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Tutorial - Federal tax incentives targeted to education
College Savings Tutorial
[Excerpted from Savingforcollege.com's Family Guide to College Savings]
One of the best ways to increase the affordability of your child's education is to take advantage of federal tax breaks aimed at families saving and paying for college. These include the following:
Qualified Tuition Programs (529 plans)—EEarnings grow tax-deferred and distributions are tax-free when used for qualified post-secondary education costs.
Coverdell Education Savings Accounts— Earnings grow tax-deferred and distributions are tax-free when used for qualified post-secondary education costs. ESAs can also be withdrawn tax-free for primary and secondary school expenses.
U.S. Savings Bonds—EE and I bonds purchased after 1989 by someone at least 24 years old may be redeemed tax-free when bond owners, their spouses, or dependents pay for college tuition and fees. Since 2016 the tax exclusion is phased out for incomes between $77,200 and $92,200 (between $115,750 and $145,750 for married taxpayers filing jointly). These income limits increase each year.
Individual Retirement Accounts—Early withdrawal penalties are waived when Roth IRAs and traditional IRAs are used to pay the qualified post-secondary education costs of yourself, your spouse, your children, or your grandchildren. There are drawbacks to this, however. Taxes may still be due on the withdrawals, and you may be foregoing state-specific benefits offered by alternate products. Further, while retirement assets are excluded from federal financial aid calculations, once a withdrawal is taken to pay for college, that income is considered in future calculations, and has a much higher impact on the financial aid formula.
American Opportunity Tax Credit—A parent can claim a tax credit for 100% of the first $2,000 and 25% of the next $2,000, of a dependent child's college tuition and related expenses (including course materials), for a maximum $2,500 annual tax credit per child. Students can claim the credit only if they are not claimed as a dependent on another person's tax return. The credit is phased out for incomes between $80,000 and $90,000 (between $160,000 and $180,000 for married taxpayers filing jointly). The credit is allowed only for students who are attending a degree program at least half-time and who have not completed their first four years of academic study before the beginning of the taxable year. It cannot not be claimed in more than four tax years for any one student. For eligible taxpayers—anyone beyond the "kiddie tax" age—as much as 40 percent of the credit is refundable.
Lifetime Learning Credit—A taxpayer may claim a tax credit for 20% of up to $10,000 in combined tuition and mandatory fees for themselves, their spouse, and his or her dependent children. This equates to a $2,000 tax credit. In 2016, the credit is phased out for incomes between $55,000 and $65,000 (between $110,000 and $130,000 for married taxpayers filing jointly). Claiming the American Opportunity credit described above means that you may not claim a Lifetime Learning credit for any of that student's expenses in the same tax year. There is no requirement that the student be studying towards a degree or be enrolled at least half-time, and there is no limit on the number of years the credit may be taken.
Tuition and Fees—An above-the-line deduction (this means you do not have to itemize your deductions) for up to $4,000 of the college tuition and related expenses of yourself, your spouse, or your dependent is available through the end of 2016 for taxpayers with incomes of $80,000 or less ($160,000 or less for married taxpayers filing jointly). The deduction may not be claimed if an American Opportunity or Lifetime Learning credit is claimed. This deduction is detailed in IRS publication 970
Deduction for Student-loan Interest—Up to $2,500 in student loan interest may be deducted above-the-line as long as the debt was incurred to pay the college costs for yourself, your spouse, or your dependent, while enrolled as a student at least half-time in a degree program. For 2016, the deduction was phased out for incomes above $80,000 ($160,000 for married taxpayers filing jointly). A student claimed as a dependent may not take the deduction on his or her own return.
Tax-free Scholarships—Most scholarships and grants are tax-free if the recipient does not have to provide services in exchange for the award.
Tax-free Educational Assistance—Employers may pay and deduct up to $5,250 in college and graduate school costs for each employee under a Section 127 educational assistance plan. The education does not have to be job-related. The benefit is tax-free to the employee, but cannot be used to pay for an employee's children or other family members.
For more information on tax incentives for education, see IRS Publication 970,
Tax Benefits for Higher Education, available at www.irs.gov.