On Monday July 22, 2013 the British monarchy welcomed a new heir in Prince George. Almost immediately, speculation began about his life including his college education. No matter which university Prince George chooses to attend he won’t have to worry about paying for it. But so many American parents have the high costs of college to look forward to unless they plan ahead. It’s never too early to plan and save for future college expenses and the U.S. tax code gives parents some options.
We currently have 2 types of IRAs which can be used to fund education. The Qualified Tuition Programs (OTP) and Educational Savings Programs (ESA) are set up along the lines of the Roth IRA. Contributions aren’t deductible but distributions can be tax free if the funds are used to pay for education expenses.
The Qualified Tuition Program, also know as 529 plans, are state or college plans that are used to pre-pay college expenses. They have no contribution limits and can be used to pay tuition, fees, books, supplies and room and board for students who are at least half time. They can also be used to cover special needs services for the student. This plan is limited to expenses for undergraduate or graduate programs.
The Education Savings Accounts used to be called the Cloverdell IRA and is limited to a $2000 contribution for each beneficiary. The ESA can be used for the same expenses as the QTP and expenses for students in K-12.
Both these types of plans have different requirements and the taxpayer needs to do a little research to choose the plan that will suit their intentions. But once the money begins to be distributed, the earnings are taxable unless the money has been used to pay qualified education expenses. Since the taxpayer can’t deduct their contributions, pulling them out of the plan isn’t taxable. As always, once an education expense has been used for a credit, deduction or to offset a distribution, it can’t be used again. If the distribution from an ESA or QTP is greater than the education expenses not used elsewhere, the earnings allotted to the distribution become taxable and may be subject to a 10% penalty. This is a time where good records and a tax pro really can help.
Beside the education IRA, paying for college can provide relief from the 10% penalty on a withdrawal from an IRA. The money actually taken out of the IRA will be included in income and taxed but education expenses not used elsewhere can reduce the amount subject to the early withdrawal penalty.
If savings bonds, especially Series EE purchased after 1989 and Series I bonds, are cashed in to pay qualified tuition and fees the interest may be excluded from income. The key is to set up bond ownership correctly. The bond must be issued after the owner turns 24 and must be in the name of the taxpayer or spouse. No other co-owner is allowed. And the tuition and fees can’t be for classes in sports, hobbies or games unless they are part of the major. Of course, you can’t use expenses used for other educational credits, deduction or reductions. But savings bonds can be used to invest in QTP and ESAs.
You don’t have to be royalty or rich to pay for college but it takes the will to save ahead. The earlier you begin to contribute to the plans, the larger the earnings and tax advantage. There are a lot of ways to save money on taxes by using education expenses for credits, deductions and to reduce income. But the rules for each program are a little different and you want to check to make sure you are using those expenses as effectively as possible.