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What You Need to Know to Start a Successful Education Savings Plan Thumbnail

What You Need to Know to Start a Successful Education Savings Plan


With college expenses increasing every year, it’s more important than ever to put a plan in place for saving for your children’s college years. Taking steps to save today could save your child from massive student loans in the future. This will allow them to enjoy the immense educational opportunities that the United States offers, without any of the burden.

This article discusses everything you need to know about education planning. You’ll learn about funding needs and sources, tax credits and deductions, qualified tuition plans, coverdell education savings accounts, savings bonds, financial aid, and other sources for funding education. It’ll be easy to determine the advantages and disadvantages after diving in to this information.

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Brainstorm Education Expenses You’ll Need to Pay For

Before creating an education funding plan, you’ll need to first determine what education expenses you need to save for. Here are a few examples of common college costs to take into consideration.

  • Tuition
  • Books, school supplies, and equipment
  • Lodging
  • Meals
  • Transportation
  • Entertainment
  • Travel expenses
  • Tutoring
  • Extracurricular activities
  • Clothing

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Education Tax Credits and Deductions

There are many tax advantages that come from paying for furthering a child’s education. When the time comes, speak to your accountant about which tax credits and deductions you’re eligible for.

American Opportunity Tax Credit (AOTC)

The AOTC is for qualified education expenses that are paid for an eligible student for the first four years of higher education. The maximum credit in a year is $2,500 per student, if there are $4,000 of qualifying expenses. Additionally, 40% of AOTC is refundable ($1,000), but only one credit is allowed per child. Additionally, the student must meet certain IRS requirements.

Lifetime Learning Credit

The credit provides reimbursement for qualified tuition and related expenses up to $2,000 per tax return. However, the taxpayer must spend $10,000 annually on qualified expenses to qualify for the full credit. Although, a partial credit can still be obtained with lower expenses. Only one credit is allowed per child, and the student must meet certain requirements by the IRS

Employer’s Educational Assistance Program

An employer is able to reimburse the cost of the employee’s tuition, enrollment fees, books, supplies, and equipment. These benefits will be excluded from the employees income up to $5,250 per year. However, the employee cannot claim an education credit for the same expenses unless the employee has expenses greater than $5,250.

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Deduction For Student Loan Interest

A student can deduct the interest they pay on their student loans for higher education expenses only. The interest is deductible as an adjustment to reach AGI, the maximum that can be deducted in $2,500 per year.

Section 529 Plans (Qualified Tuition Plans)

Plan Sponsors

States are allowed to enact qualified tuition programs (QTPs) in accordance with IRC section 529. Although state plans may differ from each other, they all should contain provisions that are required under IRC Section 529 which are created by eligible educational institutions. They are generally an accredited post secondary educational institution. However, to be an eligible educational institution, the plan has to receive a ruling of determination by the IRS.

The Types of Section 529 Plans (QTPs)

Prepaid Tuition Plans

Prepaid tuition plans allow a contributor to prepay tuition today at a particular school for an individual in the future. The plan will lock in today’s price, but they are still subject to risks:

  • The beneficiary may choose a different school

  • The beneficiary may not be accepted into the school

  • Therefore, Before investing in this type of plan, the participant will want to research the details of the plan

College Savings Plan

This plan allows an individual to make contributions today towards a savings fund. The earnings will grow tax-deferred, and if the proceeds are only used for higher education related expenses, the distribution will be received income tax-free as well.

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Section 529 Plan Rules

  1. The contributions must be made in the form of cash, check, money order or credit cards

  2. The plans must use separate accounting for each beneficiary

  3. Investments: A college savings plan permits the contributor to select among different investment strategies such as stock mutual funds, bond mutual funds, money market mutual funds, and age-based portfolios

  4. The account cannot be used as collateral for a loan

Advantage of 529 Plans

  1. Tax-deferred growth

  2. Tax-free distributions if used for education

  3. Removes assets from the estate

  4. Low commission and management fees

  5. Many states offer state income tax deduction for this plan contribution

  6. The owner can change the beneficiary at any time

  7. The owner gets to decide when and how the expenses are paid

  8. The amount deposited varies by state but can be as much as deemed reasonable

  9. For gift tax purposes, the contributions are treated as though they were made in a five-year period

  10. There is no phase out for contributions, even at higher AGI levels

  11. Can be coordinated with other education plan

Qualified Expenses

Qualified expenses for 529 plan purposes include tuition, fees, books, supplies, and certain room and board expenses.

Gift Tax Consequences

Contributions can be done in a split gift. For example, the donor can give half, and the donor's spouse can give another half. The contribution will be considered a complete gift of present interest, and will qualify for the annual exclusion. A five year accelerating contribution can be elected, allowing an individual to use five years worth of annual exclusion on an initial contribution.

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Change of Beneficiary

A change of beneficiary can be done at any time. However, rollovers will not be a taxable distribution if the funds are transferred to one of the following within 60 days of the distribution:

  • To another qualified tuition program for the benefit of the designated beneficiary

  • To the credit of another designated beneficiary under a qualified tuition program

Any change in the interest of the designated beneficiary is not considered a taxable distribution if the new beneficiary is already a member of the previous beneficiary’s family. A transfer of a change in the designated beneficiary, or a rollover of credits from the account of one beneficiary to the account of another beneficiary, will be treated as a taxable gift from the previous beneficiary if the new beneficiary is assigned to a lower generation than the previous beneficiary.

Example: In the first year, a parent makes contribution to a QTP on behalf of his child. In year four, the parent decides to rollover that distribution to an account for the benefit of a grandchild. The rollover is treated as a taxable gift by the child to the grandchild because the grandchild is a different generation than the child.

Funds that are Used for Non-Qualified Expenses

The earnings from the distribution will be included in the gross income of the distributee, and 10% additional tax will be applied to any distribution that is includable in gross income. However, the penalty is waived in the following cases, as long as the amount of the payment is not larger than the amount of the scholarship, allowance, or payment.

  1. Made to a beneficiary on or after the death of the designated beneficiary

  2. Made because the designated beneficiary is disabled

  3. Made because of a scholarship, allowance, or payment being received by the account holder. As long 

Distribution of Funds

Distributions are allocated between contributions and earnings.

Example: Let's say a contributor deposited $5,500 and the account had an earnings of $500. The total value of the account is now $6,000. A non-qualified distribution of $300 is taken. In this case, 90% of the distribution will be a tax-free return of basis, and 10% is earnings ($500/$6,000) subject to taxes. Therefore, $30 of the distribution (10% of $300) will be taxable.

For distributions that are made after December 31, 2017, “qualified higher education expenses” will include tuition made at elementary or secondary public, private, or religious school, up to a $10,000 limit per tax year.

Contribution Limits

Contribution limits are set differently by each state. However, contributions cannot exceed the reasonable cost for education.

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ABLE Accounts

ABLE accounts provide individuals with disabilities and their families the ability to fund a tax-preferred savings account to pay for “qualified” disability-related expenses.

Coverdell Education Savings Account (CESA)

Coverdell Education Savings Accounts are designed to offer tax benefits to individuals who want to save money for a child’s or grandchild’s qualified education expenses. This account is established with nondeductible contributions of cash.


  1. The contributions will grow tax free

  2. Withdrawals will be free from tax or penalty if they decide to use the funds for qualified education expenses

  3. Qualified education expenses include not only higher education, but also private elementary and secondary education

  4. The earnings are subject to income tax and a 10% penalty if the funds are used for anything other than qualified expenses

  5. Usually, the parent has the right to change the beneficiary to another family member at any time


Please see the IRS website for more information on the following requirements.

  1. Has to be established for any child under the age of 18 by a parent, grandparent, other family members or friends, or even by the child. They are subject to modified adjusted gross income phaseouts.

  2. Contribution requirements: Cannot be made after the beneficiary turns age 18, unless they are a special needs beneficiary and must be in cash

  3. There are phase out limits

  4. Annual contributions are allowed up to $2,000 for each beneficiary. It includes contribution from all sources

  5. Qualified education expenses for post secondary school expenses include: Tuition and mandatory fees, books, supplies, equipment for courses, room and board paid directly to the school, and special needs expenses for special needs students.

  6. In order for the school to qualify, it must be able to participate in federal financial aid programs administered by the Department of Education.

  7. Qualified education expenses for elementary and secondary school include: Tuition, fees, academic tutoring, special needs services, books, supplies and other equipment, computer technology, room and board, uniforms, transportation, and supplementary items or services required by the school.

  8. When the beneficiary turns 30, the account must be distributed to the beneficiary within 30 days unless the beneficiary has special needs. The distribution will be subject to income tax and a 10% penalty. However, the CESA may be rolled over to another family member, but if the new beneficiary is a generation below, then the rollover will be treated as a taxable gift. If the beneficiary has passed and the account has not been distributed, the account will be considered distributed and included in the beneficiary's estate.

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Gift Tax Consequences

Contributions can be a split gift. For example, half by the donor, and the other half by the donor’s spouse. Contributions are also considered as a completed gift of a present interest. This allows the contribution to be included in the annual exclusion.

Distribution and Withdrawals

Distribution or withdrawals are taken from the principal or the earnings, but the beneficiary may take withdrawals at any time. The principal is always excluded from taxes. However, earnings are only excluded if they are used for qualified education expenses. Withdrawals are tax free as long as the withdrawals don't exceed the students qualified education expenses.

Funds that are Used for Non-Qualified Expenses

The earnings from the distribution will be included in the gross income of the distributee. On top of that, a 10% additional tax will be applied to any distribution that is includable in gross income. However, the penalty can be waived if the distribution is:

  • Made to a beneficiary on or after their death

  • Made because the beneficiary is disabled

  • Made on account of scholarship

  • Coordination with tax credits

A taxpayer can still claim the American Tax Credit or Lifetime Learning Credit for a taxable year and can exclude from gross income amounts distributed from a CESA on behalf of the same student. This can be done as long as the distribution is not used for the same education expenses.

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Savings Bonds (Series EE Savings Bond)

Usually interest that is made on Series EE and I bonds that are cashed in will be considered taxable income. However, if the bonds are cashed during the year in which a taxpayer or taxpayers family member qualifies for higher education expenses, then the interest can avoid taxation. 

These limits will apply:

  • Face values that start as low as $25, and increase up to $10,000

  • Must be purchased electronically at full face value, and have varying interest rates

  • They must be purchased after 1989 to be eligible for special tax treatment

  • Qualified higher education expenses can include rolling over the earnings from the savings bonds into a qualified tuition program or a CESA

  • EE bonds must be purchased in the name of one or both parents of the student to attain tax free status

  • The parents have to be at least 24 years old before the first day of the month of the issue of the bond, they are also considered the owner of the bond

  • Owners must redeem the bonds at the same year that the students higher education expenses are paid

  • There is a phaseout for the exclusions for which the bonds are cashed and the tuitions paid

  • For the purposes of qualified higher education expenses, Series I bonds have the same tax benefits as Series EE bonds

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Government Grants and Loans (Financial Aid)

Federal Pell Grants

Federal Pell Grants are gifts from the government based on the student’s needs and cost of attending the chosen school. Those who are eligible are undergraduate students that have not previously received a bachelor's degree. The maximum award changes each year depending on the funding of the program. This is considered to be the largest need-based student aid program.

Federal Supplemental Education Opportunity Grant (SEOG)

This is a program for undergraduates with exceptional financial need. Instead of being managed by the federal government, the program is managed by each college themselves. Students are automatically considered for these grants when they submit a FAFSA form.

Federal Perkins Loan Program

This is a program that is administered by colleges, but is federally funded. The program provides loans up to $5,500 per year for undergraduate students, and $8,000 per year for graduate students. It has a cumulative limit of $27,500 for undergraduate, and $60,000 for undergraduate and graduate loans combined. The program usually has a 5% interest rate, deferred repayment, a nine-month grace period, and a maximum of 10 years to repay the loan. Students are also automatically considered if they complete a FAFSA form. The 5% interest is subsidized by the federal government while the student is still in school, and during the 9-month deferral period.

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Federal College Work-Study Program

This program is sponsored by the government, but is administered through each college. Students can work 10-15 hours per week at an on-campus job to earn a portion of their financial aid package.

Federal PLUS Loans

The loan allows the parents of undergraduate students to borrow up to the total cost of education minus any other financial aid awards. The loans are not made on the basis of financial need, but borrowers need to show that they do not have unsatisfactory credit history. The repayment of the loan has to begin within 60 days of the disbursement of the loan. Graduate and undergraduate loans are placed into deferment for an additional six months after the student ceases to be enrolled at least half-time.

Subsidized Federal Stafford Loans

The loan is given based on financial need, and the government pays the interest while the student is enrolled in college. The repayment of the loan can take up to 10 years, and is deferred until six months after the student graduates, leaves, or drops below half-time from school.

Unsubsidized Federal Stafford Loans

They are available for students that do not qualify for subsidized loans, and require additional funds. For this loan, the government does not pay the interest during the college years. However, the interest may be capitalized. The repayment rules are the same as a Subsidized Federal Stafford Loan.

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Other Funding Sources

Traditional and Roth IRAs

Traditional IRA

Usually in a traditional IRA, a taxpayer has to pay a 10% penalty if they withdraw before the age of 59-1/2. However, if they withdraw the funds from a Roth or Traditional IRA to pay for qualified higher education expenses for themselves, or their family, the penalty does not apply. Although, the taxpayer will still owe federal income tax on the amount withdrawn.

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Roth IRA

With a Roth IRA, contributions are not tax-deductible, but the contributions grow tax-free. Distributions from a Roth IRA are not included in the owner’s gross income if it is a qualified distribution. Qualified distributions are those that occur after a five-year holding period and also for: death, disability, attainment of age 59-1/2, and first-time home buyers (limit of $10,000). 

If the distribution is not a qualified distribution and exceeds the contribution to the Roth IRA, then the distribution may be subject to an income tax and 10% penalty. In addition, excess distributions can avoid the 10% penalty if the proceeds are used for qualified higher education costs. The taxpayer is also able to withdraw any amount up to the total contribution without an income tax or penalty.

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Benefits of IRAs

Distributions that are used for qualified higher education expenses are excluded from the 10% penalty, regardless of the family member’s age. Unlike CESA, which only qualifies until age of 30, funds that are not used for education can still be used for retirement. Qualified higher education expenses can include: Tuition, Fees, Room and board( if the student is enrolled at least half-time).

Home Equity Borrowing

A home equity loan is also called a home equity line of credit (HELOC). They are used to fund college related expenses. The interest rates for the loan are usually lower because of the loan being secured by the home. Interest is usually deductible as an itemized deduction for tax purposes. That being the case, a home equity loan should be a last resort.

Uniform Gift to Minors Act or Uniform Transfers to Minors Act

The act allows parents to put assets into a custodial account for their child. If the child is younger than age 19 (or 24 if a full-time student), then a portion of the unearned income such as interest and dividends may be taxed at the income tax rate of the parents. Custodial account assets are considered assets of the child and are taken into account when determining financial aid.

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College Is Getting Closer!

Use the information outlined in this article to make decisions about your education savings plan. Figure out what expenses you need to save for, how much you need to save, and which methods you will use to accumulate funds. Reach out to a financial planner if you would like a partner in reaching your education savings goals. They will guide you every step of the way and keep you accountable.

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