Tax Friendly Ways To Build Your Child’s College Fund

Tax Friendly Ways To Build Your Child’s College Fund

By: Whitney Hodge

Published: August 13, 2021

Most parents hope that their children will go to college one day, and with education costs higher than ever, it pays to plan. Saving can seem like a daunting process, especially when tuition and fees can be thousands, or even tens of thousands of dollars per semester. However, smart parents can help their kids be financially ready for college and maximize tax benefits to minimize their costs.

While some parents start thinking about saving for college before they’ve even had kids, others may not start saving until much later. No matter when you begin building a college fund, there are ways to help maximize those savings to benefit your family.

There’s a college savings plan for everyone, from special savings accounts to savings bonds and beyond. While every family’s situation is different, you could be able to take advantage of one or more of these to help reduce your tax liability while saving for your college student’s future. 

U.S. Savings Bonds

Qualified savings bonds can help you save for your child’s college while offsetting your tax liability. If your family qualifies for the tax savings, these bonds can help in two different ways.

  • Interest earned from the bonds doesn’t have to be reported until the bonds are cashed in.
  • Interest from certain Series EE and Series I bonds could be exempt from being taxed if the money from the bonds is used to pay for qualified higher education expenses.

The bonds must be purchased in your name or jointly (with a spouse) to qualify for the tax savings. Also, the proceeds from the bond have to be used to pay for things like tuition and fees, not fees for room and board.

While many people can take advantage of these bonds, the tax exemption is phased out if your Adjusted Gross Income is above certain levels, so make sure you talk to your tax advisor about your options.

529 Plans

You may be more familiar with 529 Plans, as they’ve become very popular with families in the last few years. These plans are qualified tuition programs that let you buy tuition credits for your child or put money in a qualified account to cover education-related expenses.

With 529 plans, your contributions aren’t tax-deductible. Instead, the contributions are treated as taxable gifts to your child. To avoid paying tax on the contributions, they’re counted under the annual gift exclusion. Up to $15,000 (as of 2021) can be excluded from taxation, but if you contribute more, there is an option to spread the gift out over a five-year period to maximize tax savings.

Earnings on the contributions to the 529 plans will accumulate tax-free until the funds are used to pay for college costs. Then, any money spent on qualified expenses is tax-free, but you’ll pay taxes plus a 10% penalty tax on any money spent on unqualified expenses.

Coverdell ESAs (Coverdell Education Savings Accounts)

Like 529 plans, Coverdell ESAs allow you to put money into a savings account set up expressly for education. There is a limit to how much you can contribute each year. You may contribute up to $2000 per year for every child under the age of 18.

For those with AGIs over a certain limit, the right to contribute to an ESA is phased out, but your child can still contribute to one on their behalf. These contributions aren’t tax-deductible, but income in the accounts isn’t taxed at all if the funds are used to pay for qualified expenses.

If you fund an account and your child doesn’t go to college by the time they’re 30, they must either cash out the account (and pay the required fees and taxes), or they can transfer it to another ESA on behalf of another child under the age of 30 within their family. 

Coverdell ESAs were once known as Education IRAs. You may hear your tax consultant refer to them this way to keep you from confusing them with K-12 ESAs, which are state-created.

Roth  IRAs

Most people think of Roth IRAs as retirement plans, but you can also use them for college savings. Young people who contribute to a Roth IRA can usually take advantage of typically being in a lower income tax bracket when they begin making contributions.

Contributions to a Roth IRA are taxed, but the earnings on those contributions are not. You can withdraw the contributions (but not the earnings) without paying tax or penalties at any time. Then, when you reach age 59 ½, you can withdraw everything tax-free. 

If you have children later in life or want to help out your grandchildren with college expenses, this could be an excellent way to do so.

Start Early, Plan For Savings

It’s easy to be overwhelmed by the options you have regarding saving for college and tax savings. The earlier you start planning, the better your chances of making the most of the available tax breaks there are.

At Lloyd & Hodge, we can offer individuals and small businesses reliable tax advice to save you and your family money. Contact us today to help you navigate your options and choose the best college saving strategy for your family.

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