Highlights of Tax Breaks
Coverdell Education Savings Account (ESA, formerly known as Education IRA)
This trust or custodial account is created exclusively for the purpose of paying the beneficiary's qualified higher education expenses. From 2002 to 2010, it can also be used to pay expenses for grades K-12 at public or private schools. The annual contribution limit is $2000 per beneficiary from 2002 to 2010, and $500 beginning in 2011. Contributions are not deductible. Contributions must be made by the beneficiary's 18th birthday. From 2002 to 2010, special needs students are exempt from the age limit. From 2002 to 2010, not only individuals but also entities such as corporations and nonprofits can make contributions.
Distributions for qualified education expenses are tax-free. Qualified expenses do not include classes merely to improve or acquire skills. Any amounts withdrawn that are not used for qualified expenses or that are in excess of qualified expenses are taxed and subject to a 10 percent penalty tax. When the beneficiary reaches age 30, any money left will be taxed and assessed a 10 percent penalty tax. Avoid this penalty by rolling the money into an Education Savings Account for a younger family member or changing the beneficiary on the existing account.
Hope Scholarship Credit
This tax credit is only available for the first two years of post-secondary education. The credit of up to $1500 per student is calculated as 100% of the first $1100 of tuition and fees plus 50% of the next $1100 (2006; as indexed for inflation). The credit is used to reduce your income taxes, but it is not refundable if the credit reduces your taxes to less than zero. To qualify for the Hope Credit, a student cannot have been convicted of a federal or state felony involving the possession or distribution of a controlled substance. Married taxpayers must file jointly to claim the credit. This credit cannot be used for classes to improve or acquire skills.
Lifetime Learning Credit
The Lifetime Learning Credit allows a wide range of students and educational programs to qualify, including half-time degree students and adults taking classes to acquire or improve job skills. This tax credit can be as much as $2000 per tax return, calculated as 20 percent of tuition and fees up to $10,000. The credit is used to reduce your income taxes, but it is not refundable if the credit reduces your taxes to less than zero. Married taxpayers must file jointly to claim the credit.
Student Loan Interest Deduction
Taxpayers can deduct interest on qualified higher education loans as an above-the-line deduction, meaning that even those who do not itemize will be able to take the deduction. Beginning in 2011, the deduction will be limited to interest paid on the first 60 payments.
Qualified higher education loans are debts incurred to pay qualified higher education expenses for the taxpayer, the taxpayer’s spouse, or any dependent of the taxpayer as of the time the debt was incurred. Loans for classes to improve or acquire skills do not qualify. The loan must be for expenses that were paid or incurred within a reasonable period of time before or after the debt is incurred. Married taxpayers must file jointly to claim the deduction.
Qualified Tuition Programs (529 Plans)
These programs, often referred to as Section 529 plans, meet federal requirements that allow taxpayers to save for or prepay tuition for a beneficiary. Distributions used for qualified expenses are non-taxable; this rule was made permanent in 2006. Nonqualified withdrawals are subject to a 10 percent penalty tax. Tuition plans are for degree programs, not for classes to improve or acquire skills. Rollovers from one plan to another with the same beneficiary are limited to once in 12 months.
Two types of plans fall under this category. Prepaid tuition programs and savings plans.
Prepaid tuition plans: Check the prepaid plan to see what flexibility you have if the student attends an out-of-state school or a private college. Until 2002, only states could set up 529 plans. Since then, both public and private educational institutions have been able to offer prepaid tuition programs; distributions from those programs have been tax-free since in 2004.
Savings plans: Compare deferred savings plans from several states to find the best arrangement for you and your children. Evaluate the investment choices and the variety of schools that are covered. Some plans, especially the ones sold through brokers, charge high commissions and annual expenses.
Gift taxes may be owed if more than $12,000 (for 2006 and as indexed in future years) is contributed per year. However, a contribution can be treated as if made over up to 5 years, allowing single contributions of up to $60,000 (2006, as indexed) without gift tax consequences.
Employee Assistance Plans
Employers may offer programs under which employees can receive financial assistance for education of up to $5250 per year that is not reported as income, whether or not the classes are job-related. The exclusion applies to both graduate and undergraduate classes.
Savings Bond Interest Deduction
Interest from US savings bonds may be excludable from income if used to pay for higher education expenses of family members. The exclusion phases out above certain income levels. The bond owner must have bought the bond after reaching age 24 and must be the sole owner or joint owner with spouse. The interest deduction applies in the year the bond is redeemed. Married taxpayers must file jointly. This deduction applies to both EE savings bonds purchased after 1989 and the newer I-bonds that offer inflation-adjusted interest payments.
Withdrawals from IRAs
Traditional IRA. The early withdrawal penalty tax (10 percent) does not apply if the distribution is used to pay qualified higher education expenses (of taxpayer, spouse, child/grandchild of taxpayer or taxpayer's spouse). However, income tax is still due.
Roth IRA. The early withdrawal penalty tax (10 percent) does not apply if the distribution is used to pay qualified higher education expenses. You will still owe income tax on the earnings in the account. However, you may owe little or no tax since withdrawals from a Roth are treated as being taken from contributions first, and there is no tax on withdrawals of contributions. Therefore, the only tax you might owe is on any earnings you withdraw after you have withdrawn all of your original contributions. You may not owe tax even on the earnings if you meet the criteria for regular retirement withdrawals.
Education Bonds
Sometimes called college savings bonds, these are state programs that offer tax-free interest and may offer other benefits as determined by the state when proceeds are used for higher education.
