Tax Code Incentives That Help Pay For College: Part 2
This is the 2nd in a two-part series on how the tax code helps you meet the ever increasing cost of higher education. Part 1, dealing with planning for college expenses, appeared here September 3rd. This time, we'll address how the tax law can assist you in actually paying for college.
Paying college expenses. You may be able to take a credit for some of your child's expenses. There are also tax-advantaged ways of getting your child's college expenses paid by others.
Tuition tax credits. You can take the American Opportunity tax credit of up to $2,500 per student for the first four years of college (a 100% credit for the first $2,000 in tuition, fees, and books, and a 25% for the second $2,000). You can take a Lifetime Learning credit of up to $2,000 per family for every additional year of college or graduate school (a 20% credit for up to $10,000 in tuition and fees). The American Opportunity tax credit is 40% refundable, meaning that you can get a refund if the amount of the credit is greater than your tax liability. Both credits are phased out for higher income taxpayers, so be sure to check those limits.
Only one credit can be claimed for the same student in any given year. However, a taxpayer is allowed to claim either credit for a tax year AND to exclude from gross income amounts distributed from a Coverdell education savings account for the same student, as long as the distribution isn't used for the same educational expenses for which a credit was claimed.
Scholarships. Scholarships are exempt from income tax if certain conditions are met. The most important are that the scholarship must not be compensation for services, and it must be used for tuition, fees, books, supplies and similar items (not for room and board). Although a scholarship is tax-free, it will reduce the amount of expenses that may be taken into account in computing the credits discussed above, and could reduce or eliminate those credits.
Employer educational assistance programs. If your employer pays your child's college expenses, the payment is a fringe benefit to you and is taxable to you, unless the payment is part of a scholarship program that's "outside of the pattern of employment." Then the payment will be treated as a scholarship (if the other requirements for scholarships are satisfied).
College expense payments by others. If someone other than you pays your child's college expenses, the person making the payments is generally subject to gift tax, to the extent the payments and other gifts to the child by that person exceed the annual (per donee) gift tax exclusion of $13,000. Married donors who consent to split gifts may exclude gifts of up to $26,000.
If the other person pays your child's school tuition directly to an educational institution, however, there's an unlimited exclusion from the gift tax. The relationship between the person paying the tuition and the person on whose behalf the payments are made is irrelevant, but typically it's a grandparent. The unlimited gift tax exclusion applies only to direct tuition costs. There's no exclusion (beyond the normal annual exclusion) for dormitory fees, board, books, supplies, etc. Prepaid tuition payments may qualify for the unlimited gift tax exclusion under certain circumstances.
Student loans. You can deduct interest on loans SOLELY used to pay for your child's education at a post-secondary school. This is an exception to the general rule that interest on student loans is personal interest and, therefore, not deductible. The deduction is an above-the-line deduction, meaning that it's available even to taxpayers who don't itemize. The maximum deduction is $2,500, subject to phase-out at higher income levels.
Bank loans. The interest on loans used to pay educational expenses is personal interest which is generally not deductible (unless you qualify for the deduction for education loan interest, described above). However, if the loan is “home equity indebtedness,” and interest on the loan is “qualified residence interest,” the interest is deductible for regular income tax purposes, although not for alternative minimum tax purposes. If interest is deductible as qualified residence interest, it can't be deducted as education loan interest.
Borrowing against retirement plan accounts. Many company retirement plans permit participants to borrow. This option may be an attractive option to a bank loan, especially if your other debt burden is high. The loan must carry an interest rate equal to the prevailing commercial rate for similar loans, and, unless you qualify for the deduction for education loan interest (described above), there's no deduction for the personal interest paid. Moreover, unless strict requirements are satisfied, a loan against a retirement account is treated as a premature distribution that's subject to tax and an additional penalty.
Withdrawals from retirement plan accounts. IRAs and qualified retirement plans represent the largest cash resource of many taxpayers. You can pull money out of your IRA (including a Roth IRA) at any time to pay college costs without incurring the 10% early withdrawal penalty that usually applies to withdrawals before age 59½. However, the distributions are subject to tax.
Some qualified plans either don't permit withdrawals or restrict them. For example, a 401(k) plan may allow distributions if the participant has an immediate and heavy financial need and lacks other resources to meet that need. IRS regs name a college education as such a need. To the extent they represent previously untaxed dollars and earnings, amounts withdrawn from a retirement plan are fully subject to tax and are also hit by a 10% penalty if they are made before the participant reaches age 59½. (Note, however, that you cannot roll over a 401(k) plan “hardship” distribution into an IRA to set up a later penalty-free withdrawal to pay college costs.)
Not all of the tax breaks discussed in the last two columns may be used in the same year, and use of some of them reduces the amounts that qualify for other breaks. It takes careful planning to determine which should be used in any given situation.
