Having a child start college is an exciting part of both the college-bound student and parents’ life. Nonetheless, a child heading off on their own to college has more implications than just an empty bedroom at home. There are many financial considerations to be discussed with your advisor, such as tax dependency status, health insurance needs, available tax credits, retirement saving strategies, and more. Below are some items to consider when a child in your home heads off to college.
529 College Savings Distributions
529 plan accounts can be used for college room and board, tuition, books and supplies, including purchasing computers and internet access. Things a 529 don’t cover include health insurance, travel costs, college application fees, or extracurricular activity fees. In addition to qualified college-related costs, you can make a $10,000 per year withdrawal for K-12 school and a one-time $10,000 withdrawal to pay for student loans after college. 529 plans may now also be used to pay for fees, books, supplies, and equipment required for participation in certain apprenticeship programs.
For those who still have assets remaining in the 529 account after college, you have the option of either leaving the funds to use for other children or grandchildren, or withdrawing the funds and paying a 10% penalty as well as income taxes on any earnings on your original contributions.
Child Dependency Status
For higher income earning households, it can sometimes make sense to not claim a college student as a dependent in order to allow that student to claim the various tax credits available to lower income earners as outlined below. Regardless, you technically can claim college students as dependents until they are age 24, after which you could claim them as a “qualifying relative.”
College students who are not claimed as dependents can still remain on parents’ health insurance plans until age 26, even if they get married, have a child, or move out of their parents’ house. This is especially helpful if the parents are on a high deductible health insurance plan because the student has the option of opening their own Health Savings Account (HSA) and funding it with the max contribution of $3,600 for individual coverage as a means of a retirement savings vehicle. HSAs do not require a student to have earned income in order to contribute funds.
American Opportunity Tax Credit (AOTC)The AOTC is a $2,500 partially refundable tax credit per eligible student for the first four years of college available to individuals with modified adjusted gross income (MAGI) below $90,000 (or $180,000 for joint filers). Depending on whether your income – or your college student if they aren’t claimed as a dependent – meets this criterion, you might pay the first $2,500 of expenses directly and not from a 529 plan in order to claim the credit.
Lifetime Learning Credit (LLC)The LLC is a $2,000 not refundable tax credit per tax return for any college courses taken during four years of college or taken to improve job skills, and is available to individuals with MAGI below $69,000 (or $138,000 for joint filers). Unlike the AOTC, which can only be claimed for four years per student, this credit can be claimed an unlimited number of times. If you are looking to claim this credit and have a 529 plan, you would want to pay the first $10,000 (as the first 20% of $10,000 equals the $2,000 credit) outside of 529 plan assets.
Employer Payment of Student LoansStarting in 2020, employers can now pay up to $5,250 of an employee’s outstanding student loan balance. The payment is not considered income to the employee and is free of any FICA taxes (roughly 6.2% social security tax and 1.45% Medicare tax). For any college students who have paid internships or start post-college jobs, they should be aware of this new IRS regulation that can be negotiated into employment contracts.
Earned Income and Retirement Savings
If your college age student has earned income, you can open and fund a Roth IRA for them to jump start their investing for retirement. Roth IRA contributions can only be the lower of total earned income or the $6,000 maximum contribution for 2021. New legislation enacted in 2020 now allows taxable stipends and nontuition fellowships received by graduate and postdoctoral students to be treated as compensation for the purpose of making IRA contributions.
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Disclaimer: Information provided is for educational purposes only. Your advisor does not provide tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions. Further, your advisor makes no warranties with regard to such information or a result obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.