The Top Tax Benefits for College

college books by wohnaiWhen faced with the high cost of college, you want to find and take advantage of every opportunity that you can to cut down on your out-of-pocket expenses, before you give in and take out loans.  So after you’ve applied for all of the grants, scholarships, and other non-loan financial aid that you can, it’s time to consider what sorts of tax benefits may help out with your situation.

Credits

There are two different kinds of tax credits currently available in tax year 2010: American Opportunity Credit – This credit is available for students (and parents of students) that are in their first four years in a degree program at college.  The credit is a maximum of $2,500, and is calculated as:  100% of the first $2,000, and 25% of the next $2,000 of Qualified Higher Education Expenses (QHEE) paid for that student.  QHEE is limited to tuition, fees, books, supplies, and other equipment required for the course of education at an accredited institution of higher learning. Up to 40% of the credit can be refundable – meaning that, even if you don’t pay any tax at all, you may be eligible to receive as much as $1,000 in refunded credit.  (Note:  if you’ve been around the college tax credits block in recent years, this credit has replaced – or rather expanded – the old Hope Credit.) Lifetime Learning Credit – This credit can help you to pay for any level of postsecondary education, including professional degree courses, graduate courses, and courses to improve job skills.  The credit is equal to 20% of the first $10,000 of QHEE paid for all students on the tax return, for a maximum of $2,000 in credit for the family.  There is no limit to the number of years that this credit can be applied to.

Deductions

There are two types of deductions available for education-related expenses as well: A tuition and fees deduction is available for parents and students – which is a reduction to your Adjusted Gross Income (AGI).  Depending upon your income, you may be eligible to deduct as much as $4,000 in QHEE. In addition, a Student Loan Interest Deduction is also available to help ease the pain of those student loans after college.  This deduction also reduces your AGI – and it doesn’t just have to be for a qualified student loan.  If you’ve used a home equity loan, a credit card, or other personal loan that was used exclusively for QHEE, the interest can also be deducted.  But be careful, the exclusive use provision can catch you – if any part of the non-qualified loan is used for a purpose other than QHEE, the interest is not deductible.

College Savings Plan Benefits

There are also two types of college savings plans that can be used on a tax-benefited basis, to help you pay college expenses. Section 529 Qualified Tuition Programs – These programs, often referred to as 529 plans or QTPs, provide a vehicle for families to save up for college expenses on a tax-favored basis.  With a 529 plan, families can contribute amounts to the savings plan, and the account is invested – as the account grows, if the distributed funds are used for QHEE (in this case, including room and board), there is no tax on the growth.  The only limit to the amount of contributions is in relation to gift tax limitations – for most folks this isn’t a problem, but consult your advisor if you have questions. Coverdell Education Savings Accounts (ESA) – ESAs are similar to 529 plans, with a few differences.  ESAs can also be used for private elementary or high school expenses, in addition to QHEE.  In addition, there is a specific limit of $2,000 in contributions per student per year.  The same tax treatment as the 529 plans applies to ESAs – as long as the distributions are used for education expenses, there is no tax on growth in the account.

Coordination of Benefits

The Lifetime Learning Credit and the American Opportunity Credit cannot be claimed for the same student in the same year.  Likewise, neither credit can be applied to the same student in the same year as a tuition and fees deduction.  You also cannot claim the same expenses as the offset for distributions from a 529 or an Education Savings Account.  As you might have guessed, the same holds true for coordination between the tuition and fees deduction and a 529 or ESA – the costs used for either cannot be used for the others.
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IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

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