Education Tax benefits

[jIM_Ohio]

I am looking at what tax benefits exist for education. Both HS and college tuition.

Here's my premise-

I am thinking that the tax deductions for paying college tuition (the year of the payment) are better than any of the other options. My understanding is tuition is fully tax deductable. If it's not, this whole premise is invalid.

529- money is put in post tax, compounding is tax free, withdraws are tax free for education needs. No tax deduction on the tuition paid.

Taxable account- put in money post tax, compounding is taxed, pay taxes at capital gains rates when investment is cashed in. The payment for tuition is fully tax deductable.

The math:

Put 3600 per year into 529. $66100 is cost basis. Grows to 130k in about 16 years (100% return). Withdraw most of 130k for tuition and paid only $13500 in taxes to do this.

Put 3600 per year into taxable account. Grows to 130k in about 16 years. Fund I am thinking of pays around .10 per share per year in dividends (90 taxes year 1, goes up to 3k in taxes just prior to year of withdraw). Total taxes paid are $22k in dividends, plus $13500 in income taxes, plus $9600 in capital gains taxes. 44k in taxes paid.

The 130k payment to tuition is fully deductable (around 32k deducted from income each year). So ultimately I get the 44k in taxes paid back, plus another 90k in taxes back at a time in life when deductions go away.

Thoughts?

Not sure what the hope credit is, not sure of other education deductions. Comments?

[sweeps]

Don't forget about the Coverdell Savings Account. It tops out at $2000 per child per year, but it is also tax free, and you have choice over the investments. (Mine are at Vanguard, naturally. ) Also you can use it for elementary and high school education expenses.

The Hope or Lifetime learning credit can be claimed in the same year your child takes a distribution from a 529 or a Coverdell, as long as the same expenses are not used for both benefits.

I can see going with a taxable account over a 529 or Coverdell if you're not sure your kids will go to school. But I think that is unlikely and worst case you have a 10% penalty if you can't transfer the funds to someone else who can use it for education.

[zetta]

A quick google of "college tuition deduction" turned this up:
The College Tax Breaks Explained (College Planning: Personal Finance) at SmartMoney.com

The $4,000 (or $2,000) Deduction
For 2007 you can deduct up to $4,000 of college tuition and fees paid for you, your spouse or any other person claimed as a dependent on your return. This is an "above-the-line" deduction, which means you don't have to itemize in order to take advantage of the break. However, the $4,000 figure is the annual maximum, regardless of how many students may be in your family. The other ground rules are as follows:
· You don't get the full deduction if you are unmarried with modified adjusted gross income above $65,000, or a joint filer with modified AGI above $130,000. However, if your modified AGI is between $65,001 and $80,000 for singles or between $130,001 and $160,000 for joint filers, you are entitled to a reduced deduction of up to $2,000.


· You're completely ineligible if you're married and file separately from your spouse.


· No deduction is allowed on the tax return of any person who can be claimed as a dependent on another's return. So your dependent college-age child can't claim the deduction when your own AGI is too high to qualify. The deduction expired at the end of 2007 but will probably be restored by Congress sometime this year.


· No deduction can be claimed for expenses paid with earnings from a Section 529 plan or withdrawals from a Coverdell Education Savings Account. Also, you can't claim the deduction in the same year you claim the Hope Scholarship or Lifetime Learning tax credit for the same student.

So as usual, it depends -- will tuition be more than $4k? If your AGI is above $130k, the max deduction is only $2k, and above $160k you lose it completely. Even if you qualify for the deduction, you are screwed if you have two kids in college at the same time, because it doesn't increase with more kids.

Better rerun the numbers with this info -- I suspect the 529 will be a better deal for high income families.

[moneybags]

The 130k payment to tuition is fully deductable (around 32k deducted from income each year).

Sorry, this doesn't work. The most you can deduct from income for college education is $4,000/year, and I think that is a temporary item (it may get renewed, who knows). The other options are the hope (max of 1650/student/year) or lifetime learning credits (max of 2000/return). So, with your example, I am thinking the 529 looks more tax advantageous.

[jIM_Ohio]

Don't forget about the Coverdell Savings Account. It tops out at $2000 per child per year, but it is also tax free, and you have choice over the investments. (Mine are at Vanguard, naturally. ) Also you can use it for elementary and high school education expenses.

The Hope or Lifetime learning credit can be claimed in the same year your child takes a distribution from a 529 or a Coverdell, as long as the same expenses are not used for both benefits.

I can see going with a taxable account over a 529 or Coverdell if you're not sure your kids will go to school. But I think that is unlikely and worst case you have a 10% penalty if you can't transfer the funds to someone else who can use it for education.

Is the coverdell like a 401k (money in is pre-tax)? Is the coverdell per child or per family? 2k deduction per child per year or 2k deduction per family per year?

[sweeps]

It's post-tax... more like a Roth than a 401k. $2K for each child each year. Tons more info here.

[jIM_Ohio]

I am looking for a way for the contributions to be pre-tax, if at all possible.

If I get a deduction NOW, I am more likely to do it. If I am restricted how the money is spent later, I want a deduction now. If there are fewer restrictions on back end (no 10% penalties), then I could contribute post tax.

But why contribute post tax to pay a 10% penalty (that money was already taxed) if education is not in the cards for the child?

[sweeps]

I am looking for a way for the contributions to be pre-tax, if at all possible.

If I get a deduction NOW, I am more likely to do it. If I am restricted how the money is spent later, I want a deduction now. If there are fewer restrictions on back end (no 10% penalties), then I could contribute post tax.

But why contribute post tax to pay a 10% penalty (that money was already taxed) if education is not in the cards for the child?

Good question. That's why I wouldn't recommend funding a child's education 100% with a 529 or Coverdell. I plan on funding 1/3 to 1/2. In the small chance that one of my children doesn't go to college, I can transfer it to the other child. If both don't go to college, then at least I've limited the damage of the penalty.

If you find a good pre-tax way to save for college, please let me know.

[MonkeyMama]

It is a good idea to put small amounts into a 529 or Coverdell. Because they behave more like ROTHs. Let them compound for the next 18 years tax-free. Strategically it makes sense to put at least some money into these vehicles very early on.

I actually plan to fund a very small amount of college with these vehicles, because the money is so limited what you can spend it on. But early on all of our dollars are going into 529s and UGMAs (where they grow tax free in the early years since not a lot of earnings now).

There has been some tax planning talk of using ROTHs for college savings as well. That can get very complicated, but is an idea.

We actually prefer to save most college money in our name (& not earmarked specifically for college). But the idea of letting some money compound tax free for 18 years was kind of hard to pass up. It helps to know the money does not have to go to the kids. Though we are a "public school" family (we didn't spend much on college at all - no one in my family has) the kids have 4 cousins from very "private school" families. We figure odds are someone in the family can use the money. (& if it comes to that we can give them the money to avoid penalty, but have their parents reimburse us).

Anyway, I am not a big fan of 529s, but that is my take. Some parts are too good to pass up. Though I will not save six figures in these accounts, we may save up $10k-$20k before the kids hit grade school.

[zetta]

But why contribute post tax to pay a 10% penalty (that money was already taxed) if education is not in the cards for the child?

Your investments in a taxable account are also post-tax, btw.

Just for grins, let's assume you could put $1000 in a taxable account and $1000 in a 529 today, and both funds grow at 12% (just to make the math easy.) In 18 years your money has doubled 3 times, to $8000 (an interest calculator says it's actually $7689.97). Let's assume your child does not go to college.

In the taxable fund, you pay 15% on the capital gains each year. I ran a quick spreadsheet to sum up the annual gains. Total tax paid: $1003

In the 529, you pay a 10% penalty. Total penalty paid: $769

The 529 comes out slightly ahead, even if your child doesn't go to college. If he does, you've saved $1000 in taxes.

Of course, this is for a lump sum contribution -- the numbers may work out differently for annual contributions.

[cptacek]

We figure odds are someone in the family can use the money. (& if it comes to that we can give them the money to avoid penalty, but have their parents reimburse us).

You can do that? I suppose you could...you could keep it in the account and fund your grandchildrens' education 40 years from now, too, if your kids don't go to college!

[Like2Plan]

I am looking for a way for the contributions to be pre-tax, if at all possible.

If I get a deduction NOW, I am more likely to do it. If I am restricted how the money is spent later, I want a deduction now. If there are fewer restrictions on back end (no 10% penalties), then I could contribute post tax.

But why contribute post tax to pay a 10% penalty (that money was already taxed) if education is not in the cards for the child?

jIM_Ohio,
The 10% penalty is on the earnings, not the contributions.

Earnings on withdrawals not used for qualified higher education expenses may be subject to federal income tax and a 10% federal tax penalty. As with all tax-related decisions, contact your tax advisor.

College Advantage


Another factor to consider is if you took a state tax write off on the contributions, you may have to add it back into state income for non qualified expense:

$2,000 Ohio state tax deduction
CollegeAdvantage is the only 529 college savings program that allows Ohio taxpayers to deduct their contributions from Ohio taxable income. Each contributor (or married couple) can deduct up to $2,000 per beneficiary, per calendar year, with unlimited carry forward in future years.

CollegeAdvantage 529 plan FAQs