Clearing Up Tax Confusion For College Savings Accounts

By Andrew Schwartz AAA

Back in the old days, saving for a child's college education was much simpler. Not only was sending a child to college more affordable, but there were also a lot fewer tax breaks to navigate through. Over the years, the tax rules have evolved into a confusing array of tax-advantaged college savings accounts, tax credits and other tax breaks available to families trying to fund a child's college education.

Tax Advantaged College Savings Accounts
The first tax-advantaged college savings opportunity was instituted back in 1990. The Education Savings Bond Program ensured that tax payers wouldn't pay taxes on interest earned on certain government bonds redeemed to pay for a child's tuition. Currently, Series EE Bonds and I Bonds qualify.

To qualify, the bond must be in your name or the name of you and your spouse, which means bonds issued in your child's name aren't eligible. Plus, you won't benefit from this tax break unless your modified adjusted gross income (MAGI) is less than $139,250 if married or $87,850 if single (in 2012).

If you'd prefer to invest in mutual funds to save for a child's college education, take a look at 529 Plans and Coverdell Education Savings Accounts (ESAs). Both plans offer tax-deferred growth as long as the money remains invested. Here's how these two plans differ:

Maximum Annual Contribution
You can contribute up to $2,000 per year per child into an ESA versus $13,000 per year per donor into a 529 plan.

Tax-Free Distributions
While distributions from both plans that are used to pay for qualified education expenses are tax free, you can also withdraw money from an ESA, tax-free, to pay for private kindergarten, elementary school and high school.

Income Limitation
If you earn more than $220,000 if married ($110,000 if single) you're not eligible to contribute to an ESA that year. With a 529 Plan, there are no income limitations.

Are you wondering which opportunity makes the most sense for you? It all depends on your specific situation and how much you're looking to put away for your child's education.

Tax Credits For College Tuition
A tax credit, known as the Lifetime Learning Credit, is equal to 20% of the first $10,000 of qualified educational expenses incurred each year, providing you with a tax savings of up to $2,000 per year.

Like many other provisions, there is an income threshold for these tax breaks as well. For 2012, single individuals who earn more than $61,000 and married couples who earn more than $122,000 aren't eligible.

More Tax Breaks
If you're working full time while taking classes, the government allows your employer to pay up to $5,250 toward your education each year, including tuition, books, supplies and equipment. Under the current rules, this tax-free benefit applies to undergraduate and graduate level classes.

Through 2012, there was also the Tuition and Fees Deduction, allowing you to claim a deduction of up to $4,000 annually in connection with your higher education expenses, provided your income was less than $130,000 if married or $65,000 if single for 2012. If your income exceeded that threshold but fell below $160,000 married ($80,000 if you're single), you could still deduct $2,000.

Don't forget about the student loan interest deduction. Each year, you can deduct up to $2,500 of student loan interest paid. This deduction, which is also available to non-itemizers, phases out for married couples who earn between $120,000 and $150,000 and for single individuals who earn between $60,000 and $75,000 in 2012.

The Bottom Line
With all these different tax breaks, coordinating these opportunities to minimize the after-tax cost of sending a child to college is quite a challenge. Plus, it's important not to overlook how each of these strategies might impact the financial aid package your family ultimately receives.

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