If you have children, you’ve likely got college savings on your mind. Here are some tax-favored ways to save for future education costs so that you can take advantage of your options.
Savings bonds
When used to finance college expenses, Series EE U.S. savings bonds offer two tax-saving benefits:
- Until the bonds are cashed in, you don’t have to report interest on them for federal tax purposes.
- If the bond proceeds are put toward qualified college expenses, interest on qualified Series EE and Series I bonds may be exempt from federal tax.
To qualify for the college tax exemption, bonds must be purchased in your name or jointly with your spouse—not in your child’s name. Additionally, proceeds must be used for education-related expenses only (i.e., tuition and fees but not room and board). If only some of the proceeds are used for qualified expenses, then only some interest will be exempt.
Note that if your modified adjusted gross income (MAGI) exceeds certain thresholds, the exemption will be phased out. For example, the exemption for bonds cashed in 2023 begins to phase out when MAGI hits $137,800 for married joint filers (or $91,850 for other returns). The exemption is completely phased out when MAGI is at or above $167,800 (or $106,850 for others).
529 plans
Qualified tuition programs, or 529 plans, are established by state governments or private institutions. These programs allow you to purchase tuition credits or contribute to an account specifically designed for your child’s future education costs.
These contributions are not deductible and are calculated as taxable gifts to the child. They are, however, eligible for the 2023 annual gift tax exclusion of $17,000. Donors who contribute more than the annual exclusion limit for the year may treat the gift as if it were given in increments throughout a five-year period.
Until college costs are paid from the funds, earnings on these contributions accumulate tax-free. Distributions from 529 plans are also tax-free to the extent that the funds are used to pay for qualified higher education expenses, including up to $10,000 in tuition costs for elementary or secondary school.
Distributions of earnings not used for qualified higher education expenses will generally be subject to income tax in addition to a 10% penalty.
ESAs
For each child under the age of 18, you can establish a Coverdell education savings account (ESA) and make contributions of $2,000. Note that this age limit does not apply to beneficiaries who have special needs.
Once AGI is above $190,000 on a joint return ($95,000 for others), the right to make contributions will begin to phase out. If the income limit becomes an issue, the child can then contribute to their own account.
Despite contributions not being deductible, income in the account is not taxed and distributions are tax-free when put toward qualified education expenses. If the child does not pursue higher education, the money must be withdrawn when they turn 30, and any earnings will be subject to tax plus penalty. However, those unused funds can be transferred to another family member’s ESA if they have not yet reached age 30. (This age requirement does not apply to those with special needs.)
Talk to a financial advisor today
This is not an exhaustive list of all the tax-wise ways to save for your children’s college education. If you would like to discuss these options or learn about others available, contact us to speak with a certified CPA.