Supporting the goals and dreams of future generations is important work and deserves a thoughtful planning process.
Planning for the education of a child is an important goal for many families, but finding the right solution can be complex. Time horizon, type of education and family circumstances all play a role in defining the right approach. Saving for pre-school requires a different strategy than saving for college or graduate school, and planning options vary in terms of flexibility, contribution limits, tax benefits and more.
The following summary of potential tax benefits and long-term savings options can help make the planning process less daunting. It will also equip you to have better conversations with your tax, financial and legal advisors, who can help you put a plan in action.
Before considering specific funding strategies, it is important to understand the following three potential tax benefits of paying for education more broadly. This includes considering the federal and state gift and generation-skipping transfer (GST) tax consequences, as summarized below:
The Annual Gift Tax Exclusion
The annual federal gift tax exclusion for 2022 allows a family to give a single beneficiary $16,000 ($32,000 per married couple) per year without incurring any gift or GST tax liability. The beneficiary can use this money to cover education or non-education expenses.
If your gift is made to a trust, ensure that the trust is designed to qualify for the annual gift tax and GST exclusions.
Direct Tuition Payments
Direct tuition payments to elementary, secondary, post-secondary or other qualifying schools are not subject to gift tax. The exclusion for direct tuition payments is available regardless of the relationship between the donor and the student, but the exclusion is limited to tuition only and does not extend to books, room and board, and other expenses.
Income Tax Credits
State and federal governments also offer education income tax credits. At the federal level, there are two credits: the Lifetime Learning Credit and the American Opportunity Tax Credit. Taxpayers can only claim one of the credits.
Evaluate whether the student should file an independent tax return in order to claim a credit. An education tax credit is available only to students who are not claimed as a dependent on someone else’s tax return. Under 2017 tax law, parents generally claimed students as dependents. Under current tax law, the personal exemption has been suspended, so there may be more incentive for students to file independently.
Federal Education Income Tax Credits
Long-Term Savings Plans:
According to the College Board, the average cost of tuition at a private, four-year institution for the 2021-2022 school year was $38,070. If you factor in room and board, books, and other expenses, this amount balloons to more than $50,000 annually.1
Fortunately, there are a number of savings plans to help you pay these significant costs. They vary in terms of contribution limits, qualified expenses, tax treatment and other features, as summarized below:
Long-Term Savings Options
The 2017 Tax Cuts and Jobs Act (Tax Act) expanded 529 plan rules to include qualified elementary and secondary education tuition expenses. But consult your advisors before taking advantage of this change, as there is a $10,000 annual cap on distributions for K-12 education2, and state-level rules and limitations may apply.
While the above overview provides a good starting point, in practice, picking the best funding solution is highly dependent on a myriad of variables unique to your family’s needs. Work with your advisors to identify these needs, align them with a strategy and execute a plan. Future generations will thank you.