SM: The College Tax Breaks Explained

If you've got college-bound kids, we don't need to tell you that the cost of college these days is staggering. Mercifully, Washington has delivered some valuable tax breaks over the past few years to parents trying to foot those bills. Here's a rundown of what's available.

The $4,000 (or $2,000) Deduction

For 2011 you can deduct up to $4,000 of college tuition and fees paid for you, your spouse or any other person claimed as a dependent on your return. This is an "above-the-line" deduction, which means you don't have to itemize in order to take advantage of the break. However, the $4,000 figure is the annual maximum, regardless of how many students may be in your family. The other ground rules are as follows:

You don't get the full deduction if you are unmarried with modified adjusted gross income above $65,000, or a joint filer with modified AGI above $130,000. However, if your modified AGI is between $65,001 and $80,000 for singles or between $130,001 and $160,000 for joint filers, you are entitled to a reduced deduction of up to $2,000.

You're completely ineligible if you're married and file separately from your spouse.

No deduction is allowed on the tax return of any person who can be claimed as a dependent on another's return. So your dependent college-age child can't claim the deduction when your own AGI is too high to qualify.

No deduction can be claimed for expenses paid with earnings from a Section 529 plan or withdrawals from a Coverdell Education Savings Account. Also, you can't claim the deduction in the same year you claim the American Opportunity or Lifetime Learning tax credit for the same student. Note: this break expired at the end of 2011 but will probably be renewed for 2012 under the same rules explained above.

Coverdell Education Savings Accounts (CESAs)

You can contribute up to $2,000 per year, which makes CESAs a nice little savings vehicle. This is especially true if you have several children (or grandchildren), since you can contribute a cool two grand annually to separate CESAs set up for each child (or grandchild). Annual contributions are allowed up until the account beneficiary (the college-bound child) turns 18.

If you are unmarried, your ability to make CESA contributions is phased out between adjusted gross income of $95,000 and $110,000. For joint filers, the phase-out range is between $190,000 and $220,000.

CESA earnings build up tax-free. Then the money can be withdrawn (also tax-free) to pay the account beneficiary's college expenses. Like contributions to Roth IRAs, CESA contributions are nondeductible, but the tax-free withdrawal privilege makes up for that. If the beneficiary doesn't attend college or doesn't incur enough expenses to exhaust his or her account, the balance can be rolled over tax-free into another family member's CESA.

You can also take tax-free CESA payouts to cover the account beneficiary's elementary and secondary school (K-12) costs. Eligible expenses include tuition and fees to attend private and religious schools, room, board, uniforms and transportation. You can also withdraw CESA money tax-free to pay costs to attend public K-12 schools. Eligible expenses include books and supplies; academic tutoring; computers, peripheral equipment and software; and even Internet access charges.

You have until April 15 (adjusted for weekends and holidays) of the following year to make your CESA contribution for the tax year in question. For example, you can make your 2012 CESA contribution as late as April 15, 2013.

Tax-Free Employer Education Reimbursements

Should your employer agree to reimburse you for a class you take, up to $5,250 of that income is tax free. Even graduate-level courses qualify for employer reimbursements.

This break is available only for costs incurred by you, the employee. So outlays for your kids or spouse to take college classes are ineligible. On the plus side, high income won't be held against you; there's no AGI-based phase-out rule for this benefit.

State-Sponsored College Savings Plans ("Section 529 Plans")

State-sponsored college savings plans, often called "Section 529 Plans," are a great deal, since withdrawals to pay the account beneficiary's qualified college costs are tax-free. If you can afford to make substantial account contributions while your kids are still young, the tax advantages should sharply reduce the amount needed to fund their future college educations.

Most college savings plans now permit lump-sum contributions of well over $250,000. For gift-tax purposes, you can spread a large lump-sum contribution over five years. As you probably know, gifts made under the so-called $13,000 tax-free-gift rule, won't trigger any federal gift taxes, nor will they reduce your federal gift- or estate-tax exemptions. But when contributing to a 529 plan, you can claim five years' worth of $13,000 exclusions upfront. This means a married couple can make a lump-sum payment of up to $130,000 (5 x $13,000 x 2 = $130,000) without any adverse gift tax consequences.

College savings plans typically offer several investment options, including equity mutual funds. Many plans also welcome out-of-state investors. They allow payouts for costs to attend any accredited college or university in the country. You should shop around to find the Section 529 college savings plan you like best. But keep in mind your in-state program may offer state tax advantages that tip the scale in its favor.

The tax benefits are available regardless of how high your income may be. In contrast, most of the other breaks covered in this article are phased out for high earners.

For more on both types of plans, click here

Student Loan Interest

Thanks to more relaxed rules regarding the deduction of student loan interest, many folks who weren't previously able to take advantage of this tax break can now do so. If you qualify, you can write off up to $2,500 of annual college loan interest charges. The catch, however, is that this break is phased out if your modified AGI is too high.

Specifically, the 2012 phaseout range for unmarried taxpayers is between modified AGI of $60,000 and $75,000. For joint filers, the range is between modified AGI of $125,000 and $155,000.

American Opportunity and Lifetime Learning Tax Credits

For 2012, the American Opportunity credit amounts to 100% of the first $2,000 of a college student's annual tuition and fees (no room and board costs) plus 25% of the next $2,000. So the maximum American Opportunity credit is $2,000 per qualifying student. But here's the rub: The American Opportunity credit can be claimed for only four tax years for any one student. It's unavailable after the student has logged four years' worth of academic hours. Also, the American Opportunity credit is allowed only when the student carries at least half of a full-time load for at least one academic period beginning in the year the credit is claimed.

The Lifetime Learning credit is less restrictive. It's mainly intended to help defray college costs after the first four years, when the American Opportunity credit is no longer allowed. The Lifetime credit is available for an unlimited number of years and without any requirement to carry a certain course load. Graduate courses are cool. So are random classes not intended to lead to any sort of degree, such as professional training seminars and courses to update your software skills. The credit equals 20% of tuition and fees up to $10,000, for a maximum annual credit of $2,000.

Qualifying expenses for both the American Opportunity and Lifetime credits include post-secondary tuition and mandatory enrollment fees for you, your spouse, and any other person claimed as a dependent on your tax return.

The American Opportunity credit is phased out between AGI of $160,000 and $180,000 for joint filers; $80,000 to $90,000 for unmarried taxpayers. Those who use married filing separate status are completely ineligible. For 2011, the Lifetime credit is phased out between AGI of $104,000 and $124,000 for joint filers; $52,000 to $62,000 for unmarried taxpayers. You're completely ineligible if you're married and file separately from your spouse.