For many, sending children to college is usually near the top of the list when it comes to financial goals. A quality education can set your child up for a more prosperous career than they might enjoy otherwise. A college degree used to allow you to stand out from the crowd. These days, however, not having one often causes you to stand out. It is almost mandatory for many fields of work. Unfortunately, many individuals don’t know how they are going to be able to pay for college. Saving enough money for this purpose can be a big challenge.
The costs for a college education have been rising steadily over the years. Attending a public two year college is the least expensive option. The next step on the cost scale is a public four year college, followed by a private four year college. You can also make it more affordable to pay for college by attending a public college within your own state. College costs also vary within these broad categories, so some research is required for specific college costs.
Fortunately, there are many different ways you can save and pay for college. The government provides several savings vehicles. Investments in such accounts can grow on a tax deferred basis. Further, they can be withdrawn tax free if used to pay for college. There are also grants, loans, and scholarships which your child may be able to use to help pay for college if they qualify.
Section 529 College Savings Plans
Qualified Tuition Programs, more commonly known as 529 plans, have been around since 1996. They are named after Internal Revenue Code Section 529. This is the part of the IRS code which establishes the tax advantages of such plans. Section 529 plans are generally operated by states, but also by some colleges.
Tax Incentives of 529 Plans
The main purpose of 529 plans is to allow for tax efficient saving so that you can ultimately have the capability to pay for college or other higher education expenses. Contributions to a 529 plan are not tax deductible on your federal tax return. Some states, however, allow deductions for contributions. New York State, for example, allows a deduction as long as you contribute to their state’s plan. The deduction is limited to $5,000 of you are single, or $10,000 if you file jointly.
Investment income earned within the plan is not taxed at the federal or state level. So the contributions can grow tax-free until withdrawn for their intended use. The money can be used for tuition, required fees, supplies, and equipment, books, and room and board. Once the money is withdrawn, it will not be subject to tax as long it is used for such college expenses. Otherwise it may be subject to tax as well as a 10% penalty.
Note: A new tax law taking effect in 2018 allows up to $10,000 from 529 plans to be used annually for K-12 education expenses as well. It also allows those with a Coverdell ESA (see below) to convert such an account to a 529 plan on a tax free basis.
How Much Can I Contribute to a 529 Plan?
The maximum you can contribute to 529 plans varies by state. But it can range from a couple of hundred thousand dollars to over $300,000 per beneficiary. The minimum is usually very small, so anyone can start saving immediately. There may also be gift tax consequences if you give too much in a particular year. However, this will generally not be an issue for most contributors. Even so, the IRS also provides an exception for 529 plans to make this issue less likely.
You Should Compare Different Qualified Tuition Programs
However, you are not required to participate in your own state’s 529 plan. It is wise to look at several plans, their features, and what types of fees they charge. Also look into which colleges or higher education institutions they can be used for. This way you can determine which plan may be right for you.
529 Plans Can Also be Very Flexible
You can set up and contribute to a 529 plan regardless of your income level. There is no limit on the number of plans you can set up, and you can name anyone as the beneficiary. The beneficiary should be the individual who will ultimately attend school and use the savings for that purpose. You can set up a plan for anyone. It doesn’t have to be your child. For example, it can be a grandchild or someone else.
There is also flexibility in changing beneficiaries. So if the original beneficiary decides not to attend college, you can name a new one. You can also do a rollover of plan funds to another fund without penalty. This may be done if you decide that the original plan’s feature do not suit your needs. You can usually open an account by visiting the plan’s website and following their instructions.
Coverdell Education Savings Account (ESA)
ESA accounts are another type of tax advantaged savings account. As with 529 plans, the government also created such accounts to help save and pay for college or other higher education. Although not currently as popular as 529 plans, they can be a useful tool in saving for college. You can contribute to both an ESA and a 529 plan in the same year. A Coverdell ESA can be opened at a bank, broker, or other financial institution. In addition to higher education expenses, ESA funds can also be used to pay for K-12 schooling.
There is no limit on how many ESA accounts you can set up for a beneficiary. But the most you can contribute for one beneficiary in any particular year is $2,000 across all ESA accounts. Plus, you as the contributor must earn below a specific threshold in income to be eligible to make a contribution. The threshold is based on your modified adjusted gross income (MAGI) as computed on your federal tax return. As of this writing, the income thresholds are $110,000 for single filers, and $220,000 for joint filers.
Contributions to ESA accounts are not tax deductible. However, as with 529 plans, the money grows tax free within the account. Also, upon distribution, the funds will not be taxed as long as they are used for qualified education expenses.
Scholarships, Grants, and Loans to Help Pay for College
Any shortfalls in college savings goals can usually be remedied with other funding sources. The most desirable of these are scholarships and grants. Grants can be on the fed These are preferable since they don’t have to be repaid.
There are federal grants and state grants available. Some are broad based, and others are niche based on background or area of study. The most popular and well known of the federal grants is the Pell Grant.
But not everyone can earn a scholarship or qualify financially for a grant. So a student loan may be necessary as well in many cases. When seeking financial aid for college, it is imperative that you timely file a Free Application for Federal Student Aid (FAFSA) form.
Scholarships can be based on merit such as academic, athletic, or another talent. They can also be based on other factors such as background, area of study, or financial need. Some scholarships are automatic in nature. Colleges may grant them based on your application. For example, good SAT scores and a high grade point average (GPA) can net you scholarship funds.
You should also do some research about other potential scholarships for which you may be eligible. For these, you may have to submit a separate application or write an essay. Scholarships can be offered by various organizations such charitable foundations, religious organizations, or businesses.
The specific college you will be attending may also offer additional scholarships for which you may apply. The U.S. Department of Labor and College Scholarships.org have useful tools to help you research some available scholarships.
Federal Pell Grant
The amount you may receive if you qualify varies annually. As of this writing, the maximum is $5,920 for one year. Various factors determine how much if any you will actually receive. Financial need is the main factor. But the cost of your school’s tuition, and whether or not you will be a part-time or full-time student also have a bearing. To apply for the grant, you must timely submit the FAFSA form. You must fill out the form each year to remain eligible for the grant. It is only available to undergraduate students.
Federal Supplemental Educational Opportunity Grant (FSEOG)
The FSEOG is another well known federal grant, and is very strictly based on financial need. The maximum you can qualify for currently is between $100 and $4,000 per year. The amount of other financial aid you receive affects how much you may get from the FSEOG program. The funds for the program are also more limited as compared to the Pell Grant. They are granted on a first come first serve basis. So students who may qualify are urged to fill out their FAFSA forms as early as permitted. The FAFSA form must be filled out annually to determine eligibility.
Student loans obviously are less preferable an option since they must be repaid with interest. They can be from the federal government or from private financial institutions. Your best bet is usually a federal student loan. The interest rate is usually lower and you have more flexibility in arranging repayment.
Repayment of student loans generally begins six months after college is completed. There is also a potential tax deduction available for student loan interest paid. However, you must make below a certain maximum income in order to qualify.
Tax Credits and Deductions for College Expenses
Once you start spending money to pay for college expenses, you may qualify for some government provided tax breaks to ease the pain. However, you must be within certain income limits to qualify for these. The key tax breaks for paying college expenses are the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC).
You cannot combine any of these credits in a particular year for expenses of the same student. Further, expenses paid for in a tax free manner using 529 plan or ESA funds cannot be used for purposes of figuring these tax credits and any deductions.
The college expenses must be for either yourself, your spouse (if filing jointly), or a dependent on your tax return. It does not matter who pays for the expenses. They may be paid by the parents, the dependent, or someone else. As long as they were not paid with funds from a tax advantaged account as indicated above. Finally, the student must be enrolled in a school eligible to participate in financial aid programs offered by the federal government.
American Opportunity Tax Credit
The most advantageous credit is the the AOTC for those who qualify. It is available for expenses paid for the first four years of post-secondary education. Qualified expenses include tuition, supplies, and books. A portion of the credit is also refundable if you do not otherwise have a tax liability to offset.
As of this writing, the maximum credit is $2,500 per student. Up to $1,000 can be refunded if you have little to no tax. Room and board expenses do not qualify for this credit. The student must also be at least a half-time student enrolled in a degree program. The credit is completely phased out if your federal MAGI is above $90,000 if single, and $180,000 for joint filers.
Lifetime Learning Credit
The Lifetime Learning Credit is generally claimed when the AOTC is not available. The maximum LLC credit is $2,000 per tax return. Unlike the AOTC, none of the LLC credit is refundable. So you cannot get a refund if the credit exceeds your tax balance otherwise due.
The LLC is easier to qualify for than the AOTC. The expenses do not need to be only for the first four years of college. Also, the courses the student takes may be for a degree program. But unlike the AOTC, they can also be any higher education courses taken to improve job skills. Otherwise, the qualifying expenses are the same as the AOTC.
The income phaseout limits are lower for the LLC. The credit is currently phased out completely when over $65,000 for single taxpayers, and $130,000 for those filing jointly.
This is a less beneficial tax break than the credits above. It is generally used when the taxpayer does not qualify for the above credits. The deduction is taken “above the line.” This means that you do not have to “itemize” to claim the deduction.
The income phaseout is $80,000 and $160,000 for single and joint taxpayers, respectively. The maximum deduction is $4,000. So, for example, if you are in a 15% tax bracket, you will save $600 in tax.
Update: This deduction was last available for tax year 2016. It was originally not extended by Congress for the 2017 and 2018 tax years. However, it was ultimately extended for the 2017 tax year on February 9, 2018 when the Bipartisan Budget Act of 2018 was signed into law.
Another way to help pay for college is to work. You can work part-time during the semester. You can also work more hours during the winter and summer breaks. Students can find work opportunities both on campus as well as in the surrounding area. The earnings you can make from such work can help close any funding gap you may still have. You can also look into college work study programs, but these may only be available if you meet financial need criteria.
Besides the money, working during college can help prepare you for the real world. You can learn responsibility, as well as acquire skills for the future. This work can also make your resume more impressive to recruiters. Not to mention the relationships you can build which can be a resource in finding a job after college.
Saving and having the ability to pay for college is a very important goal for many parents with children. You want to give your family the best chance to succeed in life. Using the information above should help you to manage this financial challenge. And remember, start saving something as soon as possible. Ideally you want to start when your child is born. This way you allow the power of compounding over a longer time frame to help you meet your goal. Click here for more wise money tips.