College Planning: The Tax Benefits of Education
March 23, 2011Today’s blog is the last in a series addressing the different pieces of the college planning puzzle. Last week we looked at financial aid and basically determined that no matter how much or how little we save for college, financial aid (primarily in the form of loans) will help us make up the difference. That should provide some relief, since we would like to think that our children can go to whatever school they want to no matter how expensive. At the same time the idea of our kids (and us) being saddled with debt right out of college doesn’t always sit well with us. So how do we reduce our dependency on financial aid when the amount saved is not enough? This will probably come as a shock to you (and yes, I’m being facetious), but parents and students are expected to use some of their current income to help pay for college.
So there you have it; all three pieces of the college planning puzzle: savings, financial aid, and current income.
Well, that was easy. Are we done? Unless you are renting from Hertz, not exactly.
So far we have looked at planning up to the point of going off to college, but we still have some planning to do during and after college. Specifically, there are some important tax benefits associated with paying for education, and the more familiar you are with them, the less college will cost you (and your student).
Tax credits for education
Currently, Uncle Sam offers two tax credits when you use after-tax money to pay for qualified education expenses: The American Opportunity Credit and the Lifetime Learning Credit. Qualified expenses include tuition and fees, but may also include books, supplies, and equipment when required for your course of study. Notice I said “after-tax” money. If you remember nothing else from this blog, remember this: You cannot claim a tax credit for an expense paid with tax-free dollars. For example, if you use money from a 529 plan to pay for tuition, you cannot also claim a tax credit for that same expense.
The American Opportunity Credit
An extension of the Hope Credit, the American Opportunity Credit offers a dollar for dollar tax credit on the first $2,000 of college expenses paid, with an additional 25 cents on the dollar tax credit on the next $2,000. This credit may be claimed during the first four years of your child’s post-secondary education.
The Lifetime Learning Credit
The Lifetime Learning credit offers a 20 percent credit on up to $10,000 in qualifying expenses. This credit may be claimed for any year of post-secondary education.
There are income limits, and you may not claim both credits for the same student in the same year.
Implementing a tax strategy
You may have noticed that room and board was excluded from the list of expenses that qualify for tax credits, but was not excluded from the list of qualified expenses under a 529 or Coverdell savings plan. (It’s okay if you didn’t notice, just pretend you did.) Take advantage of this information. Use tax-free money from your college savings plan to pay for room and board, and use after-tax money from your current income to pay for tuition. If you can afford to pay enough in qualifying expenses to receive the maximum tax credits available, do it. Tax credits are usually better than tax deductions, and even tax-free distributions, when paying for college.
With the cost of education skyrocketing, the idea of paying for college someday may seem a bit daunting, but understanding the different pieces of the college planning puzzle should help you maintain your sanity. There is no question higher education has value, (read more about investing in your child’s education) so look at each dollar spent as an investment in their future. Hopefully, when your student walks down the aisle to receive their diploma, they’ll appreciate all you did to get them there.
For more information on the tax benefits of education, see IRS Publication 970
