Continue Reading Below
Congratulations on your new baby! Have you started saving for college yet?
It's not too early. Children grow up quickly, and college costs go up even faster. The good news is that you have several tax-advantaged ways to come up with college cash, thanks to Uncle Sam's generous tax breaks.
Educational 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 as much on college financial aid applications as funds stored in other savings vehicles. If you want to make sure that the account also doesn't cause any financial aid problems, consider letting another relative (those doting grandparents, perhaps?) set up the plan in their name and then using the funds during the child's last year of college, after the student has received their financial aid.
All 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Coverdell contributions aren't tax-deductible, but they and subsequent earnings can be withdrawn tax-free as long as they are used to pay eligible schooling costs.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. Your contribution limit is reduced if your modified adjusted gross income is between $95,000 and $110,000 and you're a single filer or between $190,000 and $220,000 if you're married and file a joint return. If you make more than the limit for your filing status, you can't contribute to anyone's Coverdell ESA.
On the other hand, Coverdell spending rules are more flexible. Whereas most tax-favored education account 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.
The American opportunity credit, created as part of the 2009 stimulus bill, replaces the Hope credit through the 2017 tax year. The American opportunity credit has several features that make it more appealing than its predecessor.
The American opportunity credit is worth more than the Hope credit, $2,500 versus the previous $1,800. You can count expenses incurred during the first four years of postsecondary education in figuring the new credit. And best of all, up to 40 percent 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 coursework to improve job skills -- and the student doesn't have to be enrolled full time. The lifetime learning credit is 20 percent 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 learning credit.
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 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 past few years Congress, has renewed the tax break. While this deduction is available for 2014 taxes, it must be renewed for tax year 2015 and beyond.
Although its above-the-line status makes this tax break more available, it does have some limits. Single filers who make less than $65,000 or married joint filers earning less than $130,000 can take the full deduction. If you make more than those amounts, but less than $80,000 as a single filer or $160,000 when married filing jointly, you can deduct up to $2,000 in tuition and fees. 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. However, to take advantage of this deduction, your modified adjusted gross income must be less than $80,000 if you're a single filer or less than $160,000 if you're married and file a joint return. If you're married, you must file a joint return to take this deduction.
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.
Copyright 2015, Bankrate Inc.