NEW YORK It's too bad colleges don't offer a class in "advanced tax strategies" to all freshmen, along with those study skills, health and diversity sessions. That extra expertise would come in handy for anyone trying to sort through the profusion of education credits and deductions that can help offset college costs.
With the annual cost of board and tuition topping $50,000 at some private colleges, and expenses dramatically rising at public universities, it's worth learning how to maximize those breaks. Here's a brief guide:
There are three main educational tax breaks, as follows: (1) the tuition and fees deduction allows you to deduct up to $4,000 from your taxable income; (2) the lifetime learning tax credit allows you to reduce your taxes by up to $2,000 per return; and (3) the American Opportunity Tax Credit offers a $2,500 tax credit per student.
The catch is that you have to choose which one to take: For one student's tuition and fees, you must pick one, as there's no double-dipping; a family with two students may be able to mix and match but can only take one credit per student. In the case of the lifetime learning credit, you can take it only once per return.
Making matters more complicated, all three tax breaks have different eligibility requirements, with caps on income -- the highest is the American opportunity credit with a cap of $180,000 for married couples filing jointly -- and restrictions on what types of education you can use them for.
The American Opportunity credit is for undergraduate education only, while the lifetime learning credit can be used for all post-secondary education, including courses taken to improve job performance. You can find all the fine print in Internal Revenue Service Publication 970 (link.reuters.com/qar27s).
CHOOSE THE BEST BREAK
Since you cannot take more than one of these tax breaks per student, apply them in this order: First, the American opportunity credit, then the lifetime learning credit and finally the tuition and fees deduction.
That's because, in general, a credit is more valuable than a deduction since it reduces your taxes, while a deduction merely lowers the amount of income that is taxed.
In the 28 percent tax bracket, both the $2,000 and $2,500 credits trump the $4,000 deduction (which will lower your federal tax bill by just $1,120).
For those who have saved in a 529 college savings plan -- which, when used for qualified education expenses, is free of federal tax -- there's the added complication of coordinating those 529 plan withdrawals with these education tax breaks. The basic rule is that you can't count the same educational expense twice, so if any part of it was already covered by tax-free scholarships, Pell grants, or these tax credits, using money from a 529 plan to cover the same expenses may trigger a tax on that withdrawal.
Here's one scenario. Say that you have one child in college, and you incur total qualified educational expenses of $21,000. First, you'd reduce that figure by any tax-free assistance, such as scholarships, fellowships and Pell grants; if you got $12,000 in tax-free assistance, you'd now have $9,000 in educational expenses remaining. You could then claim the American opportunity credit. It works on a formula in which you get 100 percent of the first $2,000 in expenses, but only 25 percent of the next $2,000, for a total of $2,500 in credits for $4,000 in expenses. So you would then subtract $4,000 (of eligible expenses) from the $9,000 figure.
Do the math, and what you have left is $5,000 of expenses that you have paid and for which you have not received any tax breaks. That is the amount you can take out of your 529 plan tax-free. If you go above that amount, you'll owe tax on the earnings, but not on the principal, of that withdrawal; you'll see those numbers on your 1099-Q, the tax form you'll receive for taking money out of a 529 plan.
Whether or not it's worth taking that tax hit depends, in part, on whether you are burning through your 529 balance quickly or you expect to have cash left over once your kids are all done with school.
Lower-income taxpayers can qualify for an education tax benefit even if they owe no tax. In fact, the American Opportunity Tax Credit is particularly valuable to low-income taxpayers because it is partially "refundable," as it's known in tax lingo, meaning you can claim a piece of it regardless of whether you owe tax or not. That's unusual -- most credits are only available if you owe tax.
AFTER SCHOOL, THE WRITEOFFS CONTINUE
Once you're out of school -- and repaying those student loans -- there's an additional tax benefit. While personal interest payments (other than for your mortgage) are generally not deductible, student loan interest of up to $2,500 is. The caveat here, again, is the income limitations; to claim the deduction, your modified adjusted gross income must be below $75,000 if you're single, or $150,000 if you're married filing jointly.
The deduction can only be taken by the person legally obligated to make the loan payments. Most new graduates paying off loans would qualify based on those income limits, and even those who don't itemize can claim it since it's technically taken as an adjustment to income rather than as a deduction on Schedule A. Even if the new grad repays the debt with a gift from her parents or grandparents, she could take the deduction -- but if her parents continue to claim an exemption for her on their tax return, neither could take that break.
While there are no changes for this tax season, the tuition and fees deduction expired at year-end 2011, and the American opportunity credit is slated to expire at the end of 2012, though President Barack Obama's budget calls for making that credit permanent.
That means if you've got a high school student in your house this year, you'll need to save a little more than you were planning to -- unless Congress extends those breaks at the last minute, as it so often does.
(The author is a Reuters columnist. The opinions expressed are his own.)