Updated August 3, 2023

The cost of attending colleges and universities in the U.S. is among the highest in the world, according to the latest OECD statistics. For college students in the 2022-2023 academic year, the average cost of tuition and fees was $39,400 at private colleges, $10,940 at in-state public colleges, and $28,240 at out-of-state public colleges – even without counting room and board [1]. Luckily there are tax credits, benefits, and savings strategies available to pay for college, and we outline some options below.

Qualified Tuition Programs (529 Plans)

529 plans are qualified tuition programs, utilized by states, which permit an individual to make contributions to an account that pays for the higher education expenses of a stated beneficiary. Educational institutions can also create these plans, but they require the account owner to prepay their expenses. The money withdrawn from 529 plans to pay for the student’s expenses is not taxed while they are attending college.

There are many advantages to setting up a 529 plan for a student. 529 plans are simple to set up and the beneficiary can easily be changed to another family member. Distributions (withdrawals) made from 529 plans can be made to the beneficiary, the account owner, or directly to the educational institution. Distributions should be timely, meaning they should be made in the same calendar year as the college semester it is covering.

What to do with 529 over-withdrawals:

The account owner should not withdraw more than qualified educational expenses (“excess withdrawals”). Excess withdrawals from a 529 plan would result in income tax and a 10% penalty on the earnings for any amounts not used for qualified education expenses. In this situation, the account owner has until December 31 of the same year to take corrective actions to avoid the tax and penalty. The account owner may choose to recontribute or roll over such excess withdrawals within 60 days. The over-withdrawn funds could be deposited into another 529 account, which can either be for the same beneficiary or a different one. This “recontribution” must happen within 60 days of the withdrawal.

New 529 Rollover Option:

Many families have concerns about their remaining contributions after paying for college with 529 plans because non-qualified withdrawals result in penalties. This causes families to underfund their plans. Congress has responded to this situation and created a new rollover option with the Setting Every Community up for Retirement Enhancement (SECURE) Act 2.0, which was passed in 2022.

Starting in 2024, 529 beneficiaries can roll over up to $35,000 to a to a Roth IRA over their lifetimes, without taxes or penalty, as long as requirements are met. This diminishes the risk from overfunding, allows account owners to avoid withdrawal penalties for non-qualified expenses, and encourages more contributions to be made to 529 plans. In order to utilize this 529 rollover option, the following requirements must be met:

  • The beneficiary of the 529 plan must be the account holder of the Roth IRA;
  • The 529 plan must have been open for at least 15 years for the rollover to be free of tax or penalty;
  • The rollover is subject to the annual contribution limits set for Roth IRAs. For 2023, the Roth IRA contribution limit is $6,500 ($7,500 if age over 50) or earned income, whichever is less. “Earned income” is money received for work performed, such as wages, salaries, compensation from self-employment, etc. One cannot exceed these annual roll over limits in one year;
  • 529 contributions must have been made more than five years ago. Contributions made within five years of the rollover date cannot be rolled over.

Coverdell Education Savings Accounts

Coverdell education savings accounts, also referred to as Coverdell ESAs, are trusts or custodial accounts created to pay for the college expenses of a stated beneficiary. Coverdell ESAs are similar to 529 plans in principle, but they differ in distinctive ways. The beneficiary of a Coverdell ESA must be under eighteen or have special needs. Additionally, the creation of the account must be documented in writing, specifically stating it is a Coverdell ESA. There are income restrictions for account creators and contributors. Contributions to ESA accounts are not deductible, but they are tax free. The contributions for these accounts cannot exceed $2,000 in a year, and this amount should be the total for all accounts with the same beneficiary.

Distributions from a Coverdell ESA cannot exceed the beneficiary’s college expenses. If they do, the money will become taxable to the beneficiary. Enduring funds in Coverdell ESAs must be distributed within 30 days of the beneficiary reaching 30 years-old, unless the beneficiary has special needs. Enduring funds must also be distributed if the beneficiary passes before reaching 30. In this circumstance, the funds must be distributed within 30 days of that date. The remaining funds can be distributed to another beneficiary, such as another family member under the age of 30.

IRA Withdrawals for College Costs

Individual retirement accounts (IRAs) are tax-deferred investment accounts that an individual can use to save for retirement. There are two types of IRAs: traditional and Roth. Both types of IRAs can be used to fund education costs.

Ordinarily, IRA withdrawals made before the IRA owner reaches 59 ½ can result in a tax penalty. However, if the withdrawal is used toward a qualified education expense, the penalty may not be incurred.

If you are planning to use IRAs for college, a Roth IRA may be more beneficial than a traditional IRA because Roth distributions are tax-free. When using a Roth IRA to pay for college, keep in mind that despite the withdrawal being tax-free, the amount withdrawn will impact overall retirement savings.

With the new 529 rollover to Roth IRA provision (discussed above “New 529 Rollover Option”), families now could craft powerful tax savings strategies by using Roth IRAs to directly pay for college costs or rolling over unused 529 to Roth IRA for their children (or other 529 beneficiaries). It is important to carefully review overall retirement savings and tax-free growth within these accounts for the best timing of withdrawals to make them tax-free/penalty-free.

Tax Credits for College

Tax credits are helpful because they reduce the amount of income tax you owe on your return dollar-for-dollar. There are two credits usable by taxpayers: the American Opportunity Tax Credit and the Lifetime Learning Credit. General requirements for tax credits are that the funds pay for qualified education expenses for higher education, that the enrollment is at an eligible educational institution, and that the chosen student is your spouse, yourself, or a dependent listed on your tax return. Both credits cannot be claimed for the same student but can be claimed for different students on the same tax return. There are some rules that differentiate the credits.

The American Opportunity Tax Credit (AOTC) provides up to $2,500 credit per eligible student. Its limit on modified adjusted gross income (MAGI) is $180,000 if the related taxpayer is married filing jointly and $90,000 if the taxpayer is single, head of household, or a qualifying surviving spouse. 40 percent of the credit (up to $1,000) may be refundable; however, the rest is nonrefundable. It is available only if the student had not completed their first four years of postsecondary education before 2022.

The Lifetime Learning Credit (LLC) provides up to $2,000 of credit per return. The limit on MAGI for the LLC is the same as the limit for AOTC for both single and joint filers. The credit is worth 20 percent of the first $10,000 of college expenses or $2,000 per return. It is used to pay toward taxes owed and is not refundable. This credit can be used for an unlimited number of tax years, since it can be claimed all years of higher education and for job skill related courses, meaning a claimant does not need to be in the pursuit of a degree to qualify.

College Planning

There are many methods of payment that students and families should be aware of when making college decisions. Students should not feel dissuaded from enrolling in college due to its costs. There are many programs, plans, credits, and benefits available for families. Knowing how to utilize these options and understand their updates will keep students enrolling in college.

[1] https://www.collegedata.com/resources/pay-your-way/whats-the-price-tag-for-a-college-education

GRF Can Help

When it comes to saving for a college education, the key is starting early. Taxpayers should do their homework on the advantages of various savings programs and talk to a tax advisor about the best tax strategy. For more information about tax-smart college saving, contact Jennifer Galstad-Lee at the contact info below.

Jennifer Galstad-Lee, CPA, JD

Former Senior Manager, Tax