Tax Breaks to Help You Pay for College

It’s often said that buying a house is the largest investment most of us will ever make. But if you have a couple of children, the cost of sending them to a four-year college could exceed even that big-ticket item. Three kids—or at least one with Ivy League aspirations? That’s a house and a vacation home.

The average annual cost of tuition, room and board for a four-year in-state public college in 2021 was $22,690 a year, while the average annual cost of a four-year private school was $51,690, according to the College Board. But for Ivy League and many selective private colleges, the annual cost is more than $75,000. Fortunately, just as the government provides tax incentives for home buyers, the tax code includes a lot of credits and deductions designed to lower the cost of college.

Save Tax-Free With a 529 Plan

The most effective way to save for college is to start contributing to a 529 college-savings plan while your child is still in diapers. Contributions aren’t deductible on your federal tax return, but the money grows tax-free, and withdrawals are tax-free as long as the money is used for qualified expenses, which include tuition, room and board, books, computers, and internet access. If your child receives a scholarship and doesn’t need the money, you can change the beneficiary to another eligible child or family member.

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Some states allow you to deduct a portion of your contributions from your state taxes, usually as long as you invest in your own state’s plan (for a rundown, go to www.savingforcollege.com). If you don’t use the money for college, the earnings portion of your account will be subject to income taxes and a 10% penalty.

Some critics say 529 plans unfairly benefit well-off families, and there’s no question that you can stash a lot of money in these plans—up to $550,000 in some states. But most plans let you start small—$25 is a common minimum investment requirement, and some have no minimum. If you start early, even a modest monthly investment will add up over 18 years.

Other family members can also contribute to a 529 plan for your kids, and an upcoming change in federal financial aid rules removes a downside to those accounts. Currently, distributions from a 529 plan owned by grandparents (or other non-parents) are treated as student income on the Free Application for Federal Student Aid (FAFSA), potentially reducing the amount of financial aid the student is eligible to receive. Starting with the 2024–25 academic year, withdrawals from a grandparent’s (or other non-parent’s) 529 plan will no longer be counted as student income.

The change will benefit grandparents in a couple of ways, says Mary Morris, chief executive officer of Virginia529. By setting up their own plan (as opposed to contributing to a parent’s 529 plan), grandparents will be eligible for a tax deduction if their state offers one, even if the beneficiary lives in another state. In addition, grandparents will have the flexibility to change beneficiaries or use the money themselves if they need it, Morris says.

That’s particularly significant for grandparents who want to use a 529 plan as an estate-planning tool. The maximum amount grandparents or others can give in 2022 without filing a gift tax return is $16,000 per recipient (a married couple can give away up to $32,000 per recipient). But if you’re contributing to a 529 plan, you can combine five years’ worth of gift tax exclusions into one year, which means you can contribute up to $80,000 in 2022 ($160,000 for a married couple). In addition to jump-starting a 529 plan, this strategy will reduce the size of your estate for purposes of estate taxes. While the 2022 federal estate tax exemption is $12.06 million ($24.12 million for a married couple), several states have much lower estate-tax exemptions. And unless Congress agrees to extend the provisions in the 2017 Tax Cuts and Jobs Act, the federal estate tax exemption will drop to $5.49 million after 2025.

Grandparents (or other well-off relatives) can also reduce the size of their estates by contributing directly to your child’s school. Those payments are exempt from gift taxes as long as they’re made directly to the child’s college or university to cover the cost of tuition. Some grandparents may prefer this option over a 529 plan because it allows them to maintain control of their money until the child attends school. However, these payments may reduce the child’s eligibility for financial aid. And with the change in federal financial aid rules set to take effect in two years, college-savings plans may be a better option.

Using Savings Bonds to Save for College

In recent months, yield-starved, risk-averse investors have piled into inflation-adjusted Series I savings bonds, which are paying an annualized rate of 9.62% for bonds sold from May through October. In addition to providing high returns, these bonds could provide a tax-efficient way to save for college.

Under certain conditions, interest from EE or I savings bonds is tax-free if the money is used to pay for college tuition and fees for yourself, your spouse or a dependent. You may also qualify for the tax exclusion if you redeem the savings bonds and deposit the money in a 529 plan within 60 days.

To qualify for this tax break, the savings bonds must be issued in your name (or in the name of you and your spouse as co-owners), not your child’s. The original owner must also be at least 24 years old on the bond’s issue date. There are also income limits on this tax break: For 2022, the exclusion phases out if your modified adjusted gross income is between $85,800 and $100,800 for single filers and between $128,650 and $158,650 for married taxpayers filing jointly. These thresholds are adjusted annually for inflation, so if your child is still years away from college, it’s difficult to predict whether you’ll qualify for the tax break when you redeem your bonds.

The maximum you can invest in I bonds is $10,000 a year (if you’re married, you and your spouse can save up to $20,000). You can buy an additional $5,000 in paper bonds with your income tax refund. When you buy savings bonds, you must hold them for at least one year. If you redeem them before five years have elapsed, you’ll lose the previous three months of interest. Note that if you already have some EE or I bonds stashed in a drawer somewhere, you may be able to redeem them tax-free, assuming you meet the income restrictions. The exclusion applies to EE bonds issued after 1989 and all I bonds.

Tax Breaks When You’re Paying for College

No matter how diligently you save, there’s a good chance you’ll have to write some checks when your child starts school. The good news is that you may be able to get some of that money back when you file your taxes.

The American Opportunity tax credit is your first stop. This credit, available for expenses incurred by students who are in their first four years of undergraduate study, is worth up to $2,500 in costs for tuition, fees and books per child. If you have more than one child in college, you can claim more than one American Opportunity credit.

There are income limits: In 2022, the credit phases out for single tax-payers with modified adjusted gross income of between $80,000 and $90,000 and for married taxpayers who file jointly with MAGI between $160,000 and $180,000.

If your child doesn’t qualify for the American Opportunity credit, you may still be able to claim the Lifetime Learning credit, which is worth up to $2,000 in 2022. Unlike the American Opportunity credit, the Lifetime Learning credit is not limited to undergraduate educational expenses, nor does the credit apply only to students attending at least half-time. There’s also no limit on the number of years the credit can be claimed for each student. You can claim the credit for yourself, your spouse or your dependent for up to $2,000 per family each year. The credit phases out if your MAGI is between $80,000 and $90,000 for single taxpayers and $160,000 and $180,000 for married couples who file jointly.

Scholarships can provide much-needed funds for college, and in many cases the money is tax-free—but not always. A scholarship or fellowship grant is excluded from taxable income if the money is used for tuition or fees required for enrollment or attendance, or for books, supplies, equipment or other expenses that are required for a class. If the scholarship exceeds your child’s education expenses or is designated for noneducational purposes, such as room and board, the money is taxable. Likewise, the money is taxable if the scholarship represents payment for teaching, research or other services.

Tax Breaks for College Loan Interest

If your savings fail to cover the cost of college, you or your child may need to take out student loans to cover it. Once you or your child starts repaying those loans, you may be able to deduct up to $2,500 in interest on your federal tax return. The deduction is claimed as an adjustment to income, so you can claim it even if you don’t itemize. However, the deduction phases out if your MAGI is between $70,000 and $85,000 (between $140,000 and $170,000 for joint filers).

If you’re paying your child’s student loans, your child can still claim the deduction because the IRS treats the transactions as if the money were given to the child, who then paid the debt. You can’t claim the interest deduction, even if you’re footing the bill, because you’re not liable for the debt. However, if you took out a federal parent PLUS loan to help your child pay for college and fall within the income thresholds above, you can and should claim the tax deduction.