New tax credit adds planning strategy for advisors and charitable clients

Starting next year, advisors will have another charitable-giving and tax-planning tool to discuss with clients: the education freedom tax credit.

Taxpayers will be able to claim the credit, also known as the federal scholarship tax credit, beginning Jan. 1, 2027, for certain cash contributions to scholarship granting organizations (SGOs) in participating states. Qualifying organizations provide scholarships for K-12 education expenses at public, private or charter schools. 

Twenty-eight states have signed up to participate as of June 22, according to the IRS. The credit is worth up to $1,700 for individuals. The U.S. Treasury Department said it plans to propose regulations by the end of September.

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The credit is nonrefundable, meaning clients must have tax liability in order to benefit.

"Anything that you can take as a credit or a deduction is a fantastic ability for you as an individual taxpayer to utilize it," said Miklos Ringbauer, founder and principal of MiklosCPA, an accounting and tax firm based in Southern California.

Ringbauer noted the tax credit differs from a traditional charitable deduction because it directly reduces a taxpayer's tax bill, rather than reducing taxable income. He also said the credit is unlikely to benefit donors directly through scholarship eligibility because their incomes are generally too high to qualify for the aid.

If clients want to save for their own or their children's educational expenses, another method, such as a 529 plan, might make more sense.

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For clients who are already inclined to give charitably, some advisors see the federal scholarship tax credit as a way to direct dollars toward a specific cause and feel better about where their tax dollars are going — while reducing tax liability.

"You could choose to make a donation to one of these scholarship funds to wipe out the first $1,700 of your tax liability, and at least then you have a choice in where your money's going," said Ryan McKeown, a CPA and CFP based in Mankato, Minnesota, who is senior vice president at Wealth Enhancement Group. "I think most people feel their tax dollars go into a big black hole."

McKeown compared the federal tax credit to an existing one in Arizona that provides tax incentives for donations that fund private school scholarships.

If a client's own state hasn't opted in to the new program, they could still make qualifying contributions in a participating state.

"I'm in Minnesota, and so we didn't establish one, so if I want to take advantage of this credit next year, I have to make a contribution to a different state's program," McKeown said.

Whether states choose to participate in the program may depend in part on differing views about preferred types of schools and education funding models.

"I think it's viewed as sort of a political thing," Mark Luscombe, a CPA and lawyer and the principal federal tax analyst for Wolters Kluwer Tax & Accounting, said in an interview. "I think it's part of the debate over whether there should be funding for private school education versus public education."

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Use of the new federal scholarship tax credit is likely to be limited to specific circumstances, said David R. Silversmith, a senior manager of private client services at New York City-based Eisner Advisory Group.

"The only time I've seen people donate to scholarship organizations is when it's at a specific school, and they're either an alumni out of the school, or they're trying to get their child into that school, or they have a scholarship in their name at that school. Never have I seen anyone donate money to just a generic scholarship granting organization," he said. "As far as a tax strategy, I don't think it's gonna be that big a deal."