Tax Breaks for Parents and Their College Students

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Just over a month ago, I wrote New Baby? New Tax Deductions! and for many parents, it seems as if we go from changing diapers to packing the kids up to go off to college. With an in-state public college averaging over $33K for the 4 years, and private college over $120K, it’s time to look at how you can get Uncle Sam to ease the burden just a bit.

Education Credits and Deductions
Education Credits and Deductions
  • American Opportunity Tax Credit – (A modification to the Hope Credit) This tax credit is for up to $2500 per eligible student. It is available for couples filing joint with income up to $180,000 or $90,000 if single. 40% of the credit may be refundable, this means that if this tax credit is greater than your total tax for the year, you may get a check from the IRS for up to $1000 in addition to the tax you already paid.

Other requirements for this education tax credit include the fact that the student must be enrolled at least half time for at least one academic period during the tax year, and as of the end of 2011, the student must not have any felony drug convictions. Last, note that qualified expenses include not only tuition, but any enrollment fees, and required course material.

  • Lifetime Learning Credit – The rules for this credit are a bit different from the American Opportunity Tax Credit. The credit is worth $2000 per return (not per student) and there is no limit to number of years it may be taken, so long as it’s in effect. The credit may be taken for couples with income up to $122,000 or single filers with income up to $61,000. All years of post secondary school qualify for the credit as do any courses to acquire or improve one’s job skills.

The student doesn’t need to be registered for any number of classes, even just one class qualifies for the credit. Besides the tuition, fees, and books, both “supplies and equipment” also qualify. Felony drug conviction is not a disqualifier for this credit. Last, the credit in not refundable. It can only offset your tax bill, not refund in excess of what you paid.

  • The Student Loan Interest Deduction – for some time, personal interest (credit cards, car loans, etc) has not been deductible, but student loan interest might be. For those with modified adjusted gross income (MAGI) of $150,000 or less for joint filers, $75,000 if single, interest up to $2500 per year may be taken as a deduction. This is a deduction directly against your income, not subject to the need to exceed the standard deduction to get on schedule A. The interest deduction is available until the student loan is paid off, or until canceled by congress.
  • Tuition and Fees Deduction – This deduction is against income, skipping the Schedule A, and helping to reduce your taxable income if this benefits you more than either the American Opportunity Tax Credit or the Lifetime Learning Credit. The deduction is available for Joint filers whose MAGI is less than $160,000, $80,000 if single. The eligible expenses include Tuition and fees, but specifically exclude room and board.

No discussion of tax savings for college should ignore the savings accounts targeted for college expenses. Let’s take a look at the two popular ones.

  • Coverdell Education Savings Account – When first introduced, this account was called the “Education IRA” which was a bit of a misnomer as the account has nothing to do with retirement. On the other hand, it bears a striking resemblance to the Roth IRA. The deposits to the Coverdell are not tax deductible, but grow and are withdrawn tax free if used for the beneficiary’s qualified education expenses. The deposit limit is $2000 per year, and there is a limit of MAGI of $220,000, $110,000 if single to make the deposit. Any funds not used for qualified expenses must be withdrawn by the time the beneficiary turns 30. Distributions that don’t qualify for college expenses are subject to tax as well as a 10% penalty. This account may be combined with the credits and deductions above, but not for the same exact expenses.
  • Qualified Tuition Program – Commonly known as the 529 plan, this account has no income restrictions at all for deposits. The account deposit limit is currently $300,000 which is well over the amount that would be needed for any 4 year degree. Practically speaking, it’s common to limit deposits to the $13,000 gift limit ($26,000 if both parents deposit.)

One is also permitted to gift ahead up to five years with no gift tax due and not tapping into the unified lifetime gift tax amount. Withdrawals for qualified expenses are withdrawn tax free, but as with the Coverdell, tax and penalty apply if withdrawn with no qualifying expense.

One choice is to take the remaining balance and change the beneficiary for the account. Any close family member up to first cousin is eligible for the transfer. For those who are trying to get money out of their estate, this opens up the possibility to move significant sums of money out of their name to set up 529 accounts for their extended family.

There is no age restriction, so no rush to transfer funds. You can wait until your new graduate has children of her own and make them the new beneficiaries to educate the next generation. This account may be combined with the credits and deductions above (including the Coverdell), but not for the same exact expenses.

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