Try Jim Cramer's Action Alerts PLUS
15 Days of Cutting Your Tax Bill
Return to Article

How to Save Money on Your Kid's Tuition

Tracy Byrnes

03/23/07 - 01:57 PM EDT

Editor's note: As a special feature for March, TheStreet.com offers an ongoing series on everything you need to know about taxes. Today is part 12.

It costs a ton of money to send your kid to a keg party these days.

Whether he's whooping it up at a $45,000-a-year private university or your local state college, the cost of admission is not cheap.

Uncle Sam understands, sort of. There are a few education tax credits and deductions available to help defray the costs of your child's four years of bliss. And while they won't wipe out your whole tuition bill, you have to take what you can get.

In today's column I'll take a look at these tax tips:

529 Skidoo, Hike!

Big thing to note: The only expenses that qualify for these credits and deductions are the tuition and fees you need to pay for enrollment or attendance at any college, vocational school or other post-secondary educational institution.

That means you're on your own for room and board, books and all the other expenses that your little darling must pay.

But that's where your 529 college savings plan will come in handy. Imaginatively named after the section of the IRS code that created it, a 529 plan is an education savings plan run by a state or educational institution designed to help families set aside funds for future college costs.

"Distributions from those plans can be used for books, supplies, equipment, room and board, transportation and other necessary expenses in addition to tuition," according to CCH, a company that provides tax info to the pros.

And don't forget: As long as the money is used for those college expenses, the distributions are federally tax-free (and tax-free in some states too). So be sure to open a 529 account for your kid, pronto.

The Hope and Lifetime Learning Credits

The Hope Credit is a tax credit for college students in their first two years of post-secondary education, such as college or vocational school. The maximum credit is $1,650 on the first $2,200 of tuition and fees.

This credit does not apply to graduate and professional-level programs, and the student must be enrolled at least part time to qualify.

The Lifetime Learning Credit, on the other hand, is for anyone who takes college classes. That means that if you, your spouse or your dependents are enrolled at an eligible educational institution and you are responsible for paying the expenses, you can take this credit.

And the upside here is that the credit not only applies to undergraduates, it will work for graduate and professional degree courses too. Better yet, you don't need to be a full-time student. So if you decided to go take one class at a local college to improve your current job skills, you could take advantage of this credit. The maximum tax credit here is 20% on the first $10,000 of college tuition and fees, or $2,000.

However, on both the Hope and Lifetime Learning credits, there are income limitations. The amount of these credits is phased out when your adjusted gross income hits $90,000 for those filing jointly ($45,000 for individuals) and then eliminated completely when your AGI reaches $110,000 ($55,000 for individuals).

Tuition and Fees Deduction

The tuition and fees deduction allows you to deduct up to $4,000 of the tuition bill you pay for any post-secondary school. Even better, the AGI limitations are higher.

For 2006, if your adjusted gross income didn't exceed $130,000 as a married couple ($65,000 if you're single), you can claim the full deduction of $4,000. If your AGI is greater than $130,000 ($65,000 for individuals) but is not more than $160,000 ($80,000 for individuals), your maximum tuition and fees deduction is $2,000. The deduction is gone once your AGI goes above $160,000 ($80,000 for individuals).

This deduction is actually a bit better than the Hope or Lifetime Learning credits, because it can benefit people in the higher income brackets as well. But that's probably why 2006 is the last year for this deduction unless Congress decides to extend it.

Remember, Congress extended this deduction for 2006 in late December, after the tax forms were printed. So there's no line on the Form 1040 to claim this deduction. Use a tax preparation program such as TurboTax or TaxCut, because it will put the numbers in the right place for you.

If you're doing your return by hand -- why? -- pay attention. You have to place the letter "T" on line 35, the line for the domestic production activities deduction, which mostly small businesses take. If by chance if you're taking both the tuition deduction and the domestic production activities deduction, then put a "B" on the line for "both" and include a separate statement explaining the combined deduction, according to CCH.

Do Some Party Planning

So you have three options. You need to pick the Hope or Lifetime Learning credit or the tuition and fees deduction. Only one perk per student, reminds Bob Scharin, editor of Warren, Gorham & Lamont/RIA's Practical Tax Strategies, a monthly journal for tax professionals.

Unfortunately, you have to understand arcane tax rules to make some sound decisions. Here's the big issue: The Hope and the Lifetime Learning credits are negated from your total tax bill. The tuition and fees deduction reduces your adjusted gross income. So there are different planning issues here.

In many instances you'll be better off just taking a credit, if you qualify, and reducing your total tax bill. But run the numbers first. You could get more benefit from other credits by taking the tuition and fees deduction and reducing your AGI. Here's an example.

Let's say your AGI is $112,000. At $110,000 your child tax credit starts to diminish. So if you can lower your AGI with the tuition and fees deduction, you'll then qualify for the full child tax credit and still get to deduct up to $4,000 of tuition expenses -- a double bonus.

It's really important to try different scenarios, especially if there are multiple students in the house. H&R Block's Web site has an Education Tax Benefits Estimator that can help you decide whether the credits or the deductions will work best.

Here are a few more things to consider:

So be sure to crunch some numbers. You want to make sure that while your kid is having the most expensive time of your life, you're keeping some money in your pocket.

Next in the tax series: Answering Your Taxing Questions

TheStreet.com tax series previously featured:

Brokerage Partners