If you’re a parent with a college-bound child, you may be concerned about being able to fund future tuition and other higher education costs. You want to take maximum advantage of tax benefits to minimize your expenses. Here are some possible options.
Series EE U.S. savings bonds offer two tax-saving opportunities for eligible families when used to finance college:
- You don’t have to report the interest on the bonds for federal tax purposes until the bonds are cashed in, and
- Interest on “qualified” Series EE (and Series I) bonds may be exempt from federal tax if the bond proceeds are used for qualified education expenses.
To qualify for the tax exemption for college use, you must purchase the bonds in your name (not the child’s) or jointly with your spouse. The proceeds must be used for tuition, fees and certain other expenses — not room and board. If only part of the proceeds is used for qualified expenses, only that part of the interest is exempt.
The exemption is phased out if your adjusted gross income (AGI) exceeds certain amounts.
A qualified tuition program (also known as a 529 plan) allows you to buy tuition credits for a child or make contributions to an account set up to meet a child’s future higher education expenses. Qualified tuition programs are established by state governments or private education institutions.
Contributions aren’t deductible. The contributions are treated as taxable gifts to the child, but they’re eligible for the annual gift tax exclusion ($15,000 for 2021). A donor who contributes more than the annual exclusion limit for the year can elect to treat the gift as if it were spread out over a five-year period.
The earnings on the contributions accumulate tax-free until college costs are paid from the funds. Distributions from 529 plans are tax-free to the extent the funds are used to pay “qualified higher education expenses.” Distributions of earnings that aren’t used for qualified expenses will be subject to income tax plus a 10% penalty tax.
Coverdell education savings accounts (ESAs)
You can establish a Coverdell ESA and make contributions of up to $2,000 annually for each child under age 18.
The right to make contributions begins to phase out once your AGI is over a certain amount. If the income limitation is a problem, a child can contribute to his or her own account.
Although the contributions aren’t deductible, income in the account isn’t taxed, and distributions are tax-free if used on qualified education expenses. If the child doesn’t attend college, the money must be withdrawn when he or she turns 30, and any earnings will be subject to tax and penalty. But unused funds can be transferred tax-free to a Coverdell ESA of another member of the child’s family who hasn’t reached age 30. (Some ESA requirements don’t apply to individuals with special needs.)
These are just some of the tax-favored ways to build up a college fund for your children. Once your child is in college, you may qualify for tax breaks such as the American Opportunity Tax Credit or the Lifetime Learning Credit. Contact us if you’d like to discuss any of the options.
© 2021 Covenant CPA
When investing for retirement or other long-term goals, people usually prefer tax-advantaged accounts, such as IRAs, 401(k)s or 403(b)s. Certain assets are well suited to these accounts, but it may make more sense to hold other investments in traditional taxable accounts.
Know the rules
Some investments, such as fast-growing stocks, can generate substantial capital gains, which may occur when you sell a security for more than you paid for it.
If you’ve owned that position for over a year, you face long-term gains, taxed at a maximum rate of 20%. In contrast, short-term gains, assessed on holding periods of a year or less, are taxed at your ordinary-income tax rate — maxing out at 37%. (Note: These rates don’t account for the possibility of the 3.8% net investment income tax.)
Choose tax efficiency
Generally, the more tax efficient an investment, the more benefit you’ll get from owning it in a taxable account. Conversely, investments that lack tax efficiency normally are best suited to tax-advantaged vehicles.
Consider municipal bonds (“munis”), either held individually or through mutual funds. Munis are attractive to tax-sensitive investors because their income is exempt from federal income taxes and sometimes state and local income taxes. Because you don’t get a double benefit when you own an already tax-advantaged security in a tax-advantaged account, holding munis in your 401(k) or IRA would result in a lost opportunity.
Similarly, tax-efficient investments such as passively managed index mutual funds or exchange-traded funds, or long-term stock holdings, are generally appropriate for taxable accounts. These securities are more likely to generate long-term capital gains, which have more favorable tax treatment. Securities that generate more of their total return via capital appreciation or that pay qualified dividends are also better taxable account options.
Take advantage of income
What investments work best for tax-advantaged accounts? Taxable investments that tend to produce much of their return in income. This category includes corporate bonds, especially high-yield bonds, as well as real estate investment trusts (REITs), which are required to pass through most of their earnings as shareholder income. Most REIT dividends are nonqualified and therefore taxed at your ordinary-income rate.
Another tax-advantaged-appropriate investment may be an actively managed mutual fund. Funds with significant turnover — meaning their portfolio managers are actively buying and selling securities — have increased potential to generate short-term gains that ultimately get passed through to you. Because short-term gains are taxed at a higher rate than long-term gains, these funds would be less desirable in a taxable account.
Get specific advice
The above concepts are only general suggestions. Please contact our firm for specific advice on what may be best for you.
Sidebar: Doing due diligence on dividends
If you own a lot of income-generating investments, you’ll need to pay attention to the tax rules for dividends, which belong to one of two categories:
- Qualified.These dividends are paid by U.S. corporations or qualified foreign corporations. Qualified dividends are, like long-term gains, subject to a maximum tax rate of 20%, though many people are eligible for a 15% rate. (Note: These rates don’t account for the possibility of the 3.8% net investment income tax.)
- Nonqualified.These dividends — which include most distributions from real estate investment trusts and master limited partnerships — receive a less favorable tax treatment. Like short-term gains, nonqualified dividends are taxed at your ordinary-income tax rate.
© 2018 Covenant CPA