Military Finances 201: Getting Uncle to Help Pay for College

As an Active or Retired Senior Military Officer or NCO you have the option to use the GI Bill to help pay for college. But you might also want to take advantage of other ways the government will help you pay for Junior's college. And, by the way, I'm not talking about the Student Loan Forgiveness Program. There are basically five ways the government will help you pay for school. They are the American Opportunity Credit, the Lifetime Learning Credit, the Student Loan Interest Deduction, 529 plans and Coverdell ESAs and, finally, the Savings Bonds Interest Exclusion. Let's take a look.

American Opportunity Credit (AOC)

Since the AOC is a credit, it reduces your taxes dollar for dollar (unlike a deduction which reduces your income). The maximum allowable credit is $2,500. It is calculated as follows.

You will receive a credit for 100% of qualified education expenses up to $2,000
You'll receive a credit of 25% of the next $2,000 in qualified education expenses

The credit is only paid for the first four years of post-secondary education and the student and institution must be qualified. There is also an income limit. For those who file jointly, the credit starts to phase out at $160,000 of Adjusted Gross Income (AGI) and is fully phased out at $180,000 of AGI. For single filers, the limits are cut in half. It is worth noting that these limits are not adjusted for inflation.

Finally, the credit can be refundable which means that the credit can add to withholding and result in a refund greater than what was withheld by the taxpayer. For all practical purposes this likely only applies if the student can't be claimed as a dependent (see article below about service academy cadets/midshipmen).

Lifetime Learning Credit

The Lifetime Learning Credit can provide some assistance when the AOC can't be used. The first thing to note, is that the income limits for this credit have recently changed. Starting in 2021 the income limits were set to align with the AOC. Prior to that, the income limit was fairly low and an Active-Duty O-5 or above would have too much income to qualify for the credit.

The Lifetime Learning Credit is computed as 20% of the first $10,000 of qualified education expenses. The limit is per taxpayer not per student (unlike the AOC). So, if you have 3 kids and you're paying $30,000 in qualified education expenses, you'll only get a $2,000 credit. Also, the Lifetime Learning Credit is not limited to 4 years of post-secondary education and can be used for graduate level courses or to improve job skills. The credit is not refundable.

Student Loan Interest Deduction

If you pay interest on qualified student loans, you may be able to deduct up to $2,500. As a reminder, a deduction reduces your income subject to tax not your tax bill per se. The Student Loan Interest Deduction is taken in calculating AGI. This means that you don't need to itemize in order to take advantage of the deduction.

The downside of the Student Loan Deduction is that the deduction phases out at a lower AGI. For married couples the phase-out is from $145,000 - $170,000. For single taxpayers the phase-out is from $70,000 - $85,000. These numbers are for 2022 and they are adjusted for inflation.

529 Plans and Coverdell ESAs

At the Federal level, 529 plans and Coverdell ESAs function like a Roth IRA. You don't get a deduction when you make a contribution to these accounts. Instead, you get tax-free earnings if the distributions are used for qualified education expenses.

You can contribute quite a bit to a 529 plan (also called a Qualified Tuition Plan by the IRS). In fact, as far as income tax goes, there is no limit. With that said contributions to a 529 plan are considered a completed gift and are subject to gift reporting and potentially taxes. There is a special carve out in the Code that allows you to make up to 5 years' worth contributions and not have to file a gift tax return (you have to wait 5 more years before you can contribute again). In addition to using 529 plan distributions for qualified education expenses, you can use them to pay for student loan interest too.

Unlike 529 plans, Coverdell ESAs have contribution limits and they're kind of low. The maximum annual contribution is $2,000 (not inflation adjusted) and contributions can't be made after the beneficiary turns 18.

If you are subject to state income tax, contributions to a 529 plan may be deductible on your state income tax return.

Savings Bond Interest Exclusion

If properly titled (likely in your name), you can exclude interest earned on Series EE and I Savings Bonds from income if the proceeds from cashing the bonds are used for qualified educations expenses. The bonds must have been issued after 1989. Additionally, there is an income limit for this exclusion. In 2022 that limit is $158,650 for joint filers with a phase-out starting at $128,650. For single taxpayers the range is $85,800 to $100,800. These numbers are adjusted for inflation. The income won't be excluded on the Savings Bonds that Grandma and Grandpa gave to Junior on his birthdays.

Gotcha's

Besides all the income limit, you'll want to watch out for a thing or two. First of all, you can't double dip. As an example, if you use 529 plan funds to pay for education expenses you can't claim the AOC on the same expenses. There are penalties if you take funds out of a 529 plan or Coverdell ESA and don't use the funds to pay for qualified expenses. The penalties can be waived if you didn't need the funds due to a scholarship or Veterans' Benefits.

Military Finances are Different

Not only do you need to take the normal Tax Code into consideration when planning how to pay for school, you'll also need to account for military benefits like the GI Bill. That is the case with a lot of your financial life. That's why we think you should work with a financial planner/advisor that deals with the unique financial concerns of Active and Retired Senior Military Officers and NCOs. Use the button below to schedule a free initial consultation to find out how we do that.

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