Reap the Tax Benefits of Education Planning

The tax code includes a number of incentives that, with proper planning, can provide tax benefits while you, your spouse, or your children are being educated.

Education Financing – A major planning issue is how to finance your children’s college education. Those with substantial savings simply pay the expenses as they go, while others begin setting aside money far in advance of the education need, perhaps utilizing a Coverdell account or Sec. 529 plan.

Others will need to borrow the funds, obtain financial aid, or be lucky enough to qualify for a scholarship. Although student loans provide one ready source of financing, the interest rates are generally higher than a home equity debt loan, which can also provide a longer term and lower payments. When choosing between a home equity loan or a student loan, keep in mind the following limitations: (1) Interest on home equity debt is deductible only if you itemize and then only on the first $100,000 of debt, and not at all to the extent that you are taxed by the alternative minimum tax, and (2) student loans must be single-purpose loans; the interest deduction is limited to $2,500 per year, and the deduction phases out for joint filers with income (AGI) between $125,000 and $155,000 ($60,000 to $75,000 for unmarried taxpayers). Still unknown is whether Congress will extend the student loan interest deduction changes included in the Bush tax cuts. Unless extended, beginning in 2013:

• The AGI phase-out ranges (estimated with inflation adjustments) will be $65,000–$90,000 for joint filers and $50,000–$75,000 for other filers (except married separate filers, who are barred from claiming this deduction).
• The deduction will be limited to the interest paid on a qualified loan during only the first 60 months in which the interest payments are required.

Education Tax Credits – The tax code also provides tax credits for post-secondary education tuition paid during the year for the taxpayer and dependents. There are two types of credits: the American Opportunity Credit, which is limited to the first four years of post-secondary education, and the Lifetime Learning Credit which provides credit for years after the first four years of post-secondary schooling and can be used for graduate studies.

The American Opportunity Credit, in many cases, offers greater tax savings than other existing education tax breaks! Here are some key features of the credit:

• Tuition, related fees, books, and other required course materials generally qualify. In the past, books usually were not eligible for education-related credits and deductions.
• The credit is equal to 100 percent of the first $2,000 spent and 25 percent of the next $2,000. This means that the full $2,500 credit may be available to a taxpayer who pays $4,000 or more in qualified expenses for an eligible student.
• The full credit is available for taxpayers whose modified adjusted gross income (MAGI) is $80,000 or less (for married couples filing a joint return, the limit is $160,000 or less). The credit is phased out for taxpayers with incomes above these levels. These income limits are higher than those under the former Hope and current Lifetime Learning Credits.
• Forty percent of the American Opportunity Credit is refundable. This means that even people who owe no tax can get an annual payment of the credit of up to $1,000 for each eligible student. Other existing education-related credits and deductions do not provide a benefit to people who owe no tax. The refundable portion of the credit is not available to any student whose investment income is taxed at the parent’s rate, commonly referred to as the kiddie tax.

The bad news is that, without congressional intervention, 2012 is the last year for the American Opportunity Credit; it will be replaced by the Hope Credit, which provides only a lesser, non-refundable credit for the first two years of post-secondary education.

The Lifetime Learning Credit provides up to $2,000 of credit for each family each year. The Lifetime Learning Credit is phased out for joint filers with incomes between $104,000 and $124,000 ($52,000 to $62,000 for single filers) and is not allowed at all for married individuals filing separately. If the Hope Credit is reinstated, the phase-out ranges for it likely will be the same as those for the Lifetime Learning Credit.

Careful planning for the timing of tuition payments can provide substantial tax benefits. If Congress does not extend the American Opportunity Credit and you have not paid enough tuition to get the maximum benefit for 2012, you may consider pre-paying (in 2012) the tuition for the first quarter of 2013 so that it will count toward the 2012 credit.

Tax-Favored Savings Programs – For those who wish to establish a long-term savings program for educating their children, the tax code provides two plans. The first is a Coverdell Education Savings Account, which allows the taxpayer to make $2,000 annual nondeductible contributions to the plan. The second plan is the Qualified Tuition Plan, more frequently referred to as a Sec. 529 plan, with annual contributions generally limited to the gift tax exemption amount for the year ($13,000 in 2012). Both plans provide tax-free earnings if they are used for qualified education expenses. When choosing between a Coverdell or Sec. 529 plan, keep the following in mind: (1) Coverdell accounts can be used for kindergarten through post-secondary education and become the property of the child at the age of majority, and contributions are phased out for joint filers between $190,000 and $220,000 ($95,000 and $110,000 for others) of income (AGI), and (2) Sec. 529 plans are only for post-secondary education, but the contributor retains control of the funds.

Without congressional action, beginning in 2013, the contribution to a Coverdell account will be capped at $500 per year, and only post-secondary expenses will qualify.

Savings Bond Program – There is also an education-related exclusion of savings bond interest for Series EE or I Bonds that were issued after 1989 and purchased by an individual over the age of 24. All or part of the interest on these bonds is exempt from tax if qualified higher education expenses are paid in the same year that the bonds are redeemed. As with other benefits, this one also has a phase-out limitation for joint filers with income between $109,250 and $139,250 (between $72,850 and $87,850 for unmarried taxpayers, but those using the married separate status do not qualify for the exclusion).

If you would like to work out a comprehensive plan to take advantage of these benefits, please give our office a call.