We often are asked for tax-efficient ways to help with our children’s (or grandchildren’s) education expenses.
One of the easiest ways to help your children or grandchildren with savings for education expenses is to invest the money you have set aside for your child’s or grandchild’s college years into tax-smart investment vehicles. These plans and accounts allow you to efficiently save for your child’s or grandchild’s education while shielding the savings from the IRS as much as possible.
One of the best ways to help a child financially while limiting your own tax liability is to use a 529 college plan. You can contribute up to the gift tax annual exclusion amount each year, which is $16,000 in 2022. All withdrawals—even investment earnings—from the 529 Plan used for qualified education expenses are free from federal income tax. Since 2019, both tuition for technical schools and K-12 private school are eligible qualified expenses.
Also, Virginia allows a state tax deduction of $4,000 per account per year (unlimited if you are over 70) if you use a Virginia approved 529 plan. Each account can have only one student beneficiary. For joint returns, each spouse can set up an account for each child (allowing $8,000 of annual contributions per child). Annual contributions in excess of the allowable deduction may be carried forward to the next year.
With proper planning, those who have the funds can “superfund” a 529 plan by contributing five years of gifts at once, per child, per person without being subject to the gift tax. This means, for example, that a pair of super-wealthy grandparents could contribute $80,000 each ($160,000 per couple) when a child is young and let that money grow to cover their entire costs.
A Coverdell Education Savings Account (ESA) can be set up at a bank or brokerage firm to help pay the qualified education expenses of your child or grandchild. Like 529 plans, Coverdell ESAs allow money to grow tax-deferred and withdrawals are tax-free at the federal level when used for qualifying education expenses (same as a 529 plan).
Coverdell ESA contributions are not deductible, and contributions must be made before the beneficiary reaches age 18 (unless the child is a special needs beneficiary, as defined by the IRS). While more than one Coverdell ESA can be set up for a single beneficiary, the maximum contribution per beneficiary—not per account—per year is limited to $2,000. Also, to contribute to a Coverdell ESA, your modified adjusted gross income (MAGI) must be less than $110,000 as a single filer or $220,000 as a married couple filing jointly.
529 Plans and ESA accounts can affect eligibility for financial aid. The federal financial-aid formula expects students to contribute 20% of savings, versus a maximum of 5.6% of savings for the parents. 529 and Coverdell plans owned by children are considered their savings. Plans owned by the parents are savings of the parents, but plans owned by grandparents are not considered in the student’s eligibility for aid.
Uniform Gifts to Minors Act (UGMA) accounts and Uniform Transfers to Minors Act (UTMA) accounts are custodial accounts that allow you to put money and/or assets in a trust for a minor child or grandchild. As the trustee, you manage the account until the child reaches the age of majority (age 18 in Virginia). Once the child reaches that age, they own the account and can use the money in any manner they wish. Tax on the income from the account is paid at the beneficiary’s (presumably) lower rate.
Although there are no limits on contributions, parents and grandparents can cap individual annual contributions at $16,000 per individual ($32,000 per married couple) to avoid triggering the gift tax.
Custodial accounts count as students’ assets (rather than parents’), so large balances can limit eligibility for financial aid.
Education Improvement Scholarship Tax Credits
If you are interested in supporting private school education in Virginia, the state offers taxpayers a special tax incentive. The Education Improvement Scholarships Tax Credits Program provides state tax credits for persons or businesses making donations to foundations that provide scholarships to eligible low-income students and children attending eligible private schools and eligible nonpublic pre-kindergarten programs. The program is administered by the Virginia Department of Education. Tax credits under the program are equal to 65 percent of the donation and may be claimed against either business or individual taxes. The remaining 35 percent of the donation may be claimed as a charitable contribution.
For someone in a 35% federal tax bracket and 5.75% Virginia bracket, a $10,000 donation would result in a Virginia tax credit of $6,500 plus federal and state tax savings of $1,420.
Various foundations that support Virginia private schools, such as Catholic Diocese of Richmond, Richmond Jewish Foundation and other private school foundations, offer programs that participate in the program. For further information, contact one of those programs.
U.S. Savings Bonds Redeemed for Higher Education
Interest from certain Series EE and Series I U.S. Savings Bonds may be excluded from gross income if the redemption proceeds are used for “qualified higher education costs” for the taxpayer, the taxpayer’s spouse, or taxpayer’s dependent. The bond must have been issued after ’89 to a taxpayer who is at least 24 years old. The excludable amount is reduced if some of the proceeds aren’t used for qualified expenses. Also, the exclusion is phased out for taxpayers with modified AGI above specified inflation-adjusted thresholds when the bonds are cashed and used. The phase out currently begins at $128,650 for joint returns and completely phases out at $158,650. For other returns the phase out begins at $85,800 and phases out completely at $100,800.