Education Strategies

There are several strategies for those saving for a child’s education, such as 529 plans, Coverdell Education Savings Accounts (ESAs), and education tax credits. Navigating the different options and the temporary nature of some opportunities, however, can be challenging. Let’s take a look at the rules governing tax breaks for education.

529 Plans

These qualified tuition programs, offered as prepaid tuition plans or college savings plans, are valuable tools to help finance your children’s education. Prepaid tuition programs allow you to lock in today’s tuition rates at participating private and public colleges and universities. College savings plans, on the other hand, offer a range of investment options, typically a variety of mutual funds, which can be used to pay for tuition and other qualified education expenses at many colleges and universities nationwide.

In 2021, up to $10,000 of 529 funds per year can be used for qualified K-12 tuition expenses. Taxpayers can also rollover amounts from 529 plans into ABLE accounts. Under the Setting Every Community Up for Retirement Enhancement (SECURE) Act, up to $10,000 can be used to pay down the account beneficiary’s student loans and another $10,000 can be used to repay student loans held by their sibling. The law also allows 529 funds to be used for apprenticeships that are registered with the Federal Labor Department.

While state tax benefits for 529 plans vary, all 529 plans offer Federal tax benefits. Earnings grow tax-free and funds withdrawn to pay for qualified educational expenses, including the cost of computer equipment and Internet access, are also tax-free.

With a 529 plan, you are allowed a tax-free rollover once a year. This permits same-beneficiary transfers to another qualified tuition program. Rollovers to a different beneficiary may occur at any time, but some plans may charge a fee. You may use 529 plans in conjunction with other tax breaks. For example, you may claim the American Opportunity Tax Credit or Lifetime Learning Credit in the same year you make withdrawals from a 529 plan, as long as the same education expense is not used for both the education credit and the tax-free 529 withdrawal.

In addition, you may contribute to both a 529 plan and a Coverdell Education Savings Account (ESA) on behalf of the same beneficiary in the same year. As 529s have become more popular, many plan options have emerged. Each type of plan has its own rules and investment options. There are certain pros and cons associated with 529s, for example 529 plans may not be the best choice for low- and middle-income taxpayers who qualify for financial aid because 529 assets are considered when determining need for financial aid; you will be taxed and penalized on the earnings portion of any withdrawals if funds are not used for qualified education expenses; savings plans invested in stocks may lose money, so it may be wise to switch funds into less volatile investments as the beneficiary gets closer to college-age; you may not benefit from additional state tax breaks unless a plan is set up in your state of residence; and some states have residency requirements for establishing an account.

Contributions to a 529 plan on behalf of a beneficiary are considered a gift for gift tax purposes, and in 2021, up to $15,000 ($30,000 for joint filers) may be given tax free. Furthermore, a special gift tax rule allows individuals to make a tax-free, lump-sum contribution to a 529 plan of up to $75,000 ($150,000 for joint filers) in 2021; however, you are unable to make tax-free gifts on behalf of the same beneficiary for the next five years.