Once you have estimated the amount that you need to save for college education the next step is determining what kind of saving plan to choose from. There are several Qualified Tuition Plans (QTP) or 529 plans to choose from. It is important to use these plans as they offer some tax advantages. You can decide on the one which is most appropriate for you or you could choose a combination. There are some state specific rules on QTPs.
Broadly speaking, there are two types of savings plans, Prepaid Tuition Plans and Savings Plans.
- Prepaid Tuition Plan: As the name indicates, these plans allow the payment of future tuition at current prices or 'locks-in' your future tuition cost. It is offered jointly by state and a particular college. The idea is that the child will attend that particular college. But if for some reason child can't get in that college or some other situation demands the child to attend a different college in the state then there is some flexibility. Obviously, this plan is not very popular.
- Savings Plans: College saving plans are a great way to regularly save for your child's college education. The investment earnings in such accounts grow tax deferred (you don't need to pay taxes on them each year). In fact when your child withdraws the money for college expenses, these earnings are taxed at your child's tax rate. You can contribute up to $15,000 to each child's savings plan in a given year. This amount can be doubled if you and your spouse contribute together. A higher contribution can run into gift tax issues. However, if you have received a lump sum payout from some source e.g. a lottery or gift from someone, you can contribute up to 5 times this amount in a given year provided you don't contribute anything for the next 5 years. For grandparents this is a great way of helping the grandchildren. Each grandparent can use the 5 year payment approach. In fact, if a grandparent is considering to help a grandchild's current tuition bill, a more tax effective way is to mail the check directly to the college (payable to college). That way you don't run into generation skipping transfer taxes .
The money from such plans can only be used for qualified college education expenses. They include tuition, room and board, and books/supplies. If the funds are not utilized by the beneficiary they may be transferred to a new beneficiary within the same generation and within the same family (including first cousins of beneficiary) to avoid penalties and gift taxes. Penalties are waived if the beneficiary dies or becomes disabled or receives a scholarship of an equal amount.
Education Expense Deduction: Taxpayers may deduct upto $2,000 from gross income for qualifying expenses of tuition and fees. This expense deduction has a phaseout. For singles it is $95,000 - $110,000 of AGI and for married it is $190,000 - $220,000.
Education Tax Credits: There are two types of education tax credits, Hope Tax Credit and Lifetime Learning Credit.
- Hope Tax Credit - A Hope tax credit of up to $ per student is available for the first two years of higher education expenses if the student carries at least one-half the normal class load. The credit is equal to 100% of the first $2,000 of eligible expenses (tuition and fees only) and 25% of expenses over $2,000
- Lifetime Learning Credit - This credit is available per taxpayer for education expenses equal to of the first of eligible education expenses (tuition and fees) for any year of higher education expenses that the Hope Credit is not used. This credit can be claimed in unlimited number of years as long as the student carries one-half of the normal class load.
Both Hope and Lifetime Learning Credits have same phase out of these benefits based on AGI of taxpayers. For Single taxpayers the phase out is: $80,000 - $90,000 and for joint taxpayers it is: $160,000 - $180,000.
