By now, the excitement of receiving college acceptance letters is likely to have been long ago replaced by the shock of the tuition bills that follow enrollment. Or the joy of a child's graduating from college - and no longer incurring tuition - is eclipsed by the obligation to repay student loans. As families scramble to get the largest grants and lowest interest rates available, they should not overlook the tax implications of the arrangements they make.The tax breaks fall into two categories: ones for paying the education costs themselves, and deductions for paying interest on loans used to pay the bills. Most of the tax provisions are restricted to those with incomes below specified amounts, and those amounts vary from one tax provision to another. This creates additional confusion for families attempting tax planning and increases their need for professional guidance.
EDUCATION LOAN INTEREST
In 2007 or 2008, taxpayers can deduct (regardless of whether they itemize their deductions or claim the standard deduction) up to $2,500 of interest paid on qualified education loans. These loans must be used to pay college tuition for the taxpayer, their spouse, or the taxpayer's dependents within a reasonable period before or after the debt is incurred. (The deduction is also available for interest on loans used to refinance qualified education loans.) Families should be aware of these crucial restrictions on the deduction, however:
* In 2007, the deduction phases out in the $110,000-to-$140,000 modified adjusted gross income range for joint return filers ($55,000 to $70,000 for others). In 2008, the corresponding income range rises to $115,000 to $145,000 for joint return filers (but remains at $55,000 to $70,000 for others).
* A child cannot claim the deduction if they are another taxpayer's dependent.
* A married taxpayer must file a joint tax return to claim the deduction.
* The $2,500 limit on the deduction applies to married individuals filing joint returns, as well as to singles. This can result in an unintended - but very real - marriage penalty, as individuals with large student loans could see their deduction amount reduced from an aggregate of $5,000 (i.e., $2,500 per unmarried taxpayer) to only $2,500 after marriage.
* A taxpayer must be legally obligated to make payments in order to deduct interest. For instance, if only a taxpayer's child has a legal obligation to repay their education loan, the taxpayer cannot deduct interest payments they make on the loan, even if the child is the taxpayer's dependent.
* If a taxpayer is not legally obligated to make the payments, but makes them for their non-dependent child, the child may claim the deduction. The tax law treats the situation as if the parents gave the money to the child, who subsequently used it to pay the interest.
If both a taxpayer and their child are legally liable for the loan, and the taxpayer intends to make the repayments but their income is too high to claim the interest deduction, consider this strategy: Give the funds to the child to make the repayments. Assuming that the child's income is low enough to qualify for the deduction, and they are not a dependent of the taxpayer, the child will get the deduction that the parents don't.
Alternatively, instead of claiming the loan interest deduction, a taxpayer can claim a deduction for interest paid on a home equity loan that is used to pay college expenses. This type of deduction is classified as an itemized deduction, so it is not available to those who claim the standard deduction.
Unlike the other education tax breaks, however, it is available to married individuals filing separately. The aggregate home equity loan amount on which interest is deductible is $100,000 ($50,000 for married individuals filing separately). Eligibility for this deduction is not subject to income limitations, but the debt must be secured by the taxpayer's residence.
A taxpayer may be entitled to a Hope Credit, Lifetime Learning Credit, or higher-education expense deduction if they pay tuition and fees for the taxpayer, their spouse, or the taxpayer's dependents to attend college. Married individuals who file separate returns do not qualify for these tax breaks.
* The Hope Credit is generally capped in 2007 at 100 percent of the first $1,100 paid per eligible student and 50 percent of the next $1,100 for each of the first two years of an individual's college education. Thus, the maximum annual tax savings from this credit is $1,650 per student. For 2008, the maximum credit is 100 percent of the first $1,200 of eligible expenses and 50 percent of the next $1,200, or $1,800 per student.
* The Lifetime Learning Credit is generally capped at 20 percent of the eligible expenses of up to $10,000. (The $10,000 figure is an aggregate amount, regardless of how many students the taxpayer is putting through college.) Consequently, the maximum annual tax savings from the credit is $2,000.
* The tuition deduction is a maximum of $4,000 (or $2,000 if a taxpayer's income exceeds a certain level - see below). The tax savings that this deduction produces depend on the tax bracket of the person claiming the deduction. This deduction is scheduled to expire at the end of 2007, although Congress is likely to extend it.
In 2007, the Hope and Lifetime Learning Credits phase out in the $94,000-to-$114,000 modified AGI range on a joint return ($47,000 to $57,000 for other taxpayers). The figures for 2008 are $96,000 to $116,000 for joint returns ($48,000 to $58,000 for other taxpayers).
The education expense deduction has a $4,000 maximum if the taxpayer's modified AGI does not exceed $130,000 on a joint return ($65,000 for others); the maximum deduction is $2,000 if income is $130,001 to $160,000 on a joint return ($65,001 to $80,000 for others). Note that these income maximums are cutoff points, rather than phase-out ranges. A taxpayer who has one dollar of income above a cutoff point gets no deduction. Also, as mentioned above, the higher-education expense deduction is scheduled to expire at the end of 2007 - although it has been extended in the past and could certainly be given new life again.
OTHER TAX PROVISIONS
Subject to various restrictions, families may also qualify to cash in U.S. savings bonds tax-free if the proceeds do not exceed eligible college costs. Eligibility phases out for 2007 modified AGI in the $98,400-to-$128,400 range ($100,650 to 130,650 in 2008) for joint return filers and $65,600 to $80,600 ($67,100 to $82,100) for others. Also, because the bonds must have been issued after the owner reached age 24, this tax break is geared more to parents than to students. And this break is not available to married taxpayers filing separately.
Another education incentive in the tax law is that taxpayers may withdraw funds tax-free from a Section 529 plan or Coverdell IRA to use for qualified higher-education costs. Because the tax advantage of these savings plans is derived from not owing tax on the accumulated investment income, the longer the funds remain in the accounts before being withdrawn, the greater the tax savings are likely to be. Consequently, families should start funding them as soon as possible.
Students and their parents are bound to be interested in any tax provisions that can recoup for them even a small portion of the cash they spend on education costs. This means that their tax and financial advisors need to keep up to date on the variety of education incentives in the Tax Code.
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