3 Important Tax Planning Tips for Parents of College Students

Paying for college can be a parent’s worst financial nightmare, especially as increases in tuition rates continue to outpace inflation. There is an upside, however, since there are certain tax breaks available if you’re covering some or all of your child’s education expenses. If your budget’s feeling the pinch, here are some tax planning tips that can make managing college costs easier.

1. Choose the Right Savings Vehicle

Stuffing extra cash under your mattress is one way to save for college but it’s not going to score you any big returns. Investing the money in a tax-advantaged account can help grow your child’s college fund that much faster and benefit your bottom line. When it comes to education savings, the two most common options are 529 plans and Coverdell Education Savings Accounts (ESA).

With a 529 plan, contributions are allowed to grow on a tax-deferred basis. As long as the money is used for qualified education expenses, any withdrawals you make are tax-free. If your child decides not to go to college or doesn’t finish their degree, you can transfer the money in a 529 account to another qualified student, including yourself or your spouse. As of 2014, you could contribute up to $14,000 per student to a 529 plan without incurring gift tax. The limit doubles to $28,000 for married couples.

A Coverdell Education Savings Account also allows for tax-deferred savings and tax-free withdrawals. The main difference is that unlike a 529 plan, you can use the money in a Coverdell account to pay for elementary or secondary expenses as well as higher education. The annual contribution limit for an ESA is much lower than a 529. As of 2014, you could only chip in up to $2,000 per student each year. Your ability to contribute is also based on your income, which isn’t the case for 529 plans.

2. Know the Distribution Rules

In order to get the biggest tax benefit from either type of savings plan you need to make sure you understand what qualifies as a tax-free withdrawal. Distributions from a 529 plan or Coverdell ESA can only be used to cover qualified higher education expenses include tuition and fees, books, supplies, equipment, expenses for special needs services and room and board expenses for students who are enrolled at least half-time. The student must also attend an eligible educational institution, which simply means any school that’s eligible to participate in federal student aid programs.

With a 529 plan, there’s no specific time for when you must begin or stop taking distributions. However, if you take money out for purposes other than education expenses the IRS considers it a taxable distribution. You’ll have to pay taxes on any earnings at your regular tax rate, as well as a 10% tax penalty unless an exception applies. Examples of situations that would qualify for an exception to the 10% rule include distributions taken because the beneficiary is deceased or becomes permanently disabled.

Generally, the same distribution rules apply to Coverdell accounts with one exception. The IRS requires all the assets in a Coverdell ESA to be withdrawn before the designated beneficiary reaches age 30 unless they’re a special needs student. If the student doesn’t use the money or it’s not rolled over to another qualifying beneficiary, you’ll be subject to a hefty tax penalty.

3. Get the Right Credit

If you’re looking to minimize your tax liability it helps to know which credits you’re eligible to claim. The American Opportunity Credit is available if you paid qualified education expenses for an eligible student. As of 2014, the credit is worth up to $2,500 of expenses per student. The credit only applies to students who haven’t completed an undergraduate degree and parents have to meet certain income guidelines. For the current tax year, the credit is phased out for married couples with a gross adjusted income of more than $180,000 and single filers making more than $90,000.

The Lifetime Learning Credit can be applied to up to $2,000 in education expenses but there’s no limit on the number of years it can be claimed. That means you can still get the credit even if you’re helping your student get through grad school. The income limits are somewhat lower, with eligibility phasing out at $127,000 for married couples and $63,000 for single filers. Keep in mind that you can’t claim both credits for the same expenses in the same year so you’ll have to run the numbers to figure out which one yields the biggest tax benefit.

Sending your child to college can put a serious strain on your wallet but you can minimize the damage with some careful planning. For more information on the different education tax benefits that are available, check out IRS Publication 970.