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| The Basics | Let Uncle Sam pay for college
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Last years tax reforms mean you can save more for college and cut what you pay in April. Here are the key deductions, credit and education accounts you shouldnt miss.
By Jeff Schnepper
Knowledge is power. And our Congress wants you to be as powerful as possible. Thanks to last years annual tax-reform bill, you and the IRS are now partners in paying your kids tuition -- from kindergarten through college! Heres how to make sure Uncle Sam contributes his fair share.
The government now can reduce what you actually pay to send a child to college and encourage you to save more for college. Knowing how the tax code affects both questions will save you thousands.
Lets start with what you can do to use your tax return to reduce your college costs.
The most lucrative tax breaks are the Hope Scholarship credit and Lifetime Learning credit. These credits are important because a credit is always better than a deduction. A $100 credit saves you $100 in tax. In the 30% bracket, a $100 deduction only saves you $30.
And these credits have already proved very popular. The General Accounting Office recently estimated that about 46% undergraduate students received an education tax credit in the 1999-2000 academic year. And 14% used the credits with other federal financial aid.
The Hope Scholarship credit
The Hope credit is only for the first two years of college. Its equal to 100% of the first $1,000 in tuition and fees, and 50% of the next $1,000, for a maximum credit of $1,500.
This credit is phased out between incomes of $40,000 to $52,000 for singles and $82,000 to $102,000 for joint filers. Its a per-child credit. When originally authorized in 1997, the government expected some 5.9 million students annually to use the credit, resulting in $5.6 billion in savings. The GAO report estimated that 17% of all undergraduate students (or their families) used the Hope credit in 1999-2000. The credit was equal to 20% of tuition and fees charged to students claimed as dependents by their families and 30% of those costs charged to students paying their own way.
Lifetime Learning credit
The Lifetime Learning credit is for use after the first two years of college. This credit is good for both undergraduate and graduate expenses.
Its 20% of up to $5,000 of qualified tuition and fees, for a maximum of $1,000. The phase-out is the same as for the Hope credit. Importantly, this is a per-family, rather than a per-child, credit. Nonetheless, the government expected some 7.2 million families a year to use it, saving $4.1 billion. The GAO report estimated that 29% of students used the credit in 1999-2000. The credit was equal to 8% of tuition and fees charged to students claimed as dependents by their families and 11% of those costs charged to students paying their own way.
College tuition deduction
You cant use this one with the Hope or Lifetime Learning credit for the same student in the same year. But, if your income is too high for those credits, you might get some relief here.
For 2002 and 2003, if your income is less than $65,000 ($130,000 on a joint return), you may deduct as much as $3,000 per year for qualified education expenses paid, above the line. That is, you can claim the deduction even if you dont itemize. For a family in the 27% bracket, being able to claim the deduction means your tax bill will drop by $810. In the 30% bracket, the deduction is worth $900 in reduced federal taxes.
Student loan interest
Uncle Sam gives you deductions and credits while youre in college. He will give you tax breaks, as well discuss, to save for college. And he also now gives you breaks after you graduate.
Your student loan interest can now be deducted regardless of the age of the loan or when it was paid. The old 60-month limit for deductibility is history.
But this benefit phases out for singles with incomes between $50,000 and $65,000, and between $100,000 and $130,000 on joint returns.
Now, lets look at funding education expenses via the tax code.
Coverdell education accounts
These vehicles, also know as Education Savings Accounts, are the old Education IRAs but with lots of new twists. You used to be able to contribute a maximum of $500 per year, and the qualifying expenses were limited to college costs.
Now, you can contribute as much as $2,000 per child and qualifying expenses have been expanded to include elementary and secondary school costs. Your contributions arent deductible, but dollars used for qualifying expenses are tax-free.
There are income limitations, but theyre easily avoided. Anyone, even a non-related party, a corporation, or the child itself can make a Coverdell contribution. If you make too much, gift the money to the child and have the low-income child make the contribution.
If you have unused Coverdell funds, you can roll them over to other family members, provided theyre under age 30, without penalty. You can also claim the Hope or Lifetime Learning credits for expenses not paid with Coverdell money.
You can now make your contribution by the due date of your return, without extensions. But make that contribution as soon as possible. If you invest $2,000 a year at 7% into a Coverdell account for 18 years, youll have $36,758 in tax-free income and a total account valued at $72,758.
Because I can use this money for elementary, secondary, and college expenses, this is the first place Id put my education savings dollars. For more information, see Saving for college? Put all your tools to work.
Section 529 accounts
Qualified State Tuition Programs allow you to purchase tuition credits or make contributions into an account to pay qualified education expenses. Contributions into these plans arent deductible and the earnings on them used to be tax-deferred.
These earnings are tax-free if used to pay qualifying college expenses. Some states, e.g. New York, even allow a state tax deduction for contributions.
You can even get super creative. Name yourself as the beneficiary of the account and save money for a two- or three-year sabbatical -- tax-free as long as it involves education at an eligible institution. Not only can you use the money for books and tuition, but you can even pay for your apartment up to the amount specified in school guidelines.
You can elect to use five years worth of annual gift tax exclusions all at once to fund these plans. With an annual exclusion of $11,000, that means a married couple can put in as much as $110,000 in one year without paying any gift tax.
For details on each states plan, check the College Savings Plans Network or Saving for college.com. (See links at left to both sites.) There are some other pitfalls -- fees are a special problem. For more information, see Maximize a 529 college savings plan.
Uniform gifts to minors accounts (UGMA)
These are the accounts that were used extensively in the past. You put dollars in the account under the childs name with you as custodian. You control the money until the child is 21, but all income generated is taxed immediately to the child, at the childs lower rate.
These accounts are currently not my favorite funding vehicle. The good news is that, subject to the kiddie tax, the income earned should generate little to no tax liability to the child, depending on the size of the account.
The bad news is that the dollars belong to the child. At age 18 or 21 depending on the state, she can take the dollars and spend them at her discretion. They need never be used for college.
If Id had access to big bucks at age 21, I would have had a great year. But, I clearly wouldnt have a whole lot of the cash left at age 22.
The child may be the beneficiary, but NOT necessarily the owner, of your Coverdell or Section 529 Accounts. For those accounts, the person making the contribution is normally the owner, and the beneficiary child has no legal access to those dollars unless the owner (you) concur.
A major trap for the unwary
Remember, UGMA dollars belong to the child. If those dollars are used for college expenses, they can qualify for credits or deductions only for the child. If the child has no tax to absorb, these credits are lost forever.
Heres the solution: Have the child take out the money and gift it to you. The child can gift as much as $11,000 each to both parents ($22,000 total), each year, without even having to file a gift tax return.
I wouldnt do this a week before the tuition is due. I dont want the IRS to have a step-transaction argument where they say the gift was to pay the tuition and should be ignored for tax purposes. The more time between the gift and the due date, the less of an argument the IRS has. But, once those gifts have been made, if you use the dollars to pay for qualified education expenses, you get the credits.
Employer-provided education
Were still not done. With all this education, hopefully youve found a job. Your employer can now provide you with as much as $5,250 a year in tax-free educational benefits. This money can be used not only for undergraduate courses, but as of this year, for graduate courses as well.
Congress has done a great job in promoting education. But, then again, even a broken watch has the right time twice a day
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