There are many ways to pay for college these days. If your grades are high enough in high school, you can earn a scholarship to a local community college for two years. If they are excellent and you have a robust extra-curricular resume, you might even receive awards from the university of your choice. There is the old fashion way of saving for college through summer jobs and working your way as you go. If you think that your earning potential is strong enough, you can take out student loans to pay your way. Or, perhaps your parents, grandparents, or quirky godparent knew you were the academic type and began buying EE savings bonds for you as a toddler. Better yet, those who were watching out for your pursuits opened a Qualified Tuition Program (QTP) for your benefit and let the earnings grow tax-deferred for years and years before you were able to take them out tax-free to pay for your degree. I went the scholarship and student loan route. It has been over fifteen years since I took my first student loan out to buy pizzas and go to the movies between hitting the books, and I have been regretting every penny of compounded interest since.
To prevent the next generation in my family from being burdened by a mountain of student loan debt, I am leaning toward setting up a QTP. He won’t know it, but by putting away up to $16,000 per year per married filing jointly tax return into a Missouri MOST plan, Little Sam will have a quite a nest egg for college by the time he turns 18. I get to deduct the contributions on my state tax return, and the earnings can grow tax-free. If I put the max annual contribution in with equal monthly payments of $1,333 for the next 18 years with an average yearly return of 6%, then I would have put $287,928 in the bank and watch it grow $236,100 tax-free to total $524,028. To put that much away each month my tax rate would probably be in the 15% marginal bracket for capital gains so that would mean I would save $35,415 in federal taxes by using the MOST plan. I would have saved an extra $16,699 in state taxes assuming an average tax rate of 5.7% for each of the years I contributed to the plan. If Little Sam finished school early and there was still some money in the plan, then I can transfer the plan to another beneficiary like his little sister and use the funds to pay for her school too. If Little Sam took an extra eight years to finish school as I did (I took a roundabout way through school) then good thing there is over half a million in the plan, we may need it all for both kids.
You could buy EE bonds once you max out the QTP annual contribution amount. The interest earned on these bonds would be tax-free as well if used to pay for qualified education expenses. With interest rates being low currently, it would be better to have the funds grow in the stock market in a QTP but make sure you structure your plan to match your risk tolerance to the volatility of the stock market.
Now, one thing to make sure is that when you go to claim the education tax credits like the American Opportunity Tax Credit, you are not using the tax-free distributions in your calculation for the tax credit. The IRS will not allow you to double stack the tax benefits of using a tax-free dollar to get a tax credit. When you withdraw funds from the QTP part of the distribution will be a return of your initial investment in the plan. This money was already taxed and can be used to claim the education credit if used to pay for college. Now you can get the benefit of both the credit and the tax-free growth offered by plans like the Missouri MOST plan.
A Qualified Tuition Program is a powerful tool to use when developing a plan to pay for college. The short-term benefits of the plans are that most states allow you to claim a deduction on your state tax return, the long-term benefit is that the earnings grow tax-deferred and can be taken out tax-free when paying for qualified education expenses. Whether you use the Qualified Tuition Program or another method of financing your education, make sure you have a plan in place as this will be one of the most significant investments in yourself, or your family, that you will ever make.
For more information on the tax implications of a Qualified Tuition Program, contact us at Abacus CPAs at 417-823-7171 or www.abacuscpas.com. Better Guidance. Smarter Decisions.
Sam Shafer, CPA