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4 Ways the IRS Can Pay for School

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Sometimes help comes from unexpected places. Did you know you can use the tax code to help reduce the cost of your children’s education? Here’s an easy lesson.

It’s as American as apple pie! No member of Congress gets re-elected after voting against parents, kids and education. That’s why the education goodies flavoring our tax code are so sweet. Here are four of the best:

[How America spends and saves on college]

1. Coverdell Accounts

These used to be called Education IRAs or Education Savings Accounts. Fund a Coverdell Account with as much as $2,000 per child under age 18 in 2011, and all earnings used for qualified educational expenses (including tuition, fees, room and board) can come out tax-free. Sorry, you don’t get a current deduction. But these are the only tax-favored accounts that can be used for elementary and secondary school expenses as well as for college.

If you invest $2,000 a year earning 7% in a Coverdell Education Account for 18 years, you’ll have $36,758 in tax-free income and a total account valued at $72,758.

Afraid your oldest won’t go to college? Or what if he winds up winning a full scholarship? You can roll over any unused Coverdell money to other family members, provided they are under age 30, without penalty. All funds must be distributed before the last beneficiary hits age 30.

Congress included an income limit (the phaseout is $95,000 to $110,000 for single filers and $190,000 to $220,000 for joint returns), but it’s an empty provision. Anybody with earned income can open a Coverdell Account. You don’t even have to be related to the beneficiary. If your income is too high to qualify, gift the money to a grandparent or friend to contribute. Even a child beneficiary can contribute.

The downside:

Coverdell Accounts are considered an asset belonging to the student for college financial aid purposes. Aid eligibility is reduced by 35% of the value of the account.

On the other hand, you have the value of the account. Or maybe you used it up on elementary and secondary school expenses. Either way, you’re still ahead of the game.

2. Section 529 plans

These qualified state tuition programs, established by a state or state agency, allow you to:

  • Purchase tuition credits or certificates for the payment of education expenses, or
  • Make contributions into an account to pay qualified education expenses such as tuition, books, fees, room and board.

Unlike funds in Coverdell Accounts, these dollars can be used only for undergraduate and graduate college expenses. As with the Coverdell, you don’t get a federal tax deduction.

All distributions come out tax-free. There’s no income limit for contributions. For gift tax purposes, a single donor can claim five years of annual gift tax exclusions per recipient in a single year, which means contributing as much as $65,000 ($13,000 x 5). Some states offer state tax breaks, either a deduction or a credit, for contributions. In many cases, you still can get both state and federal benefits even if you live in one state but go to school in another. For financial aid purposes, 529 accounts are considered assets of the parents, assessed up to 5.6%. They can be transferred to other members of your family, including cousins, without penalty.

Want to get creative? Name yourself as beneficiary of a Section 529 account and save money for a two- to three-year sabbatical — tax-free as long as it involves education at an eligible institution. Even some schools abroad qualify. Not only can you use the money for books and tuition, but you can even pay for your apartment up to the amount specified in the school’s guidelines.

The downsides: Both with Section 529 accounts and Coverdell Accounts, distributions not used for qualified educational purposes are taxed at your highest marginal rate and may be subject to a 10% penalty. The penalty is on the full distribution. The tax is only on the income. The real risk is if your investment decreases in value. So, the shorter the time before you actually need the money, the more liquid and conservative your Section 529 investments should be.

Check out Savingforcollege.com and the College Savings Plans Network for details on specific plans.

[Do One Thing: Choose a 529 plan]

4 Ways the IRS Can Pay for School (con’t.) »

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