot exceed a set amount at the time of redemption. The MAGI limits are adjusted annually for inflation and vary for singles and joint filers; the exclusion cannot be claimed by a married person filing separately. The bond proceeds must be used to pay qualified higher education costs. If bonds are bought with the intention of using them for a child’s higher education but are not redeemed for this purpose, the bonds may be useful for a parent’s retirement income.
Other savings strategies.
While it is most advantageous to use tax-advantaged savings strategies, other traditional savings methods can still be useful in some families:
- Custodial accounts. Investments can be held in a child’s own name in a Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) account. The strategy of shifting income to a child has been severely restricted by the “kiddie tax,” which effectively taxes a child on investment income over a set amount ($2,100 in 2015 and 2016) at the parent’s top marginal rate [IRC section 1(g)]. However, investment income is favorably treated, with the first $1,050 tax-free and the next $1,050 taxed at the child’s rate (probably 10%).
- Trusts. Despite kiddie tax concerns, wealthy individuals often use trusts for their that serve a number of interests other than paying for college, including asset protection and estate planning goals.
Parents or other transferees cannot recoup transfers to children using either of these options. Trusts, however, can place restrictions on the use of funds by limiting when or if children gain full access to funds.
According to the National Center for Education Statistics, about 85% of all undergraduates receive financial aid (https://nces.ed.gov/fastfacts/display.asp?id=31). Students and their parents applying for federal financial aid must complete the Free Application for Federal Student Aid (FAFSA).
It is vital for families to understand the financial aid formulas used to determine how much aid will be given and how much a family is expected to contribute toward education costs. Each family must make an Expected Family Contribution (EFC), which is the measure of a family’s financial strength according to a formula established by law and based on a family’s taxable and tax-free income, assets, and benefits. Also considered are family size and the number of family members who will be attending college during the year. Forms, worksheets, and the formulas are available at https://studentaid.ed.gov/sa/resources#efc.
While the student is expected to contribute up to 20% of her assets for the EFC, for purposes of this percentage, funds in a 529 plan are not taken into account. A parent is expected to use up to 5.64% of unprotected assets, but need not contribute any part of protected assets, which include the value of retirement plan accounts.
In September 2015, President Obama announced three significant changes to the FAFSA process that will make it easier to submit the form in a timely manner. First, the form’s submission deadline has been moved back from January 1 to October 1, so families can begin the application process earlier. Second, the information on the application can be based on tax return information from two years prior, instead of just the prior year’s information. Finally, the tax return information is retrievable electronically as long as the return was e-filed. While this option is already available, the new submission deadline will make it easier to use. There may be additional simplification in the future. President Obama has asked Congress to eliminate various questions on the application, such as those related to savings and investments and untaxed income and exclusions not reported on tax returns.
Tax Incentives for Paying Tuition and Other Costs
Whether or not a family has adequately saved for college, there are various tax incentives that make paying tuition and certain other costs a little easier.
American Opportunity Tax Credit.
The American Opportunity Tax Credit is a partially refundable tax credit of up to $2,500 [IRC section 25A(i)]. It can be claimed for qualified costs paid for the taxpayer, a spouse, or a dependent. The credit applies only for the first four years of post-secondary education. It is taken on a per-taxpayer basis, so if parents have two children in college, the top credit for the parents is $5,000. Forty percent of the credit is refundable. The credit had been set to expire at the end of 2017, but has now been made permanent by the PATH Act.
Eligibility for the credit depends upon a taxpayer’s MAGI. A full credit applies if MAGI is below a threshold amount dependent on filing status, and a partial credit can be claimed if MAGI falls within a phaseout range. The phaseout range for 2015 and 2016 is $160,000–$180,000 for joint filers and $80,000–$90,000 for singles. Parents precluded from claiming the credit because their MAGI is too high may waive a dependency exemption for the student to allow the student to claim the credit. This strategy is advisable if the student has sufficient income to create a tax liability that can absorb the credit. A student who claims the credit under this strategy is not entitled to any refundable credit.
The credit can be used for prepaid expenses covering the academic period beginning in the first three months of the following year. Thus, in December 2016, a parent can pay tuition for the spring term beginning in February 2017 and claim a credit on the 2016 income tax return if otherwise eligible to do so.
Lifetime Learning Credit.
A Lifetime Learning Credit of up to $2,000 can be claimed for any post-secondary schooling [IRC section 25A(c)]. The credit applies on a per-taxpayer basis, and no portion of the credit is refundable. Again, eligibility for the credit depends on the taxpayer’s MAGI, with a threshold amount and a phaseout range. The phaseout range for 2015 and 2016 is $110,000–$130,000 and $111,000–$131,000, respectively, for joint filers and $55,000–$65,000 for singles.
Tuition and fees deduction.
An above-the-line deduction of up to $4,000 can be claimed for tuition and certain fees for a taxpayer, spouse, or dependent enrolled in an eligible education institution for higher education (IRC section 222). The deduction applies if MAGI does not exceed $65,000 if single or $130,000 if married filing jointly. Above this limit, a deduction of up to $2,000 can be claimed if MAGI does not exceed $80,000 if single or $160,000 if married filing jointly. There is no phaseout, so even one dollar of excess MAGI prevents any deduction. A married person filing separately cannot claim the deduction. As in the case of education credits, the tuition and fees deduction can be claimed for prepaid expenses for an academic period beginning in the first three months of the following year.
College work programs.
Some colleges and universities enable students to earn money and gain work experience by participating in work-learning service programs. Payments from these programs are excludable from gross income starting in 2016 due to the PATH Act. According to the Joint Committee on Taxation, a program from which payments are excludable must meet certain requirements: “A work college must require resident students to participate in a work-learning-service program that is an integral and stated part of the institution’s educational philosophy and program.”
Student loan interest.
According to the Institute for College Access and Success, nearly 70% of students graduating from public and nonprofit colleges have outstanding student loans (https://fortunly.com/statistics/student-loan-debt-statistics). An above-the-line deduction from gross income is allowed for interest on student loans, up to $2,500 annually (IRC section 221). Eligibility for a full or partial deduction depends on the taxpayer’s MAGI. A full deduction is allowed if the taxpayer’s MAGI does not exceed a set amount, and a partial deduction is allowed if MAGI falls within a phaseout range. The MAGI phaseout range for 2015 and 2016 is $130,000–$160,000 for joint filers and $65,000–$80,000 for singles.
Other education-related tax breaks.
As stated above, there are numerous tax breaks, and a full treatment of them is beyond the scope of this article. Here is a roundup of other educationrelated tax breaks:
- Scholarships and fellowships. Awards to a degree candidate for tuition, course-related fees, books, and equipment are tax-free (IRC section 117). Amounts for room and board are taxable.
- Tuition reductions. Free or partially free tuition reductions for undergraduate studies for a faculty member or school employee are tax-free [IRC section 117(d)]. Tuition-free benefits may also extend to an employee’s spouse, dependent, widow, and others.
- Employer-provided benefits. Education assistance up to $5,250 per year is tax-free to an employee (ICR section 127). If the courses are work-related, then any amount of payments by an employer is tax free to the employee; the payments are treated as a working condition fringe benefit [IRC section 132(d)].
- Work-related education. A taxpayer who takes courses to maintain or improve job skills can deduct the cost of this education as long as it does not qualify her for a new trade or business (Treasury Regulations section 1.162-5). Employees can deduct their out-of-pocket costs for tuition, books, travel, and other related costs only as a miscellaneous itemized deduction (subject to the 2%-of-AGI floor). Self-employed individuals can deduct their costs from business income.
- Penalty-free IRA withdrawals. A taxpayer under age 59 1/2 is not subject to the 10% early distribution penalty when withdrawing funds to pay higher education costs of himself, a spouse, a child, or a grandchild [IRC section 72(t)(2)(E)]. There is no dollar limit, but distributions must be used for higher education costs within 120 days to be penalty free.
There may be future changes in the rules for education-related tax breaks. Some of the rules may be consolidated to eliminate confusion. Also, there has been considerable public discussion about the high amount of outstanding student loan interest. As a result, some proposals are currently under consideration in Congress. The Employment Participation in Repayment Act would allow employees to exclude employer help with student loan payments by expanding the current exclusion for employer-provided education assistance. It has been estimated that about 3% of employers currently assist employees with student loan debt repayment, according to the Society for Human Resource Management (Joanne Sammer, “Easing the Student Loan Debt Burden? Points to Consider,” Society for Human Resource Management, Jan. 7, 2016, http://bit.ly/1T9nw99). For example, PricewaterhouseCoopers gives employees $1,200 per year for six years for the repayment of their student loans. Such assistance is currently taxable but would become tax-free up to certain limits under the proposed law. In addition, the Make Student Grants Truly Tax-Free Act would allow students to exclude Pell Grants and other loan aid from gross income.
Higher education institutions are required to issue Form 1098-T, Tuition Statement, which is an information return reporting tuition payments. Copies of the form are sent to both students and the IRS. In the past, there have been erroneous education claims, particularly with respect to the refundable portion of the American Opportunity Credit. A report by the Treasury Inspector General for Tax Administration estimated that more than 3.6 million taxpayers claimed over $5.6 billion in education credits that were likely improper (TIGTA Report Number 2015-40-027, Mar. 27, 2015, http://1.usa.gov/243NMdi). The report also said that nearly 2.1 million taxpayers claimed education breaks totaling $2.5 billion without having received a tuition statement. Due to this report, Congress enacted a new filing requirement for anyone claiming education tax breaks for tuition as part of the Trade Preferences Extension Act of 2015. Starting with tax returns filed in 2017, no tax credits or deductions can be claimed unless a taxpayer has received Form 1098-T. The new rule also requires educational institutions to include the student’s tax identification number or, if unavailable, certify that it was requested.
There is an array of tax breaks and financial planning strategies related to education. It is up to CPAs and financial advisors to help families recognize the need to start saving for college early and the ways in which tax rules can help.