Year-End Tax Guide For 2011 - Part 3

Education savings The ABCs of tax-saving education

Go ahead, breathe a sigh of relief. Many of the most valuable tax benefits for education had been scheduled to become a little less valuable in 2011, or even expire altogether. Legislation passed in late 2010 postponed these changes until 2013. So you still have plenty of choices on how to leverage the tax code to get the most out of your education spending.

This means you have plenty of opportunities to save on your tax bill while giving your children and grandchildren the best education possible. But it also means you have to consider your options carefully to make sure you use the tax preferences that will best help your bottom line.

Generally, there are two ways the tax code offers savings on education. First, there are deductions and credits for education expenses, including the American Opportunity credit, the Lifetime Learning credit and the student loan interest deduction.

The second and often better opportunity is a tax-preferred savings account to pre-fund education, which comes in the form of either a 529 plan or a Coverdell education savings account (ESA). Unfortunately, all of these tax incentives — except 529 savings plans — phase out based on adjusted gross income (AGI) (see Chart 13 for the various phase out thresholds).

Deductions and credits

If you are eligible, the credits typically provide a better tax benefit than the deductions. But if you have children who are out of college and paying back student loans, remind them they may be eligible for the above-the-line student loan interest deduction, which is scheduled to become less generous in 2013. The abovethe- line tuition and fees deduction can also be very valuable because it reduces adjusted gross income (AGI), and it has been extended through 2011.

Tax law change alert: Tuition and fees deduction extended through 2011

The above-the-line deduction for tuition and fees was extended in 2010 through the end of 2011. The deduction this year is $4,000 if your AGI is below $65,000 (single) or $130,000 (joint). You are allowed a lesser $2,000 deduction if your AGI is above those thresholds but below $80,000 (single) or $160,000 (joint). This tax benefit is scheduled to expire for 2012, but could be extended. Check with a Grant Thornton tax professional for an update.

Action opportunity: Make payments directly to educational institutions

If you have children or grandchildren in private school or college, consider making direct payments of tuition to their educational institutions. Your payments will be gift tax-free, and they will not count against the annual exclusion amount of $13,000 (for 2011) or your lifetime gift tax exemption. Just make sure the payments are made directly to the educational institution and not given to children or grandchildren (or a trust for their benefit) to cover the cost.

Tax law change alert: Above-the-line loan interest deduction extended through 2012

The above-the-line deduction for qualified student loan interest was extended in its current form through the end of 2012. It is scheduled to be much less generous in 2013 unless legislative action is taken. The maximum deduction will remain at $2,500, but only interest in the first 60 months of the payment period will be deductible. In addition, the deduction will phase out from AGI levels of $40,000 to $55,000 for singles and from $60,000 to $75,000 for joint filers (compared to $60,000–$75,000 and $120,000–$150,000, respectively).

The American Opportunity credit has been extended through 2012. It was added by the 2009 economic stimulus bill and temporarily replaces the Hope Scholarship credit for 2009 through 2012. It is equal to 100 percent of the first $2,000 of tuition and 25 percent of the next $2,000, for a total credit of up to $2,500. It is also 40 percent refundable and allowed against the alternative minimum tax (AMT). Unlike the Hope Scholarship credit, the American Opportunity credit is available for the first four years of college education. It covers tuition, certain fees and course materials (not room or board) at colleges, universities, vocational or technical schools.

The Lifetime Learning credit can be used anytime during the college years, as well as for graduate education, but it is less generous. It provides a credit of up to 20 percent of qualified college tuition and fees up to $10,000, for a maximum credit of $2,000. For 2009 through 2012, it also phases out at a much lower income threshold than the American Opportunity credit. Bear in mind that you cannot use both credits in the same year for the same student. Because the American Opportunity credit is more generous and has a higher AGI phaseout, it's likely that the Lifetime Learning credit will be useful only if you are paying tuition beyond the first four years of college education. If your AGI is too high to claim either credit, consider letting your child take the credit. But neither you nor the child will be able to claim the child as an exemption.

Section 529 savings plans

Section 529 savings plans allow taxpayers to save in special accounts and make tax-free distributions to pay for tuition, fees, books, supplies and equipment required for college enrollment.

529 plans come in two forms, prepaid tuition plans and college savings plans. Prepaid tuition plans allow you to "buy" tuition at current levels on behalf of a designated child. They can be offered by states or private educational institutions, and if your contract is for four full years of tuition, tuition is guaranteed when your child attends regardless of the cost at that time. Your state may also offer tax benefits for investments in the state qualified tuition programs.

College savings plans can only be offered by states but can be used to pay a student's qualifying tuition at any eligible educational institution. They offer more flexibility in choosing schools and more certainty on benefits. If the student doesn't use all of the account funds, the excess can be rolled over into the plan for another student.

529 plans have many benefits:

The plan assets grow tax-deferred, and distributions used to pay qualified higher education expenses are tax-free. Contributions aren't deductible for federal income tax purposes, but some states offer state tax benefits. Action opportunity: Plan around gift taxes with your 529 plan

A 529 plan can be a powerful estate planning tool for parents or grandparents. Contributions to 529 plans are eligible for the annual gift tax exclusion ($13,000 per beneficiary in 2011), and you can also avoid any generation-skipping transfer (GST) tax when you fund a 529 plan for a grandchild — without using up any of your GST tax exemption.

Plus, a special break for 529 plans allows you to front-load five years' worth of annual exclusion gifts ($65,000) in one year, and married couples splitting gifts can double this amount to $130,000 per beneficiary.

There are no income limits for contributing, and the plans typically offer much higher contribution limits than ESAs. Generally, there is no beneficiary age limit for contributions or distributions. But there are disadvantages, too:

You don't have direct control over investment decisions, and the investments may not earn as high a return as they could earn elsewhere. (But you can roll over into a different 529 plan if you're unhappy with one plan's performance, or withdraw your balance and take a loss if your account is in a loss position.) There is also a risk the child may not attend college, and there may not be another qualifying beneficiary in the family. Contributions to a 529 plan are subject to gift tax, so contributions over the annual gift tax exclusion ($13,000 in 2011) will use up your lifetime gift tax exemption (or be subject to gift tax). Coverdell ESAs

Coverdell ESAs are similar to 529 plans. The plan assets grow tax-deferred and distributions used to pay qualified higher education expenses are income tax-free for federal tax purposes and may be tax-free for state tax purposes. Contributions are also not deductible. The accounts have distinct advantages, but many of their benefits are scheduled to expire at the end of 2012. Legislation is very possible in this area, so check with a Grant Thornton tax professional for an update.

As currently structured in 2011, ESAs have two distinct advantages over 529 plans:

They can be used to pay for elementary and secondary school expenses (this will no longer be the case in 2013 without legislative action). You control how the account is invested. However, they also have disadvantages:

They are not available for some high-income taxpayers due to the AGI phaseout, which is scheduled to decrease in 2013 for joint filers. (Consider allowing others, such as grandparents, to contribute to an ESA if your AGI is above the phaseout threshold.) The annual contribution limit is only $2,000 per beneficiary (shrinking to $500 in 2013 without legislative action). Contributions generally cannot be made after the beneficiary reaches 18. Any balance left in the account when the beneficiary turns 30 will be distributed subject to tax. Another family member under 30 has to be named as the beneficiary to avoid a mandatory distribution and maintain the account's tax-advantaged status. As with 529 plans, there is always a risk the child will not attend college and there is no other qualified beneficiary. Watch out for the kiddie tax

Be careful with an alternative technique that was popular in past years: transferring assets to children to pay for education with an account under the Uniform Gift to Minors Act (UGTA) or Uniform Transfer to Minors Act (UTGA).

These accounts allow you to irrevocably transfer cash, stocks or bonds to a minor while maintaining control over the assets until the age at which the account terminates (age 18 or 21 in most states). The transfer qualifies for the annual gift tax exclusion, but the expanding kiddie tax could limit any tax...

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