Tax Planning for Parents: Saving for Your Child's Education

When Maria and Tom welcomed their first child, Sophia, into the world, they were filled with excitement and hope for her future. Like many new parents, they dreamed of giving her every opportunity to succeed, including a college education. But as the years passed and college tuition rates continued to soar, they began to worry about how they would afford it. They knew they needed to start saving early, but with so many options available—529 plans, Coverdell ESAs, and more—they felt overwhelmed by the choices. As tax season approached, they realized that understanding the tax advantages of various education savings plans could be the key to securing Sophia’s future without sacrificing their own financial stability.

The Rising Cost of Education

The cost of higher education has been steadily increasing over the past few decades. According to the College Board, the average cost of tuition and fees for the 2023-2024 academic year was $39,400 at private colleges, $10,560 for in-state residents at public colleges, and $27,020 for out-of-state residents attending public universities. These figures don’t even include room and board, textbooks, and other expenses that can easily add thousands more to the total cost.

For parents like Maria and Tom, these numbers are daunting. But with careful tax planning and the right savings strategies, they can make the financial burden more manageable.

529 College Savings Plans

One of the most popular options for education savings is the 529 plan. Named after Section 529 of the Internal Revenue Code, these plans offer tax advantages that make them an attractive option for many families.

Contributions to a 529 plan are made with after-tax dollars, but the earnings grow tax-free. When the funds are withdrawn for qualified education expenses, such as tuition, fees, books, and room and board, they are not subject to federal income tax. Some states also offer tax deductions or credits for contributions to a 529 plan.

For example, if Maria and Tom contribute $5,000 per year to a 529 plan for Sophia, and the plan grows at an average rate of 6% annually, they could have nearly $154,000 saved by the time she starts college in 18 years. This amount could go a long way toward covering the cost of her education, and the tax-free growth would maximize their savings potential.

Coverdell Education Savings Accounts (ESAs)

Another option for parents is the Coverdell Education Savings Account (ESA). While the contribution limit for a Coverdell ESA is lower than that of a 529 plan—$2,000 per year per beneficiary—it offers more flexibility in how the funds can be used. Unlike 529 plans, which are primarily intended for college expenses, Coverdell ESA funds can be used for qualified K-12 education expenses as well, such as private school tuition, tutoring, and special needs services.

Similar to 529 plans, contributions to a Coverdell ESA are made with after-tax dollars, but the earnings grow tax-free. Withdrawals used for qualified education expenses are also tax-free.

For example, if Maria and Tom expect to send Sophia to a private high school, they could use a Coverdell ESA to save for both her K-12 and college expenses, giving them more control over how and when the funds are used.

Tax Credits for Education Expenses

In addition to savings plans, parents can take advantage of tax credits to offset the cost of education. The two most prominent education tax credits are the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC).

• American Opportunity Tax Credit (AOTC): The AOTC provides a credit of up to $2,500 per eligible student for qualified education expenses during the first four years of college. This credit is partially refundable, meaning that if the credit reduces your tax liability to zero, you can receive 40% of the remaining amount as a refund.

• Lifetime Learning Credit (LLC): The LLC offers a credit of up to $2,000 per tax return for qualified tuition and related expenses for students enrolled in eligible educational institutions. Unlike the AOTC, the LLC is not limited to the first four years of college and can be used for graduate courses and professional degree programs.

For Maria and Tom, understanding these credits could significantly reduce their out-of-pocket costs when Sophia goes to college. By planning ahead and keeping detailed records of their education expenses, they can ensure they’re eligible for the maximum credit amount.

Roth IRAs for Education Savings

While Roth IRAs are typically thought of as retirement accounts, they can also be used as a tax-advantaged way to save for education. Contributions to a Roth IRA are made with after-tax dollars, and the earnings grow tax-free. While distributions are usually subject to income tax if taken before age 59½, an exception is made for qualified education expenses.

For example, if Maria and Tom have already maxed out their 529 plan contributions but still want to save more for Sophia’s education, they could contribute to a Roth IRA. If they need to withdraw funds for her education, they can do so without paying a penalty, and they’ll only pay income tax on the earnings portion of the distribution.

Balancing Education Savings with Retirement

One of the biggest challenges parents face is balancing the need to save for their child’s education with the need to save for their own retirement. While it’s tempting to prioritize college savings, it’s important to remember that there are no loans or financial aid programs for retirement.

Maria and Tom decided to contribute to their retirement accounts first, ensuring they’re on track to meet their retirement goals. They then allocate any additional funds to Sophia’s education savings. By using tax-advantaged accounts like 529 plans, Coverdell ESAs, and Roth IRAs, they can maximize their savings for both goals while minimizing their tax liability.

Conclusion

Saving for your child’s education is a significant financial goal that requires careful planning and an understanding of the available tax benefits. By utilizing 529 plans, Coverdell ESAs, education tax credits, and even Roth IRAs, parents can maximize their savings and reduce the financial burden of higher education. For families who also manage a business, working with a professional who offers tax service for small business can help navigate these strategies and ensure all potential tax advantages are fully utilized. As Maria and Tom discovered, the right approach can make a world of difference in securing a bright future for their child while maintaining their own financial well-being.