Tax Smart Ways to Pay for Your Children’s Education

A Summary of the Tax-Smart Ways to Help Pay a Child’s Education Costs - Part I

Federal employees are well aware of the increasing costs of raising a child. Everything from feeding, clothing, housing, medical care and education (from nursery school and through college) has skyrocketed in cost. According to a US Department of Agriculture study published in 2017, the average cost of raising a child from birth through age 17 is $233,610 for a middle-income married couple with two children. This estimate is based on a family of four and excludes the expense of paying for a college education.Many employees are not taking advantage of some of the tax-preferred ways to save for their children’s college education expenses. There are tax-exempt ways to help federal employees and retirees to cover the cost of education throughout the lives of their children and grandchildren.

This is the first of three FEDZONE columns related to tax smart education planning, The column presents six “exclusions from income” when it comes to paying educational expenses including: (1) Scholarships and followships; (2) Coverdell Education Savings Accounts; (3) Qualified Tuition Programs; (4) Educcational US Savings Bond interest earnings; (5) Dependent Care Assistance plans; and (6) Roth IRA account distributions. Each of these “exclusions from income” is discussed including the requirement to exclude these items from income in order to pay for educational expenses as well as which type of educational expenses are covered.

Scholarships and Fellowship Exclusion

Qualified scholarship and fellowship amounts received by a degree candidate and used for tuition, enrollment fees, books, supplies and equipment that are required for the courses by the education institution are excluded from income. But scholarships received by a student who is not a degree candidate are taxable income. A degree candidate is any of the following: (1) A primary or secondary school student; (2) A college or undergraduate or graduate student; or (3) A full-time or part-time student at an accredited educational institution that provides a program that is acceptable for full credit toward a bachelor’s or higher degree or offers a program or training to prepare students for gainful employment in a recognized occupation. Tax-free scholarships include Pell Grants and other Title IV need-based education grants.

Coverdell Education Savings Accounts

The Coverdell Education Savings Account (CESA) is a trust established to pay qualified education expenses of a designated beneficiary. Contributions to a CESA are not tax deductible. Earnings in the CESA are tax-free if used to pay qualified educational expenses. Contributions made to all CESAs set up for any one beneficiary are limited to $2,000 per year. Any individual (including the beneficiary) may contribute to a CESA. However, there are modified adjusted gross income limits for contributors; namely, married filing jointly: $190,000 to $220,000 and all other filers: $95,000 to $110,000. CESA contributions cannot be made to any beneficiary over age 17 unless the beneficiary is a special need student.

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Qualified education expenses for post-secondary education paid using CESA withdrawals include tuition, fees, books, supplies and equipment required for attending an eligible school and contributions to a qualified tuition program (see below). Qualified elementary and secondary expenses (kindergarten through 12^th grade) include tuition, fees, academic tutoring, books, supplies, and other equipment needed for enrollment at a public, private or religious school. Room and board, uniforms, transportation and supplementary items and services, including extended day programs are also included, if they are required or provided by the school.

Qualified Tuition Program*

A qualified tuition program (QTP) allows an individual to make after-taxed contributions to an account or program used to pay a beneficiary’s qualified education costs. QTPs are sometimes called Section 529 plans. Two types of QTPs are available: (1) Prepaid programs and (2) Savings account programs.

Contributions to a QTP (both to a prepaid program and to a savings account), are made with after-taxed dollars and are not subject to any adjusted gross income (AGI) limitations. Nor is the amount that can be contributed to a QTP limited to the amount necessary to provide for qualified expenses for the beneficiary. A contribution to a QTP is considered a complete gift and is excluded from the contributor’s estate. Contributions to a QTP are not deductible for federal income tax purposes. Some states with income taxes offer a state tax credit or state income tax deduction for contributions to their state QTP by residents of their states. Distributions of earnings from a QTP are excluded from income if used for qualified education expenses. If distributions are more than the beneficiary’s qualified expenses, the earnings portion of the excess is included in the beneficiary’s income. The owner of a QTP should receive Form 1099-Q (Payments from Qualified Education Programs) showing earnings and basis (contributions) related to a QTP distribution.

Qualified education expenses include: (1) Tuition, fees, books, supplies and equipment required for enrollment or attending an eligible school; (2) Tuition required for enrollment or attendance at an elementary or secondary public, private or religious school. These costs are limited to $10,000 per tax year on a per-student basis; (3) Reasonable costs for room and board for those QTP beneficiaries who are at least part-time students in a degree program; and (4) Principal or interest payments on qualified loans up to a $10,000 lifetime cap for the designated beneficiary or sibling of the designated beneficiary.

*Investors should carefully consider the investment objectives, risks, charges and expenses associated with 529 college savings plans before investing. More information about 529 college savings plans is available in the issuer’s official statement, and should be read carefully before investing.

US Savings Bonds Interest Exclusion

All or part of the interest earned on Series EE bonds issued after December 31,1989, or Series I bonds is excluded from income if the bonds when redeemed are used to pay for qualified educational expenses. The requirements for an individual to use this interest exclusion from US Savings Bonds Series EE and Series I are: (1) The Savings Bond owner must be at least 24 years old before the bond’s issue date; (2) The interest is less than the qualified educational expenses in the year the bonds are redeemed. If the redemption amount is more than the expenses, the excludable amount of interest is based on the ratio of expenses to redemption amount; (3) Qualified educational expenses are tuition and fees for the bond owner or dependents or spouse, at a qualified educational institution (college, university or vocational educational school) and contributions to a QTP and to a CESA. Room, board and books do not qualify; (4) Exclusion of interest not available to married individuals filing separately; and (5) Exclusion of interest income phases out for 2023 when the modified adjusted gross income of the bond owner is between $91,850 - $106,850 (single or head of household filers) and $137,800 - $167,800 (married filing jointly or qualified widow/widower). The modified adjusted gross income phase-out applies in the year the bonds are redeemed and interest is excluded from income.

Dependent Care Assistance Plans

Up to $5,000 can be excluded each year for the care of dependent care under the age of 13 and physically or mentally disable dependents who live with an individual over half the year. Qualified expenses include preschool, before-school and after school programs, summer day camps and adult day care. The dependent care assistance plan account must be used up each calendar year. The earnings of the lower earning spouse must exceed $5,000 threshold unless the spouse is disabled or a full-time student.

Tax Smart: Roth IRA Distributions

Already-taxed contributions from a Roth IRA may be withdrawn tax-free used to pay for college tuition and fees, but not room and board expenses. But a Roth IRA owner who is younger than age 59.5 who withdraws any accrued earnings from their Roth IRA to pay higher education expenses must pay income tax on the earnings, but not a 10 percent early withdrawal penalty.

Employees and retirees who may have problems or questions as to how to use these “exclusions from income” to help pay for their children and grandchildren education expenses are advised to contact a knowledgeable tax professional.

Edward A. Zurndorfer is a CERTIFIED FINANCIAL PLANNER™ professional, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street - Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.