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Planning for Education Costs: Gift & Income Tax Strategies

Instructor: Ian Lord

Ian has an MBA and is a real estate investor, former health professions educator, and Air Force veteran.

In this lesson, we will review some of the tools available to minimize income tax payments and avoid gift taxes while saving and paying for a college education.

Tax Strategies for Education Costs

John and Sarah are looking at strategies to get their 10-year-old son, Max, through college without having to take out student loans. Along the way, they want to use any possible tax advantages available to be able to save money. Let's help them take a look at some of the options that can help save on taxes while saving and paying for college.

Income Tax Strategies

Since John and Sarah have a few years to save for college, they have time for money invested in the stock market to earn a return that can be used to pay for education. However, if they just put the money in a regular investment account, they will have to pay capital gains taxes on the profit those investments make. John and Sarah must look for tax advantaged accounts if they want to save on taxes associated with investing.

529 Plans

Fortunately, a 529 plan allows parents to place up to the annual gift tax limit into a tax advantaged account. Each state sets up its own plan, but people are free to invest in whichever plan they wish. As of 2016, the gift tax limit is $14,000 per person. There is an exception that allows parents to preload up to five years worth of funds into the 529. For example, if John and Sarah received a bonus, inheritance, or other windfalls, they could put up to $70,000 each or $140,000 total. If they put in two years worth of funds, they would be unable to put any more money into the account for two years. The account cannot have money added until time catches up to when that money could have normally been put in.

The investments in a 529 account grow tax free and may be taken out without paying taxes if used for higher education. So, not only have they made money by investing early, they avoid paying taxes that they would have paid had the money been invested in a regular taxable account. 529 plan investments are typically in mutual funds, but individual states may also offer prepaid tuition plans for schools in the state.

Since the 529 plan doesn't create a tax bill when dividends are paid out or when dividends are sold, the investment has more money in the market to keep growing. Many, but not all, states allow taxpayers to deduct the money put in the state's 529 plan, which saves money on state income taxes the year the money is invested. If John and Sarah use the earnings for something other than education, they will pay capital gains tax plus an additional 10% on the gains. There is no penalty for using the amount that was originally invested, just the profits from the investing returns.

Tax Credits

Once Max is in college, if John and Sarah are paying his tuition, they have a few tax credits available to reduce their income tax bill. Tax credits directly reduce the amount of tax owed and may be paid to the taxpayer even if the credit exceeds the tax bill in certain cases. The American Opportunity Credit can provide up to a $2,500 tax credit each year for up to four years per student. The Lifetime Learning Credit is available for as many years as allowed expenses are paid, but the credit is capped at $2,000 per tax return instead of per student. All other student circumstances being equal, such as the amount of money paid for tuition, John and Sarah will save the most on taxes by using the American Opportunity Credit if available.

Gift Tax Avoidance

We've discussed gift taxes a bit, but what exactly are they? When a wealthy person dies, the federal government levies an estate tax. Wealthy people can avoid having their estate taxed by giving away much of their assets prior to death. As of 2016, the estate tax threshold is $5.45 million; any amount held above that figure at death is subject to the tax.

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