Like buying a house or taking a trip, education is a save first, spend later proposition. And federal tax rules affect both phases of financing a college degree.
Coverdell Accounts
Named after a former Senator from Georgia, Coverdell Education Savings Accounts work like IRAs. The contribution limit now stands at $2,000 per child per year. To participate, your adjusted gross income must be $110,000 or less for singles, or $220,000 or less for married couples.
Prepaid & State Plans
Most states sponsor prepaid tuition plans that allow parents to lock in a tuition rate years in advance of enrollment so there is no worry about whether savings will keep pace with college-cost inflation. Many states also sponsor tax-free college savings accounts (known as 529 accounts) for families.
A state-sponsored 529 account, often managed by a mutual fund company, can be used to pay expenses at any accredited university, college, technical, or trade school in the United States. You can shop around for the best state 529 plan (you don't have to use the plan in the state in which you live) and the savings can be used to pay for education in any state.
When the savings phase ends and it's time to write tuition checks, the tax codes offer credits that apply to parents financing their children's college and adults continuing with education.
Hope Scholarship Tax Credit
A family can claim a Hope credit of up to $1,500 for two years for each student who is enrolled at least half-time at an eligible school and who has not completed his or her first two years of study. The credit covers all of the first $1,000 paid for tuition and fees and half of the second $1,000.
Lifetime Learning Tax Credit
This credit covers vocational, college, graduate, and professional students and adults who want to upgrade their job skills, acquire new ones, or pursue a new course of study. Even a student taking one course can use this credit as long as the class is job-related. Taxpayers can claim a Lifetime Learning credit of up to $2,000, or 20 percent of the first $10,000 paid in tuition and fees.
There is no limit on the number of years you may claim this credit, but complications arise when using the Hope and Lifetime Learning credits at the same time. You can claim only one Lifetime Learning credit per tax year for the aggregate amount of qualified tuition and fees of those students in the family for whom no Hope credit is claimed. The law allows eligible taxpayers to claim the Hope and Lifetime Learning tuition credits in the same year that tax-free withdrawals for college expenses are made from a 529 plan - as long as the withdrawals aren't used for the same expenses claimed for the credits.
The amount of your Hope and/or Lifetime Learning credits depends on your income. The credit gradually drops if your gross income is between $41,000 and $51,000 if you file as a single taxpayer, or $83,000 and $103,000 if you file a joint tax return. Single taxpayers cannot claim a tax credit if their gross income is $51,000 or more; likewise for joint returns of more than $103,000.
Deductible Interest
For many people, savings alone won't cover the costs of education. But even here the tax rules can help.
The interest you pay on student loans is deductible for the life of the loan. Individuals with income up to $130,000 can deduct as much as $2,500 in interest payments for qualified student loans.
You may deduct interest on all loans made to you for qualified higher-education expenses. In addition to federal Stafford, PLUS, and Perkins Loans, loans from state or local governments, and loans specifically for education expenses qualify for the interest deductions. However, married individuals filing separate returns may not claim the student loan interest deduction, nor can individuals who are claimed as dependents by other taxpayers.
Milton Zall, president of the editorial consulting firm Zall Enterprises in Silver Spring, Maryland, specializes in tax, investment, and human-resources issues.
