Get Smart About Education Savings by Tara Thompson Popernik, AllianceBerstein
Educating your children or grandchildren isn’t just an expense: The Internal Revenue Service sees it as a gift.
Fortunately, direct tuition payments to elementary and secondary schools fall under the educational/medical (ed/med) exclusion. You can pay unlimited current tuition expenses, on behalf of one or more beneficiaries, without incurring gift tax. To get the exclusion, however, you must make the payment directly to the school.
As a result of the ed/med exclusion, tuition payments do not count against your $14,000 annual exclusion or the $5.43 million lifetime applicable exclusion amount (two ways that individuals can give money to other individuals without paying gift tax). Payments for room and board and other nontuition expenses do not qualify for the ed/med exclusion.
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There is also a tax-advantaged way to invest to fund future college or graduate school expenses: a Section 529 plan. Contributions to a Section 529 plan made with annual exclusion gifts grow free of federal income tax, and earnings can be withdrawn tax free as long as the funds are used for “qualified higher-education expenses.”
How a 529 Plan Works
Contributions to a 529 plan may cover a much wider array of expenses, including tuition, fees, books, supplies and equipment, and special-needs services required for enrollment or attendance at an eligible educational institution, as well as room and board, for students attending at least half-time.
Individuals can make gifts of up to $14,000 (married couples, up to $28,000) per year to a 529 account for the benefit of any number of individuals. The 529 program allows you to front-load five years of annual exclusion gifts, and thus give up to $70,000 in one year ($140,000 for a married couple) per beneficiary.
Front-loading a 529 plan can be a great way to avoid income taxes on the future growth of funds earmarked for higher-education expenses. The Display below shows the advantages of 10 years of annual or front-loaded contributions to a 529 plan versus taxable savings. Bernstein projects that, in aggregate, the taxes avoided over a 10-year savings horizon could pay for a full year of college tuition.
A Coverdell Education Savings Account can be used to pay for K-12 as well as higher education. But Total contributions on behalf of any one child are limited to $2,000 a year, no matter how many accounts are established. A Coverdell account is available only to couples with less than $220,000 and individuals with less than $110,000 in annual income.
The views expressed herein do not constitute and should not be considered to be, legal or tax advice. The tax rules are complicated, and their impact on a particular individual may differ depending on the individual’s specific circumstances. Please consult with your legal or tax advisor regarding your specific situation.