How to Handle Education Taxes Without an Advanced Degree

529 plans. Qualified tuition plans, perhaps better known as 529 plans, provide another education savings mechanism. On the front end, contributions are deductible in the federal tax calculation, and many provide breaks on state taxes as well. Earnings accumulate tax-free and distributions are also tax-free when used for qualified education expenses.

There are two types of state-sponsored plans -- college tuition prepayment plans and savings plans. Beginning in 2002, private colleges and universities are allowed to offer similar plans. Distributions from these private plans will be tax-free beginning in 2004, provided they go to paying college expenses.

The rules covering 529 plans are quirky and often specific to a particular plan, but distribution rules are similar to those of Coverdell ESAs. Consequently, taxpayers can also now claim a Hope or lifetime learning credit in the same year they withdraw from a 529 plan.

Deductibility of higher education expenses. Beginning in 2002, some taxpayers can now claim an above-the-line deduction for up to $3,000 in higher education costs. The deduction is only available to taxpayers whose modified AGI does not exceed $65,000 if filing singly or $130,000 if filing jointly. "This is a cliff and not a phase-out," Brylski says. "If modified AGI exceeds the limitation by even one cent, the deduction is completely wiped out."

This is one break that doesn't work in tandem with the Hope and lifetime learning credits, though. Taxpayers must choose between using the credit or the deduction for each student. Generally speaking, credits (which reduce the actual tax owed) are preferable to deductions (which simply lower taxable income, leading to a lower tax bill), so if you are eligible for either, choose the credits.

And for the graduates -- student loan interest deduction. The deductibility of the interest on student loans has been widened generously beginning in 2002. While the maximum amount of interest you can deduct remains $2,500, the 60-month limit on claiming the deduction has been repealed.

The income eligibility limitations have also been raised significantly: For single filers, the phaseout range begins at $50,000 and ends at $65,000 (previously it was $40,000 to $55,000); for joint filers, the range begins at $100,000 and ends at $130,000 (previously $60,000 to $75,000).

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