Let’s continue my blog series on paying for college with a look at tax breaks for college. Anyone can get government assistance in the form of tax breaks for saving and paying for college. By the time a child is ready for college, parents have had 18 years to save for college thru 529 college savings accounts, Coverdell accounts, savings bonds, and regular taxable accounts. (I’ll cover these in more detail in a future post). Hopefully you have a nice amount of savings built up that will save you big borrowing costs; probably not most of it because college costs are rising faster than our savings and just about any other expense, but every bit helps.
Tax breaks for college – education savings accounts
After you know how much your student will get in financial aid, you will need to come up with the rest. First pay qualified expenses from a non-529 account to get the tax breaks that don’t appy to expenses paid with 529 funds; then use your 529 and other savings on additional, qualified education expenses. The IRS defines “qualified education expenses” as tuition, room and board, fees, books, and equipment, for example, computers. See IRS publication 970, Tax Benefits for Education: http://www.irs.gov/publications/p970/ for information about 529s, Coverdells, education tax breaks, American Opportunity Credit, Lifetime Learning Credit, education savings bonds, and more – especially how all these relate to each other.
Tax breaks for college – Tax credits
It’s in the national interest to have an educated citizenry and workforce, so government has long fostered making college more affordable. In addition to financial aid, the federal government offers tax breaks for college. The main programs are the American Opportunity Tax Credit (AOTC) that expands the previous Hope credit, and the Lifetime Learning Credit. The AOTC provides for $2500 tax credits for couples earning up to $160,000 and requires you to pay qualifying tuition expenses from an account other than your 529 account, but you can still use your 529 account for other expenses such as room and board. Couples can also deduct $2500 per year in college loan interest if income is under $150,000. Despite the number of tax breaks, be aware that you generally can’t take multiple tax breaks for the same expense in the same year. Thus, I can’t emphasize enough how important it is to get the latest information about changes to these programs and how potentially tricky it is to coordinate between them in the same year and expense, so I’m repeating again, see IRS publication 970, Tax Benefits for Education: http://www.irs.gov/publications/p970/ for current details about tax implications while saving and paying for education expenses, especially how to coordinate the various tax breaks for college.
Tax breaks for college – effect on financial aid
Don’t worry – your savings won’t hurt your chances of getting financial aid very much. Use these savings to cover the “expected family contribution” (EFC) amount that financial aid does not cover. You aren’t expected to use it all before getting financial aid. When you apply for aid with the FAFSA, only 5.6% of the parent’s savings are considered while grandparents’ savings aren’t considered at all when determining aid. Additionally, money that parents use from their educational savings accounts does not affect the amount of future financial aid, but grandparents’ payments do and are counted as part of the student’s income.
If your student was lucky enough to get big scholarships so you don’t need to pay from your 529 account, you can withdraw from your 529 account up to the amount of the scholarship without paying a penalty.
Parents may be tempted to withdraw money from their retirement accounts to pay for children’s college. Refer to my posts on “Saving for Retirement” for rules, pros, and cons. Just remember the famous saying that, “You can get a loan for college, but no one is going to lend you money for retirement.” Bottom line – don’t even think about this unless you are many years away from retirement and can and will make it up, knowing that you are losing many years of compound earnings. Don’t worsen your retirement finances so your child needs to help support you in retirement.