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No simple course in understanding college tax breaks

By Avrum D. Lank
Milwaukee Journal Sentinel

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MILWAUKEE — Figuring out how to make the most of tax breaks available to help pay for college is getting harder.

To encourage Americans to save for and finance higher education, Congress has enacted a thicket of sometimes contradictory rules and regulations.

The problem becomes more apparent this time of year, when taxpayers are confronted with the choices they must make to fill out a Form 1040.

So hazy is the situation that the government estimates "the average taxpayer misses out on $400 worth of savings by filing the wrong combination of tax credits or deductions," according to the College Loan Corp. in San Diego.

College and taxes • Deduction for student-loan interest: Up to $2,500 in student-loan interest payments can be deducted from taxable income. Eligibility varies with income. The amount is gradually phased out between $50,000 and $65,000 in modified adjusted gross income for single taxpayers and between $100,000 and $130,000 for married taxpayers filing jointly. The deduction is not available for married taxpayers filing separately. • Lifetime Learning credit: A nonrefundable tax credit of up to $2,000 per return can be claimed if you paid qualified education expenses for yourself, your spouse or a dependent for whom you claim an exemption on your tax return. Eligibility varies with income. The amount is gradually phased out between $41,000 and $51,000 in modified adjusted gross income for single taxpayers and between $83,000 and $103,000 for married taxpayers filing jointly. • Savings bonds: Individuals can cash in qualifying U.S. savings bonds and exclude some or all of the interest earned on the bonds from their income if they use the proceeds for education expenses and meet other conditions. • Hope scholarship tax credit: A nonrefundable tax credit of up to $1,500 for each eligible student in the household is available to cover tuition and fees required for the first two years of an undergraduate (degree) program or other recognized education credential. Students must be enrolled at least half time for at least one academic period beginning during the year. Eligibility for the credit varies with income. The amount is gradually phased out between $41,000 and $51,000 in modified adjusted gross income for single taxpayers, and between $83,000 and $103,000 for married taxpayers filing jointly. • Tax-free withdrawals from traditional or Roth IRAs: Taxpayers can avoid paying the additional 10 percent tax on early withdrawals if the money is spent on qualified higher-education expenses. You can avoid the tax if the money is spent on education for yourself, your spouse, your child or grandchild, or your spouse's child or grandchild. • Tuition and fees deduction: For filing your 2003 returns, up to $3,000 can be deducted from taxable income for tuition and fees required for attendance at an eligible college, university or vocational school. For next year's filing, the maximum deduction will increase to $4,000. Eligibility for the credit varies with income. The deduction is not available for single taxpayers whose modified adjusted gross income is more than $65,000, married taxpayers filing jointly whose modified adjusted gross income is more than $130,000, and married taxpayers filing separately. Deduction cannot be taken if the taxpayer or someone else claims the Hope scholarship tax credit or a Lifetime Learning credit for the same student in the same year. • Employer-provided educational assistance: Up to $5,250 in educational assistance received from employers may be excludable from wages and other compensation reported on Form W-2. • Deductions for work-related education: Workers taking college courses directly related to their job may be able to deduct many of the costs of education as a business expense, including tuition, books, supplies, lab fees and certain transportation or other fees. Education must be to maintain or improve skills in your job or must be required by an employer or by law. To claim this deduction, employees must itemize deductions on Schedule A; the self-employed must file a Schedule C or F with their tax return. • Coverdell ESA: A savings account that grows tax-free can be set up to pay the qualified educational expenses of a designated student who must be under 18 or have special needs at the time the account is established. Any individual, including the student, can contribute to the account if the person's income is under $110,000, or $220,000 for a joint return. The maximum annual cash contribution is $2,000 per student, no matter how many contributors to the account. Generally, withdrawals from these accounts are tax-free if they do not exceed the student's qualified education expenses for the year. • 529 plans: These are established by states and private institutions and allow individuals to prepay or contribute to an account for paying a student's qualified educational expenses. No tax is due on distributions from state-sponsored plans unless the amount distributed is greater than the student's adjusted qualified education expenses. Beginning in 2004, distributions from a 529 established by an eligible education institution (private college or university) will also be excludable from income if the amount distributed is used to pay qualified education expenses. In addition, states may allow deductions for contributions on their own income tax.

One thing the tax forms make clear: Being able to take best advantage of the system is a long-term enterprise.

"It is matter of planning in advance," said Robert Dignan, president of Cardinal Investment Services, Wauwatosa, Wis. "Most people from a common-sense standpoint try to balance what they take out of pocket versus what they take out of savings."

That is because the tax code rewards both activities, but in different ways.

Saving is encouraged by tax breaks for two types of special accounts, those set up under Section 529 of the Internal Revenue Code and Coverdell accounts.

Each allows money to accumulate and be withdrawn tax free to pay for educational expenses under certain circumstances. Both are very good tools for saving money for college.

But once expenses start to pile up, the tax code contains other goodies, allowing both deductions and credits for some education costs in some circumstances.

Additional information on the tax breaks is available in Internal Revenue Service Publication 970, available on the Internet through the IRS Web site: irs.gov.

Deductions and credits have different values to different people. A deduction reduces a person's taxable income. A credit reduces taxes. Thus, credits generally are more beneficial.

But not always. Because of income limitations, some people who qualify for an education-related tax deduction might not qualify for a credit, and vice versa.

The situation is even more complicated because, even without considerations of income, the breaks are linked.

For example, the deduction of up to $3,000 for fees and tuition cannot be taken in the same year a person uses a Hope or Lifetime Learning credit.

Finding the right combination thus becomes a highly individual effort, and one that requires trying several solutions to find the right one.

"It is very hard," said Michael Arnow, a CPA and financial planner in Glendale, Wis.

He suggests taxpayers use a computer program to test possibilities "without burning up a lot of paper and pencil."

Not only is understanding the tax breaks important, so is who actually pays the expenses. Because of the income limits, some families find it advisable to have the students pay the costs so they can file their own returns and qualify for the breaks because they have smaller incomes.

But that has its own set of pitfalls, Arnow and others point out.

For one, to claim many of the breaks, the child cannot be claimed as a dependent on his or her parents' return.

Generally, students can be claimed as a dependent by their parents until they turn 25, provided the parent is providing at least half of the student's support.

However, not claiming a student as a dependent means the child might not be covered by your auto and health-insurance policies, Arnow said.

Whether a child is claimed in a parent's tax form "is not supposed to be just your choice, it is supposed to be based on facts and circumstances," said Paul Wickert, president of Acc-U-Rite Tax & Financial Services.

And then there is the question of records.

Most of the credits and deductions are based on expenses paid in the tax year. Colleges and universities are supposed to send out a special form, 1098T, itemizing them.

But the forms are tricky, Wickert said.

Box 1 tells the amount received, box 2 the amount billed. Often schools just fill out the second, which provides no proof that the amount billed was actually paid in the tax year.

"The thing where we run into the most problems with is people not having a detailed transcript of what has been billed and when it was paid," Wickert said.

"Keep your records sharp, and try all the possibilities to decide which will arrive at the least-tax situation for you."

Copyright © 2004 The Seattle Times Company