Sunday, September 14, 2014

Tax Planning For College

Paying college expenses. You may be able to take a credit for some of your child's tuition expenses. There are also tax-advantaged ways of getting your child's college expenses paid by others.
 
Tuition tax credits. You can take an 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% credit 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. That means that you can get a refund if the amount of the credit is greater than your tax liability. For example, someone who qualifies for the maximum credit of $2,500, but who has no tax liability would still qualify for a $1,000 (40% of $2,500) refund from the government.
 
Both credits are phased out for higher-income taxpayers. The American Opportunity tax credit is phased out for couples with income between $160,000 and $180,000, and for singles with income between $80,000 and $90,000. The Lifetime Learning credit is phased out (for 2014) for couples with income between $108,000 and $128,000, and for singles with income between $54,000 and $64,000.
 
Only one credit can be claimed for the same student in any given year. However, a taxpayer is allowed to claim an American Opportunity tax credit or a Lifetime Learning credit for a tax year and to exclude from gross income amounts distributed (both the principal and the earnings portions) 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 tax if certain conditions are satisfied. 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 (and 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 tax credits discussed above, and may therefore reduce or eliminate those credits.
 
In an exception to the rule that a scholarship must not be compensation for services, a scholarship received under a health professions scholarship program may be tax-free even if the recipient is required to provide medical services as a condition for the award.
 
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 as compensation, 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).
 
Tuition reduction plans for employees of educational institutions. Tax-exempt educational institutions sometimes provide tuition reductions for their employees' children who attend that educational institution, or cash tuition payments for children who attend other educational institutions. If certain requirements are satisfied, these tuition reductions are exempt from income tax.
 
College expense payments by grandparents and others. If someone other than you pays your child's college expenses, the person making the payments is generally subject to the gift tax to the extent the payments and other gifts to the child by that person exceed the regular annual (per donee) gift tax exclusion of $14,000 for 2014. Married donors who consent to split gifts may exclude gifts of up to $28,000 for 2014.
 
However, if the other person pays your child's school tuition directly to an educational institution, there's an unlimited exclusion from the gift tax for the payment. The relationship between the person paying the tuition and the person on whose behalf the payments are made is irrelevant, but the payer would typically be a grandparent. The unlimited gift tax exclusion applies only to direct tuition costs and not other college expenses.
 
Student loans. You can deduct interest on loans used to pay for your child's education at a post-secondary school, including some vocational and graduate schools. 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. However, the deduction phases out for taxpayers who are married filing jointly with AGI between $130,000 and $160,000 (between $65,000 and $80,000 for single filers).
 
Some student loans contain a provision that all or part of the loan will be cancelled if the student works for a certain period of time in certain professions for any of a broad class of employers, e.g., as a doctor for a public hospital in a rural area. The student won't have to report any income if the loan is canceled and he performs the required services.
 
Bank loans. The interest on loans used to pay educational expenses is personal interest which is generally not deductible (exception being student loans). However, if the loan is "home equity indebtedness," and interest on the loan is "qualified residence interest," the interest is deductible if you itemize. 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 cash. This option may be an attractive alternative to a bank loan, especially if your other debt burden is high. However, typically there's no deduction for the personal interest paid on such a loan. 
 
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 from an IRA before age 591/2 . However, the distributions are subject to tax under the usual rules for IRA distributions.
 
Not all of the above breaks may be used in the same year, and use of some of them reduces the amounts that qualify for other breaks. So it takes planning to determine which should be used in any given situation.