[IMGCAP(1)]In the latter part of the year we begin conducting year-end planning meetings with clients. For the ones with children or grandchildren, invariably part of the meeting focuses on planning and saving for college and possibly graduate school expenses.
Most clients have a difficult time developing a strategy based on their specific planning needs with the myriad of education tax incentives and other planning tools available to them. They look to us for support in building a cohesive course of action as part of their comprehensive overall plan. There are many education-related tax provisions and incentives available, which include credits, deductions and exclusions from income. Below is a brief overview of several of the education tax incentives built into the Internal Revenue Code that we utilize most frequently as well as of one of our favorite planning tools.
In general, qualified education expenses may only be used to take advantage of one exclusion, deduction or credit. Furthermore, there are phase-outs based on the client’s Modified Adjusted Gross Income at specific income levels, which can vary based on each education tax incentive, as well as whether the taxpayer is filing as single, jointly or head of household. Taxpayers must also reduce their qualifying expenses by the amounts received from certain scholarships and educational assistance payments that have been excluded from income. The information provided below is based on the most up-to-date figures (2015).
American Opportunity Credit: Tax credit of up to $2,500 per student; 100 percent of the first $2,000 of expenses and 25 percent of the next $2,000. Qualified education expenses cover tuition, fees, books, supplies and equipment for enrollment or attendance at an eligible educational institution. This must be for the taxpayer, spouse or dependent for the first four years of higher education. They must be enrolled at least half-time in a degree program, and parents can shift the credit to the student by not claiming the student as a dependent.
Lifetime Learning Credit: Tax credit up to $2,000 per tax return (20 percent up to $10,000 of expenses). Qualified education expenses cover tuition, fees, books, supplies and equipment that must be paid to the eligible educational institution as a condition of the student’s enrollment or attendance at the institution. This can be for undergraduate or graduate education. This is available for an unlimited number of years for both degree and non-degree programs and parents can shift the credit to the student by not claiming the student as a dependent.
Student Loan Interest Deduction: This is an “above the line” deduction of up to $2,500 in interest paid on the education loan. The loan can cover tuition, fees, books, supplies, equipment, room and board, transportation and other necessary expenses. This must be for the taxpayer, spouse or dependent for undergraduate or graduate education. The loan must be incurred solely to pay qualified education expenses of the student enrolled at least half-time in a degree program. Furthermore, the payer must be legally obligated to repay the debt.
Qualified Tuition Programs: Popularly known as 529 plans, these are either tax-free earnings via a savings program or tax-free education credits via a pre-paid plan. Contributions to the program are non-deductible. The program limits can vary by state as can possible state tax deductions to residents. Qualified education expenses cover tuition, fees, books, supplies, equipment, room and board if there is at least half-time attendance at an eligible educational institution. This can only be used for the account beneficiary for undergraduate or graduate education. The beneficiary can be anyone and the account owner can change the beneficiary if desired or reclaim the funds. The account owner can also choose to spread the gift over a five-year period.
Education Savings Accounts: Earnings from this account are tax-free. Non-deductible contributions are limited to $2,000 per child under the age of 18 and special needs children of any age. Qualified education expenses cover tuition, fees, books, supplies, equipment, room and board if there is at least half-time attendance, and computer and internet service (K-12 only). This must be paid to the eligible educational institution as a condition of the student’s enrollment or attendance at the institution. This can only be used for the account beneficiary for K-12, undergraduate or graduate education. The beneficiary can be anyone, and the contributions must be made by the original return due date.
Many clients are concerned their college education savings plan may not be enough to cover their children’s or grandchildren’s education. They may also have fears of not being able to meet the rising costs of education, their children not being able to afford college or graduate education if they die prematurely, or a sudden market downturn when their children approach college age will leave them short of funds.
One planning tool that we utilize extensively with our clients in combination with one of the education tax incentives mentioned above is life insurance. Use of a permanent life insurance policy can help pay for college on a tax-free basis and also ensure educational funding needs are met if the parent or grandparent dies pre-maturely. Policy values grow on a tax-deferred basis and the death benefit can also be income tax free to the heirs and avoid probate. Depending on the type of permanent policy utilized, it may be possible to provide peace of mind by being able to avoid market downturns. Two types of policies that we most commonly utilize in our planning strategies, depending on the client, are indexed universal life policies and second to die indexed universal life policies.
Other benefits can include avoidance of the 10 percent penalty associated with some of the education tax incentives if used for non-educational expenses, possible access to funds due to a chronic or terminal illness, and use as collateral. Life insurance policies are not counted as an asset when applying for financial aid and have possible protection from creditors (based on state eligibility, availability and/or state law).
As always, each family or individual’s needs must be properly assessed and analyzed in a comprehensive and holistic manner in developing the optimal planning strategy. Knowing the options and tools available both in the Tax Code and elsewhere are paramount as part of this process. In the end, the right strategy is invaluable to the parents, grandparents and students.
Brian D. Hartstein, MSFS, CLU, ChFC serves as the director of corporate development for Bayntree Wealth Advisors LLC in Scottsdale, Ariz. He concentrates primarily on working with CPAs, financial advisors, successful business-owners, and affluent clients in the qualified and non-qualified plan markets, estate planning and financial and investment planning. He is currently on the advisory board of the Phoenix Tax Workshop, a member of the Society of Financial Service Professionals, and served as President and on the Board of the Financial Planning Association of Greater Phoenix.
[This article has been updated.]
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