Generous tax credit on tuition

By: Savingforcollege.com

Q:

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

A:

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.

Popular Questions

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Two kids, two 529 plans?

Dear Big Bill,
While it's possible to maintain a 529 plan in just one child's name, even when you intend to send more than one child to college, I generally recommend that families open a separate 529 account for each child.

That's assuming there is no additional cost to maintaining multiple accounts. If your 529 plan charges an annual or quarterly account maintenance fee, check to see if you can avoid the fee by signing up for automatic contributions through payroll deduction or electronic funds transfer)

With a separate 529 plan for each child, it becomes easier for you to tailor the mix of stocks, bonds and stable-principal investments (e.g., stable value, guaranteed principal and money market funds) to the particular ages of your children. When your older child is nearing high school graduation, you may want to ratchet down the level of market risk in her 529 plan. At the same time, you could keep a more-aggressive asset allocation in your younger child's 529 plan, accepting more risk for a potentially higher return. Many 529 plans offer "age-based" investment options that automatically make these adjustments as the beneficiary ages.

Separate accounts for your children also offer more gift-tax leeway. Since your 529 contributions are treated as gifts from you to the account beneficiary, your $15,000 (in 2018) annual gift exclusion will go twice as far with two accounts -- one for each child -- than with just one account.

Financial aid is another reason to recommend maintaining separate accounts. You wouldn't want the investments reserved for your younger child's future college expenses to count against your older child's financial aid eligibility. Be warned: The rules here are rather murky, and the impact of a sibling's 529 account may depend on the college's own policies as well on as the type of aid -- federal or institutional -- being sought.

Finally, I believe that separate 529 accounts allow for better family bookkeeping. There will never be any doubt as to your intention to help send all of your children to college. You'll avoid the uncomfortable position of being asked to explain to a curious 8th-grader why account statements are showing up in the mail with only a brother or sister's name on them. And in the event of your death or divorce, no matter how unlikely, your legal representatives and other family members will have less reason to question your actions in setting up and funding the 529 plans.

Even with separate accounts, you'll continue to have the flexibility to shift the money around in the future. You simply need to make sure that whenever funds are withdrawn from the 529 plan to pay for college they are coming from an account in the name of the child incurring the costs. It's a simple matter to change the beneficiary designation among family members at any time, transfer 529 funds between different family members' accounts or split one 529 account into two. The ability to move assets around the family is a key advantage of 529 plans when comparing other college-savings alternatives, such as Uniform Transfers to Minors Act, or UTMA, accounts.

Original Post: 2005-10-13
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Coverdell ESA vs. 529 Plan: Which to choose? (Script)

The Coverdell ESA and the 529 plan are both excellent college savings vehicles because they are both tax-free when used for college. But many families face a choice: do they use a 529 plan for all of their child's college savings, or do they use a Coverdell for the maximum amount of $2,000 each year and put any any extra savings above $2,000 into a 529 plan? In spite of its low annual contribution cap, Coverdell's are now attracting quite a few families. There are two major reasons for that. One is that only the Coverdell allows you to self-direct your investments, just like you might self-direct the investments in your IRA. The other is that in addition to college expenses, Coverdells can be withdrawn tax-free to pay for a broad range of K-12 expenses, while 529 plans are limited to K-12 tuition. This feature is appreciated most in families planning to send their children to private grade schools, which may include additional costs such as room and board or uniforms. A 529 plan, on the other hand, does not impose age limits or income limits like the Coverdell does and so overall we see a lot more money going into 529 plans than into Coverdells. Plus many savers are happy with the investment choices offered by the 529 plans and don't necessarily want to self-direct their investments. And don’t forget this: your state may be giving you a state tax deduction for using a 529 plan, but there are no states offering a state tax deduction for investing with a Coverdell ESA.

Learn more about Coverdell ESAs.

Original post date 2013-07-15
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