Here's a refresher course on tax breaks for college

PERSONAL FINANCE

Tax breaks for college can help

February 08, 2004|By EILEEN AMBROSE

PARENTS AND students might feel they can't catch a break against rapidly rising college tuition.

But Uncle Sam can help ease the pain, at least during tax season. There are tax breaks for those in college, already out or years away from it.

Still, the government doesn't make it easy. Many tax breaks have different income requirements or gradually phase out as earnings rise. Or, by using one tax perk, you're prevented from claiming another.

And many tax breaks created in the past few years have different expiration dates. President Bush wants to make these tax cuts permanent, although a growing deficit might stand in the way.

"The biggest issue with education tax breaks is the confusion that accompanies them," said Gail Perry, an Indianapolis accountant. "It's difficult for the average taxpayer to understand which tax break is going to get them the best savings. You really need to experiment with each one and see which one gives you the better deal."

Even if you didn't qualify for certain tax breaks last year, it's worth reviewing them again.

"There are so many little quirks that change year to year," said Ingrid K. Lamb, an accountant with Bayview Financial Consulting in Chesapeake Beach.

Often the changes increase deductions and income limits, making more people eligible, she said.

Here's a refresher course on some breaks:

Hope credit. This is available for the freshman and sophomore years of college. Students must attend school at least halftime.

Under the formula, a taxpayer receives a credit of 100 percent of the first $1,000 spent on tuition and fees related to coursework, and 50 percent of the next $1,000 spent. Maximum credit: $1,500. Credits are better than deductions. Deductions reduce the amount of income to be taxed. Credits reduce the tax bill, dollar for dollar.

The Hope credit gradually phases out. You can no longer claim the credit once adjusted gross income reaches $51,000 for singles and $103,000 for married joint filers.

Lifetime Learning credit. It's not just for young college students. Those long past the age of comfortably pulling all-nighters the day before finals can qualify, too, if, say, they are taking continuing education classes for work.

Income limits for eligibility are the same as for the Hope credit. But filers can't claim both credits at the same time.

Which is better? "If you're paying under $7,500 in tuition, then the Hope will give you a better deal if you qualify," Perry said.

Tuition and fees deduction. You can't take this deduction along with the Hope or Lifetime credit. But the deduction is an alternative if you don't qualify for a credit because of income.

This tax-filing season, you can deduct up to $3,000 of tuition and fees paid last year. The deduction goes up to $4,000 for expenses incurred this year and next year, and then is set to disappear, Lamb said.

The deduction is available to singles with adjusted income of up to $65,000 and joint filers with income of up to $130,000.

Interest deduction. Borrowers can deduct up to $2,500 in interest paid each year on student loans for as many years as it takes to repay the debt. The deduction used to apply only during the first five years of repayment.

Single filers with income of less than $65,000 and joint filers with income of less than $130,000 may be eligible for a full or partial deduction.

For families trying to save for college, here are some tax-favored options:

529 plans. There are two kinds, and neither has income limits.

A prepaid tuition plan allows people to lock in the cost of tuition by paying in advance. In a college savings plan, individuals often can invest more than $200,000 in a selected group of mutual funds. The amount they end up with for college depends on the funds' investment performance.

Money in both plans grows tax-deferred, and investment gains won't be taxed upon withdrawal as long as the cash is used for college. If it's not, investment gains will be taxed as ordinary income and investors will pay a 10 percent penalty. Be aware that tax-free withdrawals will disappear in 2011 unless the tax break is extended.

States sponsor college savings plans, and investors don't have to stick with their home-state plan. Still, it's a good idea to check your state's plan for any additional tax sweeteners, Lamb advised. Marylanders, for instance, can deduct up to $2,500 in annual contributions on state tax returns.

If you shop around for a plan, don't forget to compare fees and commissions, Lamb advised.

Coverdell Education Savings Account. This tax-deferred account allows families to save up to $2,000 a year for each child younger than age 18. That's peanuts compared with a college savings plan, but the Coverdell has other virtues.

You control how the money is invested. Tax-free withdrawals can be made for education expenses from kindergarten through college.

And these tax-free withdrawals aren't scheduled to disappear the way 529 plans are, although Coverdell's contribution limits are set to drop back to $500 a year in 2011.

Contributions can be made by singles with income of less than $110,000 and joint filers with income of less than $220,000.

Savings bonds. Some or all of the interest earned on Series EE bonds issued after 1989 or I bonds won't be federally taxed if the bonds are used to pay college tuition and fees, Lamb said. Interest won't be taxed either if the bonds finance a Coverdell or 529 plan, she said

This tax break phases out as income rises. Singles with income of less than $73,500 and joint filers with income of less than $117,750 may be eligible for a full or partial tax break.

To suggest a topic, contact Eileen Ambrose at 410-332-6984 or by e-mail at eileen.ambrose @baltsun.com.

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