Higher Education Costs: How to Get the Best Tax Treatment

Coverdell education savings accounts

A Coverdell account, once known as an Education IRA, lets you contribute up to $2,000 a year per child under 18. Contributions aren't deductible, but the account grows tax-free, and only cash can go in. Anyone can open and fund one for a child, related or not, and multiple people can contribute as long as the combined total per child stays at or under the limit; exceed it and a 6 percent excise tax applies to the excess for every year it remains in the account. The contribution limit phases out at higher income levels for the contributor.

Withdrawals are tax-free to the extent they don't exceed the beneficiary's qualified higher education expenses for the year, a definition that includes tuition, but also room, board, and books. The beneficiary can be changed to another family member, and unused funds can roll from one child's account to another's. Funds generally must be distributed by the beneficiary's 30th birthday, with an exception for special needs beneficiaries. Coverdell accounts can also fund elementary and secondary education, public, private, or religious, under similar rules.

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Section 529 qualified tuition programs

Every state offers some version of a 529 plan, and funds can now be used for K-12 education as well as college. There are two basic types: prepaid tuition plans, where you buy future education at today's prices (often limited to in-state schools), and education savings accounts, where contributions grow for later use.

The account owner, usually the main contributor, chooses and can change the beneficiary at any time, and there's no income limit on who can be an owner. Contributions must be in cash and aren't federally deductible, but earnings grow tax-free, and distributions are tax-free when used for qualified expenses, which can include room, board, and books, not just tuition. Non-qualified distributions are taxed on the earnings portion and hit with a 10 percent penalty.

For gift tax purposes, contributions count as completed gifts eligible for the annual gift tax exclusion, and a special election lets you front-load up to five years of exclusions into a single year. Funds in the account at the owner's death generally aren't included in the owner's estate, which makes 529 plans a genuinely useful estate planning tool, particularly for grandparents who want to retain control while moving assets out of their estate.

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Using traditional and Roth IRAs

A traditional or Roth IRA can double as an education fund. Withdrawals before age 59 and a half that go toward qualified higher education expenses for yourself, your spouse, or your (or your spouse's) children or grandchildren escape the usual 10 percent early withdrawal penalty, though regular income tax still applies to a traditional IRA withdrawal. You don't have to trace the withdrawn dollars directly to a tuition payment; you can pay costs from other sources and still claim the penalty exception, provided the education expenses for the year are at least as much as the withdrawal.

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Education savings bonds

Interest on qualified Series EE savings bonds issued after 1989 can be excluded from income if redeemed to pay qualified higher education expenses in the same year, subject to an income phase-out that adjusts annually and is eliminated entirely above a certain income level. The bond must be in your name or jointly with your spouse, and you must have been at least 24 years old when it was issued.

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Education credits

Two credits are available for education costs: the American Opportunity Tax Credit and the Lifetime Learning Credit, both subject to income phase-outs and both requiring the eligible student's name and Social Security number on your return. You can't claim both credits for the same student in the same year, though you can claim different credits for different family members. Filing married filing separately disqualifies you from either.

The American Opportunity Tax Credit applies only to the first four years of post-secondary education, tops out at $2,500 per eligible student, and is up to 40 percent refundable, meaning you can receive part of it even if you owe no tax. The Lifetime Learning Credit has a broader reach, covering undergraduate, graduate, and job-skill courses with no limit on the number of years claimed, but only one can be taken per return regardless of how many students you're supporting.

You can't double dip: claiming a credit and a deduction for the same expenses isn't allowed, and expenses paid with a tax-free scholarship, Pell grant, or employer assistance don't count toward the credit either.

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Employer-provided education assistance

If your employer runs a qualified educational assistance program, you can exclude up to $5,250 a year in tuition, fees, books, and supplies from your income, whether or not the courses relate to your job, and whether undergraduate or graduate level. The exclusion doesn't cover meals, lodging, or transportation, and you can't both exclude and separately deduct the same expense.

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Student loans

Student loan interest is deductible up to $2,500 a year, above the line, meaning you don't need to itemize to claim it, subject to income limits that phase the deduction out for higher earners. You must be legally obligated to repay the loan, it must have covered qualified education expenses for at least half-time study, and you can't claim it if you're claimed as someone else's dependent or if you're married filing separately. Interest on loans from a related person or entity you have an ownership stake in doesn't qualify.

Separately, certain student loan cancellations tied to service obligations, in fields like teaching or medicine in underserved areas, don't count as taxable income to the borrower under specific IRS rules.

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