It is said that nothing is certain in life except death and taxes. If you are going to college or are the parent of a college-bound student, then you can add one more certainty to life and that is: tuition bills. Fortunately, Uncle Sam acknowledges this reality and offers several valuable tax credits and deductions. These tax breaks literally put money back in your pocket to help you pay those inevitable tuition bills.
The challenge with tax breaks is two-fold. First, you need to decipher the tax codes to determine if you actually qualify for a tax break. Most have income limits and other requirements that restrict their use. Second, if you qualify to take advantage of multiple tax breaks you need to figure out which combination will give you the most benefit. To complicate matters (and you shouldn't expect anything less from the IRS), some of these tax breaks are mutually exclusive, which means you'll have to choose one over the other.
Before you take advantage of any tax break, do a little long-term planning and create several scenarios to see how each choice affects your bottom line. As you will see there are some situations where electing to take a tax break may impact another area of your personal finances.
The premise for all tax breaks is to refund you money that you have paid out of your pocket for college expenses. To claim a tax credit or deduction you therefore must have spent your own money on your or your child's education. That money can't come from a source that is already tax-free such as Coverdell ESA, scholarships, veteran educational assistance, Pell grants or 529 Savings Plans. This is because any money that already receives favorable tax treatment cannot be claimed for an additional tax credit. Doing so is known as "double dipping," which is a big "no-no" to the IRS.
Since this is an important concept let's look at an example. Imagine that you have set up a 529 Savings Plan that has a balance of US Dollars 15,000. During your child's first year of college you spent the entire contribution portion (this is the money you put in) of the 529 Plan so what's left represents the earnings portion. The earning portion is totally tax-free as long as you use it for educational expenses. It just so happens that tuition for this year is US Dollars 15,000. If you use your entire 529 Savings Plan money to pay for tuition, you cannot claim any tax credits on what you have paid for tuition since you used money that already had a tax benefit.
Remember the earnings portion of your 529 Plan is tax deferred. However, if you withdraw only US Dollars 11,000 from the 529 Plan and pay the remaining US Dollars 4,000 with money from your own pocket you could claim a tax credit on US Dollars 4,000. If you use the American Opportunity tax credit (formerly the Hope tax credit) assuming that you meet the income limits, you receive the maximum amount of US Dollars 2,500. Plus, you still have US Dollars 4,000 left in your 529 Savings Plan for next year's tuition bill.
The bottom line is you need to plan in advance how you are going to take advantage of your tax breaks before you start paying for college. With a little planning you can dramatically affect the value of these tax breaks, leading to more money in your pocket to pay for college. Remember too that tax laws as well as their interpretations change each year.
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