The federal government encourages educational savings by providing tax breaks. These include tax credits (i.e., you subtract the credit directly from the amount you pay in taxes) and tax deductions (i.e., you subtract the deduction from your income before calculating the taxes). The government will even allow you to defer paying taxes while your income grows, and, in some cases, pay no taxes on interest and earnings used for education. It may be possible to take advantage of more than one of these tax incentives for saving for college, but the process is sometimes complicated. Check with a tax professional before committing your funds in anticipation of getting these tax breaks.
Hope Scholarship Credit
The Hope Scholarship Credit may help you reduce your annual tax by up to $1,650 per eligible student, depending on how much you spend on tuition. An eligible student can be you, your spouse, or your dependent. The Hope Credit is only available for the first two years of post-secondary education per student. You cannot claim the Hope Scholarship credit if your adjusted gross income is above $57,000 for single filers, or above $114,000 if filing jointly. There are other requirements you must meet to qualify;
see IRS Publication 970, Tax Benefits for Education.
Lifetime Learning Credit (LLC)
You may use the Lifetime Learning Credit to reduce your tax by 20 percent of the first $10,000 you paid for qualified tuition and related expenses for yourself, your spouse, or your dependent(s) for whom you claim an exemption. The income limits are currently the same as for the Hope Scholarship Credit. Parents with more than one child may claim an LLC for one child and a Hope Credit for a different child in the same year. The two credits, however, may not be claimed in the same year for the same child. You cannot claim the credit if you are married filing a separate return.
Deduction for Qualified Higher Education Expenses
This deduction allows taxpayers to deduct $4,000 of qualified higher education expenses. You cannot deduct higher education expenses on your income tax return if you or anyone else claims a Hope or Lifetime Learning Credit based on those same expenses. The deduction is phased out for joint filers with income between $130,000 and $160,000 and single filers with income between $65,000 and $80,000. Check with a tax professional for the most up-to-date information.
Coverdell Educational Savings Account
You are now able to set up a plan called a Coverdell Education Savings Account (CESA) for the purpose of paying education expenses. The earnings from the account are not taxed and withdrawals from CESAs are tax-free when used to pay for qualified educational expenses. The account may be opened on the day your child is born; and contributions are allowed until your beneficiary reaches age 18.
Contributions may not exceed $2,000 per child, per year. The amount is per beneficiary, and not per contributor. So if you have three children, you could contribute up to $2,000 for each of them, bringing your total to $6,000 annually. Contributions are phased out for joint filers with income above $220,000, and single filers above $110,000. Contributions are made with after-tax dollars.
The CESA allows you to make withdrawals to pay for elementary, secondary, and college expenses. Neither ordinary income tax, nor the 10 percent penalty for premature withdrawals applies if the distribution is used for tuition, fees, books, and room and board. Currently, you may also claim either a Hope or LLC credit in the same year as the distribution. Please note that part of a withdrawal will be subject to ordinary income tax and the 10 percent penalty if you do not use the entire distribution to pay for tuition, fees, books, or room and board.
