Our story last week on saving for college drew a number of questions and suggestions from readers. Jennifer in California thinks we should add IRAs to the list of saving vehicles. (Good idea.) Jean in New Jersey is looking for a tax deduction for helping a niece pay tuition bills (a long shot.) And Konrad in Arkansas is worried that he may owe taxes on his supposedly tax-free 529 savings plan (and so might you if Congress doesn't act.)
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What about Roth IRA’s? The limit this year is $4,000.00. The earnings are tax free if used for education purposes. If your child decides not to go to college, you can keep the money for retirement.
-- Jennifer L., Perris, Calif.
Absolutely. Aside from the numerous plans set up specifically for college savers, IRAs are great way to set aside money and save on taxes. You get to keep control of the money, you have more investments to choose from than 529 plans and there are provisions for penalty-free withdrawals for education expenses. And of course IRAs let you grow your investments tax free. (The main different is that with a Roth IRA, which you fund with after-tax dollars, you won’t have to pay income tax when you withdraw the money.)
If your child has a summer job, you may also want to consider opening the IRA in their name. You can deduct the contributions to a traditional IRA from their earnings, cutting their tax bill. Keep reading for more on other deductions they may be eligible for.
Are there any ways that I can put money aside for my niece and get a tax deduction for myself?
--Jean P., Linden, N.J.
The simple answer? Probably not.
First of all, you can only deduct college expenses for yourself, your spouse, or a dependent. So unless your niece lives with you as a member of your household and meets the other conditions for being claimed as a dependent, you’re out of luck.
For a dependent, college expenses of up to $4,000 are deductible from your return, but you’ll have to meet several conditions. You can’t have adjusted gross income of over $80,000 ($160,000 for married couples). And only certain expenses qualify: tuition, books and fees are on the list; room and board are not.
Keep in mind that if you’ve set up an account in the child’s name that pays a substantial part of their living expenses, they may no longer qualify as a dependent on your return. Generally, you can’t claim someone as a dependent unless you’re paying at least half their support (food, clothing, shelter etc.) If your child is paying for living expenses with money from an account in their name, you’re no longer supporting them.
But losing them as a dependent may be a good thing – because it allows them to apply for the tuition deduction based on their income, not yours. So if the child’s account owes any tax on capital gains, you’ll be able to offset those with the deduction for tuition expenses. You may want to calculate the returns both ways – with or without your child as a dependent – to see which one provides the bigger tax savings.
You should also look into what’s called a Hope tax credit, which is worth up to $1,500 per student. Here again, there are restrictions: your “modified adjusted gross income” is capped at $52,000 ($105,000 for couples) and you can only take this credit for the first two years of college. (You’re also out of luck if the student has a felony drug conviction.) There’s also something called a “lifetime learning credit” – worth up to $2,000 a year per student -- which you may be eligible for.
For more on tax credits and deductions for college costs, check out Publication 970 on the IRS Web site.
WILL THE SUN SET ON 529s?
I have interest in the 529 plans, but with my children at the ages of 3 and 5, I am concerned that if the sunset provision (making tax savings permanent) is not acted upon by Congress, I may not have made the best choice in these early years. In your article you mention that Congress "has recently moved to make those tax advantages permanent". Can you provide more information? Second, I have some concern over locking up money strictly for 'college' and incurring penalties if used for other expenses. Recently I have been pitched on investing in a Variable Universal Life insurance contract. While I have determined the need for additional life insurance, can you share thoughts on using this type of vehicle for college funding? The tax advantages seem to good to be true.
-- Konrad L., Lowell, Ark.
As the law now stands, the tax advantages of state-run, 529 college savings plans expire in 2010. So you’re right: unless Congress acts, your 529 would become a taxable account, eliminating the main reason for opening one of these accounts.
This year, both the House and Senate introduced The College 529 InvEST Act (S. 1112, H.R. 2386) to make tax advantages permanent, but the bills never made it to the floor for a vote. These measures are expected to come back when Congress does and will be one of many parts of the tax code that will be up for grabs in the next few years.
With $55 billion (and counting) in these 529 accounts, extending tax breaks for college savers is a political no brainer: restoring taxes on these accounts is not going to win a lot of votes back home. But you never know. So there is a very real risk that the tax advantages of 529 accounts won't be extended.
As for using life insurance as a savings options, we're not big on the idea. The reason is that -- like all of these hybrid products -- it's very difficult to sort out how much you're paying in fees and what your true rate of return is. If you need insurance, we like the idea of buying term insurance -- but only for those periods of your life when you need it. If you’re looking for tax breaks on saving and investing for college, there are other more direct ways of doing so that don’t include hidden fees and commissions.
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