We've discussed a number of tax issues related to education, including the Lifetime Learning Credit and the HOPE Credit. But another tax-savvy way to fund college education is through a qualified state tuition program.
Certain states and agencies maintain programs that allow you to purchase certificates or make contributions to an account to pay for future education. Contributions to a qualified state tuition program are not tax deductible (the bad news), but withdrawals used to pay for qualified education expenses will only be taxable to the extent they are more than the amounts originally contributed to the program. So, while you will eventually pay taxes on the earnings, all of the earnings will be tax-deferred until they are used for qualified education expenses.
Example: Jack and Jill enrolled in a qualified state tuition program to fund their daughter's college education. Over the last 10 years, Jack and Jill invested $5,000 per year into the program. Over the years, their investments have earned $40,000. There is now $90,000 in the account: $50,000 from the contributions and $40,000 from the earnings. Because Jack and Jill used a qualified state tuition program, none of the $40,000 in earnings has been subjected to income taxes. It was all tax-deferred.
Assume now that Jack and Jill pay $90,000 for their daughter's qualified education expenses. The tax issues are that $50,000 will not be taxed whatsoever (because it is simply a return of their original contributions), and they will pay tax on the $40,000 in previously tax-deferred earnings on the account.
You may be thinking that this is no big deal, since taxes will have to be paid on the earnings eventually. True enough, but it is STILL a big deal. Since the earnings are tax-deferred, they will grow much faster than they would if they were subject to taxes on income and capital gains on an annual basis. And, not only that, Jack and Jill may be able to manipulate their income and deductions in such a way that they may pay less than their normal tax rate in the year(s) that the qualified education expenses are paid. So, this has the potential of being a VERY big deal.
Like an Education IRA, a qualified state tuition program will allow a rollover to another family member if the original beneficiary is unable (or unwilling) to use the funds for qualified expenses. But, unlike the Education IRA, there is no limit to the amount of contributions that can be made to the tuition program in any given year (but be careful about the $10,000 annual gift exclusion). And, even better, there are no adjusted gross income (AGI) phase-out limitations associated with qualified state tuition programs. This will allow many "high-income" taxpayers, who may be shut out of other tax breaks, to participate in this program.
State tuition programs are hot! Smokin'! They have become so popular that many investment firms (such as Fidelity Investments) are offering specific investment programs that will allow you to make contributions to the fund that will qualify as state tuition program contributions... regardless of your actual state of residency. They are commonly called "Section 529" programs (for the IRS code section that sets out the rules regarding the qualified state tuition program). So, check with your favorite brokerage or investment firm for additional information on the plans that might be available to you.
For more information on a specific state tuition program, contact your local state agency that established and maintains the program. In addition, you may want to read more about qualified state tuition programs in IRS Publication 970 at the IRS website.
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