YOUR MONEY-Navigating through a sea of college tax breaks
By Amy Feldman
NEW YORK, March 12 (Reuters) - If you have kids in college, you already know that higher education isn't getting any cheaper - some private schools will now set you back more than $60,000 a year.
You may need a high-priced education just to figure out how to write it off. The federal government offers a variety of tax breaks to lessen your burden. But they are complicated, limited and overlapping, and it is not always easy to figure out how to maximize them.
And if you've already saved money in a tax-favored 529 college savings plan, that adds another layer of complexity to your tax calculations.
Here's a brief guide for the perplexed.
THREE BIG BREAKS
There are three main educational tax breaks to consider at tax time. First, the American Opportunity Tax Credit, which offers a $2,500 tax credit per student. It is the best of the bunch.
Second, the Lifetime Learning Credit, a less-valuable credit, allows you to reduce your taxes by up to $2,000 per return.
Finally, the tuition and fees deduction lets you deduct up to $4,000 from your taxable income. Remember that a deduction, which reduces the income subject to taxes, is worth less than a credit, which lowers your tax bill dollar for dollar.
Of course, there is a catch: You have to choose which credit or deduction to take, and there's no double-dipping.
If you have one child in college, you must pick one. A family with two kids in college may be able to mix and match but can take only one credit per student. In the case of the Lifetime Learning credit, the maximum credit is $2,000 per return, regardless of how many students your family may have in school.
Making matters more complicated, all three tax breaks have different income limits and eligibility requirements on the kinds of educational costs they will cover. (For all the nitty-gritty details, see the Internal Revenue Service's publication 970, Tax Benefits for Education.)
FORMULATING A PLAN OF ATTACK
Since you cannot take more than one of these tax breaks per student, you need to prioritize. If you qualify for all of them, take them in this order: First, the American Opportunity credit; then the Lifetime Learning credit; and finally the tuition and fees deduction.
In the 28 percent tax bracket, for example, both the $2,000 and $2,500 credits will trump the $4,000 deduction, which would lower your federal tax bill by just $1,120.
The American Opportunity credit has advantages for both upper-income taxpayers and lower-income ones. It has the highest income cap of the three, partially phasing out at $160,000 in income for married couples filing jointly and disappearing completely above $180,000.
At the low end, the credit is especially valuable because it is partially "refundable," as it's known in tax lingo, meaning you can claim a piece of it even if you don't owe any tax. That's unusual; most credits can only be used to lower the tax you owe.
The caveat is that the American Opportunity credit is for undergraduate education only, and you can claim it only four years per student.
The Lifetime Learning credit, on the other hand, can be used for all post-secondary education, including courses you take to improve your job performance. A student in graduate school, for example, would qualify for the Lifetime Learning credit but not the American Opportunity credit; so, too, would someone taking a few college courses but not pursuing a degree. Since you can take it for an unlimited number of years, you also could claim it for a student who's already maxed out the American Opportunity credit.
For tax purposes, those paying for higher education will receive a Form 1098-T from the college or university. Check it over closely; some recipients have found errors on their forms that can bring unwanted attention from the IRS.
WHO TAKES THE CREDIT?
Because of the income limitations, many upper-income parents may not qualify for the education credits, though their children might. That can be a great strategy.
"I just finished somebody's return, and it saved them $800 to take the education credit on the child's return," says Bill Fleming, managing director in PwC's personal financial services division. "The kid had made money in the summertime, so was going to pay some income taxes."
The general rule is that if the parents claim their kids as dependents, only they can claim a college credit. For the student to claim the credit, he or she cannot be claimed as a dependent on the parents' tax return. That can be worthwhile if, as in Fleming's clients' case, the parents make so much that they would lose tax breaks for their kids anyway under alternative minimum tax rules.
It's a case-by-case determination, Fleming says, and you need to run the numbers. Then you need to remember from year to year which children are on the parents' tax returns.
"We are constantly doing these back-and-forth calculations," he says.
WEAVING IN THE 529 PLAN
If you've saved in a 529 college savings plan or a Coverdell education savings account, congratulations - the funds you withdraw for tuition and fees won't be taxed. But that will add another layer of complexity to your tax return.
You can't get double tax breaks for the same educational expense, 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.
Let's say you have one child in college and incur qualified educational expenses of $21,000. If you got $12,000 in tax-free assistance (from scholarships, fellowships or Pell grants), you'd have $9,000 in remaining educational expenses. You could then claim the American opportunity credit. It works on a formula in which you get to claim 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.
How much could you withdraw tax-free from your 529 plan? Subtract the eligible expenses from that $9,000 to get the answer: $5,000. If you go above that amount, you'd owe tax on the earnings, but not the principal, of that withdrawal.
So plan your withdrawals accordingly, and then give yourself a back pat: If you can work your way through all that financing, you deserve some sort of honorary degree, at least.
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