Tax breaks that can help when paying for college

If you have a child that is heading off to college soon, you know how hard it is to save money for tuition. But if you think spending it is easy, think again. If you don't want to lose valuable financial aid and tax savings, how you withdraw these funds to pay for college costs really makes a difference.

For starters, when cashing in appreciated assets to pay for college, consider the different income tax brackets of the student and the parents. The parent's top rate for gains on appreciated assets is 23.8 percent. But children under age 19 and full-time college students under 24 pay no tax on the first $1,000 of unearned income, and then a 15 percent rate on the next $1,000 in capital gains.

To take advantage of the difference in the students and parents tax rates, transfer some shares of appreciated stock or funds into the student's name before selling it to use the proceeds for college costs.

However, a majority of students get some form of financial aid and that makes decisions on what to sell when even more complicated. Almost all students are eligible for one or more of the various types of student loans -- the most common form of financial aid. The federal financial aid guidelines and individual schools determine how much aid or how large a loan students can receive based on the earnings and assets of the parents and student.

According to the financial aid guidelines, students are expected to contribute 20 percent of their money toward college costs while parents are only expected to contribute up to 5.64 percent of their assets each year. So if the student and parent have $20,000 in assets each, $4,000 of the student's assets and $1,128 of the parent's assets must be used towards the cost of college.

So here's the rule to keep in mind: the more money that's in the student's name, the less financial aid you could receive. If you want to get the maximum financial aid over the period of time a student is in school, spend down the student's money sooner. Coverdell education savings accounts, formerly known as education IRAs and custodial accounts are both considered student assets. And 529 plan accounts, when the parent is the account holder, are considered the assets of the parent.

Also, some assets are not taken into account for financial aid purposes. This includes IRAs, 401(k) plan accounts and pensions. But withdrawals from these accounts are included in the income calculations and must be reported on the financial aid application that covers the year in which the withdrawals occurred. So try not to use the money from those tax protected accounts when you're applying for financial aid.

Many middle-income families qualify for tax credits and deductions when they spend money on tuition and fees for their student's education.

The American Opportunity Tax Credit allows folks to claim a tax credit of up to $2,500 when you pay $4,000 in tuition and fees. This tax credit is phased out for married taxpayers with incomes between $160,000 and $180,000 (between $80,000 and $90,000 for single filers.) This credit is only allowed for students enrolled at least half-time in a degree program and can only be claimed during their first four years of study.

Alternatively, people paying tuition and fees for themselves or a dependent may claim the Lifetime Learning Credit, which is a tax credit of 20% of up to $10,000 in covered expenses, resulting in a maximum tax credit of $2,000. This tax credit is phased out for married tax payers with incomes between $108,000 and $128,000 (between $54,000 and $64,000 for single filers.) To claim the credit, the student is not required to be enrolled half-time and is allowed regardless of the four-year requirement mentioned above.

But IRS rules prohibit "double dipping." You cannot claim both credits in the same tax year. Also, you cannot claim the tax credits for the same education expenses paid for with tax-free withdrawals or exempt interest from certain college savings investments or accounts. So if you withdrew $6,000 from a 529 savings plan, where the withdrawals are tax-free when used to pay your college bills, you would not qualify to claim the same $6,000 of expenses for the education tax credits mentioned above.

If you qualify for the tax credits, they are almost always more valuable for the average taxpayer. Make sure to spend your first $4000 to $10,000 each year from a taxable account (such as a mutual fund, savings account, custodial account) and then draw the remainder from a 529 plan or other tax-advantaged education account or investment.

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.