COLLEGE SAVINGS 101

Generous tax credit on tuition

04/06/2009

QUESTION:
Dear Joe,

Can I get any tax breaks for paying my daughter's college tuition out of pocket? I am currently paying $20,000 a year for my daughter to attend college. The rest is paid through scholarships and grants.

-- Mary

ANSWER:
Dear Mary,

I've got some good news for you. The President's recently signed economic stimulus bill provides for a federal tax credit, called the American Opportunity Tax Credit, worth as much as $2,500 for college tuition paid in 2009. It's also available in 2010. The student cannot be beyond the first four years of postsecondary education.

If you or your daughter qualifies for the full credit, you will see a dollar-for-dollar reduction in your federal tax bill equal to 100 percent of the first $2,000 in "qualified tuition and related expenses" and 25 percent of the next $2,000.

The credit phases out for incomes between $80,000 and $90,000, and between $160,000 and $180,000 for joint filers. If a parent's income is above the phase-out range, but the dependent student's income is not, the credit can be claimed on the student's federal tax return provided the parent agrees to forego the dependency exemption.

Low-income taxpayers are helped further, up to 40 percent of the American Opportunity Tax Credit is refundable.

However, those taxpayers who are potentially subject to the "kiddie tax" at the parent's higher rate, including any full-time student under age 24 with earned income of less than half of his or her total support, are not eligible for the refund under the terms of stimulus.

Whenever scholarships and grants are involved, you need to be extra careful. Scholarships received for tuition are tax-free, but that tuition cannot then be used to generate a tax credit.

A better result can be achieved in some situations by allocating scholarship monies to non-tuition costs such as room and board. Although that will lead to taxable scholarship income, the tax cost to the student from reporting that income may be much lower than the value of the tax credit attributable to the tuition. With $20,000 in annual out-of-pocket costs, I suspect you will have the maximum of $4,000 in credit-eligible tuition and fees in any event. The cost of qualified course materials can be counted as well.

Plenty of other tax incentives exist for college students and their families. These include the "old" Hope credit, the Lifetime Learning credit, the tuition-and-fees deduction and the tax exclusion for redeeming qualified U.S. savings bonds. But because tax law generally does not permit double dipping, you'll have to choose among the available incentives, or coordinate their use.

IRS Publication 970 has further details concerning all of the tax incentives for higher education. Taxpayers living in Midwest areas where a major disaster was declared between May 20 and July 21, 2008, should pay attention to special rules for more generous tax savings.

For the typical undergraduate student who was not living in a Midwest disaster area, the new American Opportunity Tax Credit should be of most interest. But remember, it's available only for 2009 and 2010. The game plan shifts again starting in 2011.

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