College tax 101: 4 breaks for students

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(MoneyWatch) Got college-bound kids? Congratulations and condolences. This means that your children are likely to earn better-than-average incomes someday -- if the cost of sending them to college doesn't bankrupt you first. On the bright side, the federal government offers a number of tax breaks to defray the high cost of education. But you'll have to negotiate America's ever-evolving tax code to figure out what breaks you can take and how much they'll get you.

Feel like you need a course in College Tax 101? Here's what you need to know.

Basics

There are four different college-related tax breaks currently written into federal law. Two help those who are still in the saving phase; two help those who are already paying college bills. There's a fifth break that helps graduates (and parents) who are repaying their loans. There's another deduction for tuition and fees that's expired, but some experts expect it to be brought back from the dead.

Moreover, most of the breaks in current law only last until the end of 2012. What happens then, particularly for the savings accounts that are supposed to provide tax-free withdrawals, is anyone's guess.

"There are a lot of question marks," says Jackie Perlman, senior research analyst at H&R Block's Tax Institute. "The important thing is to stay tuned and see what Congress decides to do after 2012."

What's available now?

Breaks for saving

529 plans: If you've got several years before the kids head to college, you should check out so-called 529 plans. These plans, which are sponsored by state governments, allow you to earn investment income on a tax-free basis as long as the savings are eventually used for school. Different state plans have different limits, but in many you can save up to $350,000 per child -- almost enough to get Junior through med school.

Realize that you do not need to invest in the 529 plan offered by your state. But if your state offers state income tax deductions for your contributions, you might want to. Thirty-four states and the District of Columbia offer these breaks, primarily to parents who contribute to their home state's plan (check out this piece at SavingforCollge.com for more detail). If your state does not offer a tax deduction for contributions, consider contributing to the 529 plan that has the best service and lowest costs. Some good options: The Nevada, New York and Utah plans offered by Vanguard, and the California and Oregon options managed by TIAA-CREF.

Coverdell savings accounts: These accounts, originally called "education IRAs," allow you to set aside up to $2,000 per year per beneficiary for education expenses. Contributions are not deductible, but income earned in the account is tax free, as long as the money is eventually used for qualified purposes. One unique benefit to Coverdell accounts is that the money saved in these accounts may be used for private grammar and high schools, as well as for college bills (529 plan assets may only be used for college.) The detriments: The contribution limits are relatively low, and money must be distributed by the beneficiary's 30th birthday.

Breaks for paying

American Opportunity Tax Credit: This tax break provides up to a $2,500 reduction in your federal income tax bill. However, the credit phases out for singles earning more than $80,000 and married couples with more than $160,000 in adjusted gross income. Maximum write-offs go to those who spend more than $4,000 on college costs in a single year. This break can be taken every year that you have a child in college; however, if your eligible expenses are offset by other tax breaks or you're funding college with 529 assets, you can't double-up. The best advice is to seek professional tax help, if you think you can claim more than one tax break for a single child.

Lifetime Learning Credit: This provides a credit equal to 20 percent of your eligible school expenses up to a maximum of $2,000 annually per student. The credit phases out for singles earning more than $52,000 and for married couples with more than $104,000 in adjusted gross income. It disappears once AGI exceeds $62,000 for singles and $124,000 for married couples, Perlman says.

Break for repaying loans

Student loan interest deduction: This tax break allows people repaying college loans to write off as much as $2,500 in interest costs, but starts to phase out for those earning more than $60,000 when single or $120,000 when married. It's gone completely once adjusted gross income exceeds $75,000 single or $150,000, when married, filing jointly.

(This post has been modified to correct an error about the student loan interest deduction.)

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