Jeff's Personal Finance Basics #82 - Tax... | Gather

by Jeff S.

Member since:
August 16, 2008

Tax aspects of education funding

Creating a plan for college ahead of time will save you both time and money.? Saving for your own retirement is more important than saving for college. The sooner you start saving, the better.

A Coverdell Education Savings Account

A Coverdell Education Savings Account, also known as an Education Savings Account, a Coverdell ESA, a Coverdell Account, or just an ESA, is a tax-advantaged investment account in the United States designed to encourage savings to cover future education expenses), such as tuition, books, uniform, etc.

The tax treatment of Coverdell ESAs is much the same as that of 529 plans with a few important differences. Like a 529 plan, Coverdell ESAs allow money to grow tax deferred and proceeds to be withdrawn tax free for qualified education expenses at a qualified institution. However the definition of qualified expenses in an ESA includes primary and secondary school, not just college and university. Differences with 529 plans and Coverdell are listed below:

• Coverdell ESAs have lower maximum contribution limits; currently $2K can be contributed per year per child, while 529 plans generally have no restrictions on contributions, up to the maximum lifetime contribution.
• Coverdell ESAs can allow almost any investment inside including stocks, bonds, and mutual funds, while 529 plans only allow a choice among a number of state run allocation programs. The rules for investments allowed in ESAs are the same as those for IRAs.
• Balances in a Coverdell ESA must be disbursed on qualified education expenses by the time the beneficiary is 30 years old or given to another family member below the age of 30 in order to avoid taxes and penalties; there is no age limit for 529 plans.
• Coverdell ESAs allow withdrawing the money tax free for qualified elementary and secondary school expenses; 529 plans do not. The income level of a donor may affect contributions into a Coverdell ESA, but would not affect contributions to a Section 529 plan.

529 College Plan

Since 529 plans became exempt from federal taxes in 2002, the market for them has exploded into a multi-billion dollar business. The 529 plans are tax deferred, and are sponsored by individual states, but many are open to all comers -- in state or out of state. Many are also administered by familiar investment companies. Investing in a 529 plan can sometimes compromise other financial aid. And like an IRA, the plans can limit your flexibility: Should you want to withdraw your funds for something other than college-related expenses, you'll have to pay taxes plus a 10% IRS penalty on earnings. It's also important to note that there are good plans and bad plans, making the process of choosing one a little complicated.

Hope Tax Credit (replaced by American Opportunity Credit in 2011)

The American Opportunity Tax Credit

• Worth up to $2,500
• For single filers with income below $80K (partial credit for those between $80K and $90K) and joint filers with incomes below $160K (partial credit for those between $160K and $180K)
• 100% of the first $2K in qualified tuition and related expenses; and
• 25% of the next $2K in qualified tuition and related expenses
• For the parents of a dependent student or for the student if not claimed as a dependent
• 40% of the credit ($1K) is refundable

Expenses that are?required for enrollment at an eligible school, such as:

• tuition
• fees (only if mandatory)
• books (whether bought at the school store or not)
• supplies that are necessary for a course of study
• equipment that is necessary for a course of study
• any expense that the school mandates as a condition for attendance

Lifetime Learning Credit

The Lifetime Learning Credit is a tax credit aimed at helping to offset the cost of higher education. The credit does so by reducing the taxable income for individuals paying for certain college-related expenses. The Lifetime Learning Credit allows you to take a tax credit of $2K for those qualifying expenses of an eligible student. If you're aware of the Hope Credit, then much of the Lifetime Learning information will look familiar. In 2011 and 2012, The Lifetime Learning Tax Credit applies to 20% of the first $10K of a taxpayer's out-of-pocket expenses for all students attending an institution of higher education. This means the maximum tax credit you can claim under the Lifetime Learning provision is $2K each year you qualify. The Lifetime Learning Credit eligibility rules are fairly complex. There are income limits, qualifying educational institutions, qualifying expenses, and even qualifying students. You also need to understand how the Hope and Lifetime Learning tax credits fit together. In 2011, the income limits under the Lifetime Learning program increased. You can now claim a full credit if your modified adjusted gross income is less than $50K or $100K if you file a joint return. In 2012, the income limits increase to $52K and $102K.

Student Loan Interest Deduction
You may be able to deduct interest you pay on a qualified student loan (a loan you took out solely to pay qualified higher education expenses). Generally, the amount you may deduct is the lesser of $2,500 or the amount of interest you actually paid. The deduction is claimed as an adjustment to income so you do not need to itemize your deductions on Schedule A. You can claim the deduction if all of the following apply:

• You paid interest on a qualified student loan in tax year 2011
• You are legally obligated to pay interest on a qualified student loan
• Your filing status is not married filing separately
• Your modified adjusted gross income is less than a specified amount which is set annually, and
• You and your spouse, if filing jointly, cannot be claimed as dependents on someone else's return

Next post will discuss Financial aids, good and bad

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