Let Uncle Sam Help Pay for College

Congratulations on your new baby! Have you started saving for college yet?

It's not too early. Children do grow up quickly, and higher education costs go up even faster. The good news is that you have several tax-advantaged ways to come up with college cash.

529 Plans

529 plans get their name from the Internal Revenue Code section under which they were created. These plans are the overwhelming favorite of families and financial planners alike. Your contributions to a 529 plan are not deductible on your federal return, but the money invested in the plan accumulates tax-free. Even better, when you withdraw account funds to pay for qualified education costs, those distributions are not taxed.

Another appealing aspect of 529s is that they are set up by an adult who names the child as the beneficiary. Anyone can contribute to a 529 plan, such as the beneficiary child's grandparents. Because the money is not in the youth's name, it won't hurt on college financial aid applications. If you want to make sure that parental ownership of the account also doesn't cause any financial aid problems, consider letting another relative (those doting grandparents, perhaps?) set up the plan.

529 plans are administered by states, and every state now has at least one. You don't, however, have to limit yourself to your state's options. You can establish an account with any 529 program. But you might get additional tax advantages, such as a deduction on your state tax returns, by establishing a plan in your home state.

You also can change the beneficiary on the plan if the child for whom it was established decides against college or completes his or her education without using all the money in the plan. Simply roll over plan funds without any tax penalty to a 529 for an immediate family member.

Coverdell Education Savings Account

Coverdell education savings accounts, or ESAs, were once known as education IRAs because the accounts operate much the same way. When the education accounts were expanded in 2002, they were renamed in honor of the late Sen. Paul Coverdell of Georgia.

Coverdell contributions aren't tax-deductible, but they and subsequent earnings can be withdrawn tax-free as long as they are used to pay eligible schooling costs.

Like 529 plans, Coverdell ESAs are established by an adult with the child as the beneficiary. Also, like 529s, anyone can contribute to the account, with the annual contribution deadline being the tax year's April filing deadline.

Most financial institutions can serve as home to a Coverdell account. There are, however, some restrictions. Only $2,000 a year is allowed from all contributors, not $2,000 from each. Also, if you make a lot of money, you can't contribute.

On the other hand, Coverdell spending rules are more flexible. Whereas most tax-favored education accounts money must be used for higher education costs, Coverdell money can help pay educational expenses from kindergarten to college, such as a junior high student's new computer.

And as with a 529 plan, if your child doesn't use all the Coverdell money, it can be rolled over to a plan for another family member.

Educational tax credits

Tax credit amounts are subtracted directly from any tax you owe, usually making them a better tax break than deductions, which reduce your taxable income amount. When it comes to education, the tax code offers several tax credits.

Last year's stimulus bill created a new school-related tab break, the American Opportunity Credit. For 2009 and 2010, it replaces in most instances the Hope credit. The new credit has several more appealing features.

The American Opportunity Credit is worth more than the Hope, $2,500 vs. the previous $1,800. You can count expenses incurred during the first four years of post-secondary education in figuring the new credit. And best of all, up to 40% of the new credit is refundable. This could get you up to $1,000 back from the IRS even if you owe no taxes.

The Lifetime Learning Credit can be used by any student at any level -- undergraduate, graduate, or even course work to improve job skills -- and the student doesn't have to be enrolled fulltime. The Lifetime Credit is 20% of up to $10,000 in educational expenses, meaning you could get a possible $2,000 credit. Also note that the $10,000 limit applies to all educational expenses, not per student. So if you have several kids in college and their total expenses are more than $10,000, the amount in excess of that won't count toward the Lifetime Credit.

The Hope credit is still available for students who attended colleges in a Midwest disaster area.

Tuition and Fees Deduction

This tax break is an above-the-line deduction that can be claimed regardless of whether you claim the standard deduction or itemize. It's found on both Form 1040 and Form 1040A and could reduce your taxable income by as much as $4,000. This deduction technically is temporary, but for the last few years, Congress has renewed the tax break.

Although its above-the-line status makes this tax break more available, it does have some limits. If you make over a certain amount, your deduction amount is reduced. If you claim one of the education tax credits, you cannot use this deduction for other expenses by the same student in the same year.

You can, however, take the tuition and fees deduction, as well as distributions from Coverdell ESAs and 529 plans, as long as you paid for different educational expenses with the various funds.

Student Loan Interest Deduction

This is another above-the-line deduction that enables you to deduct up to $2,500 in student loan interest. It, too, is phased out for higher-income taxpayers. If you're married, you must file a joint return to take this deduction.

Savings Bonds

When you cash in U.S. savings bonds, you must pay tax on the deferred interest that the bonds earned. But if you use the bonds to pay for educational expenses, the interest could be tax-free.

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