The pressure to pay for college has become as powerful as the other two requirements in life: death and taxes. Recent and proposed Federal reductions in the federal Pell Grants program and other aid have made it even more important to understand your options when paying for college.
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As people save for college, they are bombarded with ideas about college savings plans, education savings accounts, gifts, prepaid tuition plans and more. Missing from the discussion in most cases is the first big issue that I see regularly as a tax professional: the financial aid form (Free Application for Federal Student Aid--more commonly known as a FASFA). Because it’s often overlooked, it’s important to know how individual savings plans influence the amount of financial aid you receive.
There are several common options available to save for college: Series EE Bonds, Coverdell Education Savings Accounts, Section 529 plans, traditional IRAs and Roth IRAs. In this first part of a multi-part series, we will discuss Series EE Bonds and Coverdell Savings Accounts. As we discuss each option you may want to examine the summary table at the end of this article.
Series EE Bonds
The savings bond education tax exclusion permits qualified taxpayers to exclude from their gross income all or a portion of the interest earned on the redemption of eligible Series EE and Series I bonds issued after 1989. You must be at least 24 years old before the bond's issue date. To qualify for this exclusion, the taxpayer, the taxpayer's spouse or the taxpayer's dependent at certain post-secondary educational institutions must pay tuition and other educational expenses. Persons with income levels above certain thresholds may not be eligible to participate. Additionally, amounts paid to a qualified state tuition program or education IRA also qualify for exclusion based on the table below. The exclusion is phased out based on the taxpayer’s filing status and gross income.
Age consideration is a common mistake most parents make when buying bonds in their child's name. Parents should buy the bond in their name because the owner must be at least 24 years old before the bond's issue date to qualify for the exclusion. The issue date is printed on the front of the savings bond and is not necessarily the date of purchase; it will be the first day of the month in which the bond is bought. Also, if the taxpayer is married, the taxpayer must file a joint return in order to exclude the bond interest from income.
Eligible educational expenses include tuition and fees, (such as lab fees and other mandatory course expenses), required for the enrollment of or attendance by the taxpayer, the taxpayer's spouse or dependent at an eligible educational institution. Payments to qualified state tuition programs are also eligible. However, expenses relating to any course or other education offerings involving sports, games, or hobbies are eligible only if required as part of a degree or certificate-granting program. The costs of room and board, as well as books, are NOT eligible expenses.
Coverdell Education Savings Accounts (ESA)
The ESA allows an annual non-deductible contribution of up to $2,000 per beneficiary of tax- deferred money. The contribution phases out at $110,000 (single) and $220,000 (married filing joinntly) for the contributor.
There is no limit on the number of separate Coverdell ESAs that may be established for a designated beneficiary. However, total contributions for the beneficiary in any year cannot be more than $2,000, no matter how many accounts have been established.
The benefit applies to expenses for kindergarten through college, including private schools (but generally not home schooling). This distinct pre-college use advantage of the Coverdell means that Coverdell’s should always be established before 529 plans. Earnings on the account are tax deferred and withdrawals from the account, if used for education expenses, are tax free.
The balance in the account must be distributed earlier than the beneficiary’s 30th birthday (within 30 days) or death. Contributions may be made to both an ESA and a 529 plan in the same year for the same beneficiary.
There are two annual contribution limits. The annual $2,000 maximum contribution per beneficiary through 2012 (contributor limit), and the annual $2,000 each beneficiary may receive (beneficiary limit) in his or her account.
Qualified expenses include tuition and fees, books, supplies, equipment, special needs students’ costs and room and board if enrolled at least half the time in higher education. For K-12, only if required, the list expands to include uniforms, transportation and the purchase of computer technology, equipment, or Internet access. Technology-related services are qualified expenses during the elementary and secondary education years if used by the beneficiary and the beneficiary's family during any of the years the beneficiary is in elementary or secondary school. (This does not include expenses for computer software designed for sports, games, or hobbies unless the software is predominantly educational in nature.)
Assets may be rolled over from one Coverdell ESA to another, or the designated beneficiary can be changed. Any amount distributed from a Coverdell ESA is not taxable if it is rolled over to another Coverdell ESA for the benefit of the same beneficiary or a member of the beneficiary's family (including the beneficiary's spouse) who is under age 30.
American Opportunity Tax Credit, also called Hope Credit, or lifetime learning credit may be claimed in the same year the beneficiary takes a tax-free distribution from a Coverdell ESA, as long as the same expenses are not used for both benefits.
Part II: The next installment will cover: Section 529 plans, traditional IRAs, and Roth IRAs
Bob Jennings is a Certified Public Accountant, Certified Financial Planner and Enrolled Agent. Bob is the author of “Understanding Social Security & Medicare”. His website is www.ssmcare.com and you can find him on Twitter @Jenningsseminar.