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With the costs of a college education rising every year, the keys to funding your child's education are to plan early and invest shrewdly. However, there are steps you can take if you get a late start.

When should I start saving for my child’s education?

This depends on how much you think your children’s education will cost. The best way is to start saving before they are born. The sooner you begin, the less money you will have to put away each year.

Example: Suppose you have one child, age six months, and you estimate that you'll need $120,000 to finance his college education 18 years from now. If you start putting away money immediately, you'll need to save $3,500 per year for 18 years (assuming an after-tax return of 7%) . On the other hand, if you put off saving until the child is six years old, you'll have to save almost double that amount every year for twelve years.

Another advantage of starting early is that you'll have more flexibility when it comes to the type of investment you'll use. you'll be able to put at least part of your money in equities, which, although riskier in the short-run, are better able to outpace inflation than other investments in the long-run.

How much will my child’s college education cost?

It depends on whether your child attends a private or state school. In the late-90s, the total expenses--tuition, fees, board, personal expenses, and books and supplies--for the average private college are about $21,000 per year. and about $10,000 per year for the average public college. . However, these amounts are averages: the tuition, fees, and board for some private colleges can cost more than $25,000 per year, whereas the costs for a state school can be kept under $10,000 per year.

If you’re trying to estimate future costs, you can estimate that school costs will grow by about two percentage points above the inflation rate. To be on the safe side, we suggest you assume costs will grow by at least 7% per year.

How should I invest my child’s college fund?

As with any investment, you should choose those that will provide you with a good return and that meet your level of risk tolerance. The ones you choose should depend on when you start your savings plan—the mix of investments if you start when your child is a toddler should be different, from those used if you start when your child is age 12.

The following are often recommended as investments for education funds:

  • Series EE bonds: These are extremely safe investments. They should be held in the parents’ names. If the adjusted gross income of you and your spouse at the time of redemption is at or under the amount set by the tax law, the interest on bonds bought after January 1, 1990 is tax-free as long as it is used for tuition or other qualified education costs. If your adjusted gross income is above the threshold amount, the tax break is phased out. This phase-out begins at about $80,000 for married couples filing a joint return.
  • U.S. government bonds: These are also investments that offer a relatively higher return than CDs or Series EE bonds. If you use zero-coupon bonds, you can time the receipt of the proceeds to fall in the year when you need the money. A drawback of such bonds is that a sale before their maturity date, could result in a loss on the investment. Further, the accrued interest is taxable even though you don’t receive it until maturity.
  • Certificates of deposit: These are safe, but usually provide a lower return than the rate of inflation. The interest is taxable. These should generally only be used by the most risk averse investors and for relatively short investment horizons.
  • Municipal bonds: Assuming the bonds are highly rated, the tax-free interest on them can provide an acceptable return if you’re in the higher income tax brackets. Zero-coupon municipals can be timed to fall due when you need the funds, and are useful if you begin saving later in the child’s life.

    Tip: Be sure to convert the tax-free return quoted by sellers of such bonds into an equivalent taxable return. Otherwise, the quoted return may be misleading. The formula for converting tax-free returns into taxable returns is as follows:

    Divide the tax-free return by 1.00 minus your top tax rate to determine the taxable-return equivalent. For example, if the return on municipal bonds is 5% and you are in the 30% tax bracket, the equivalent taxable return is 7.1% (5% divided by 70%).

  • Stocks: An appropriate mutual fund or portfolio containing stocks can provide you with a higher yield than bonds at an acceptable risk level. Stock mutual funds can provide superior returns over the long term. Income and balanced funds can meet the investment needs of those who begin saving when the child is older.  

What is the "kiddie tax"?

In the past, parents would invest in the child's name in order to shift income to the lower-bracket child. However, the addition of the "kiddie tax" mostly put an end to that strategy.

Investment income over $1,700 of children under the age of 17 is taxed at the parents' rate. (This threshold is indexed annually for inflation.) Once the child reaches age 17, however, all income is taxed at the child's rate. Of this $1,700, one-half probably won't be taxed due to the availability of the standard deduction while the other half would be taxed at the child's rate. Note in 2008, the age limit will increase to through age 18, or through age 23 for full-time students.

Note: These rules apply to unearned income. If a child has earned income, this amount is always taxed at the child’s rate.

What is an Education IRA and who is eligible for one?

Effective starting in 1998, $500 per year can be contributed to an Education IRA from which distributions used to pay for qualified educational expenses are not taxable. The contribution, however, is not deductible. For those filing as single, the contribution is phased out once AGI exceeds $95,000. For joint filers, the contribution is phased out once AGI exceeds $150,000.

If you have insufficient savings for your child’s education when he is close to entering college, what should you do?

Many families find themselves in the same boat. Fortunately, there are ways to generate additional funds both now and when your child is about to enter school:

  • You can start saving as much as possible during the remaining years. However, unless your income level is high enough to support an extremely stringent savings plan, you will probably fall short of the amount you need.
  • You can take on a part-time job. However, this will raise your income for purposes of determining whether you are eligible for certain types of student aid. In addition, your child may be able to take on part-time or summer jobs.
  • You can tap your assets by taking out a home equity loan or a personal loan, selling assets or borrowing from a 401(k) plan.
  • You (or your child) can apply for various types of student aid and education loans.

What types of grants are available for college?

Grants—the best type of financial aid because they do not have to be paid back -- are amounts awarded by governments, schools, and other organizations. Some grants are need-based and others are not.

  • Pell grants are federal aid based on need.

    Tip: Don’t assume that middle class families are ineligible for needs-based aid or loans. The assessment of whether a family qualifies as "in need" depends on the cost of the college and the size of the family.

  • State education departments may make grants available. Inquiries should be made of the state agency.
  • Employers may provide subsidies.
  • Private organizations may provide scholarships. Inquiries should be made at schools.
  • Most schools provide aid and scholarships, both needs-based and non-needs-based.
  • Military scholarships are available to those who enlist in the Reserves, National Guard, or Reserve Officers Training Corps. Inquiries should be made at the branch of service.

What types of loans are available for college?

There are various student loan programs available. Some are need-based, and others are not. Here is a summary of loans:

  • Stafford loans (formerly guaranteed student loans) are federally guaranteed and subsidized low-interest loans made by local lenders and the federal government. They are needs-based for subsidized loans; however an unsubsidized version is also available.
  • Perkins loans are provided by the federal government and administered by schools. They are needs-based. Inquiries should be made at school aid offices.
  • Parent loans for undergraduate students (PLUS) and supplemental loans for students are federally guaranteed loans by local lenders to parents, not students. Inquiries should be made at college aid offices or by calling 800-333-4636.
  • Schools themselves may provide student loans. Inquiries should be made at the school.

How can I increase the amount of financial aid my child is entitled to?

Here are some strategies that may increase the amount of aid for which your family is eligible:

  • Try to avoid putting assets in your child’s name. As a general rule, education funds should be kept in the parents’ names, since investments in a child’s name can impact negatively on aid eligibility. For example, the rules for determining financial aid decrease the amount of aid for which a child is eligible by 35% of assets the child owns and by 50% of the child’s income.

    Example: If your child owns $1,000 worth of stock, the amount of aid for which he or she is eligible for is reduced by $350. On the other hand, the amount of aid is reduced by (effectively) only 5.6% of your assets and from 22 to 47% of your income.

  • Reduce your income. Income for financial aid purposes is generally determined based upon your previous year’s income tax situation. Therefore, in the years immediately prior to and during college, try to reduce your taxable income. Some ways to do this include:
  1. Defer capital gains.
  2. Sell losing investments.
  3. Reduce the income from your business. If you are the owner of your own business, you may be able to reduce your taxable income by taking a lower salary, deferring bonuses, etc.
  4. Avoid distributions from retirement plans or IRAs in these years.
  5. Pay your federal and state taxes during the year in the form of estimated payments rather than waiting until April 15 of the following year.
  6. Since a portion of discretionary assets is included in the family’s expected contribution from income, reduce discretionary assets by paying off credit cards and other consumer loans.
  7. Take advantage of vehicles which defer income, such as 401(k) plans, other retirement plans or annuities.
  • Detail any financial hardships. If you have any financial hardships, let the deciding authorities know (via the statement of financial need) exactly what they are, if they are not clear from the application. The financial aid officer may be able to assist you in explaining hardships.
  • Have your child become independent. In this case, your income is not considered in determining how much aid your child will be eligible for. Students are considered independent if they:
  1. Are at least 24 years old by the end of the year for which they are applying for aid
  2. Are veterans
  3. Have dependents other than their spouse
  4. Are wards of the court or both parents are deceased
  5. Are graduate or professional students
  6. Are married and are not claimed as dependents on their parents’ returns

How can I save taxes on college savings?

If you decide to invest in your child’s name, here are some tax strategies to consider:

  • You can shift just enough assets to create $1,700 in 2007 taxable income to an under-18 child.
  • You can buy U.S. Savings Bonds (in the child’s name) scheduled to mature after your child reaches age 18.
  • You can invest in equities that pay small dividends but have a lot of potential for appreciation. The dividend income earned when your child is under 18 will be minimal with tax relief, and the growth in the stocks will occur over the long term.
  • If you own a family business, you can employ your child in the business. Earned income is not subject to the "kiddie-tax," and is deductible by the business if the child is performing a legitimate function. Additionally, if your business is a sole proprietorship and your child is under 18, then he or she will not pay social security taxes on the income.

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Like saving for retirement - the earlier you start your plan the better! Use this calculator to help develop and fine tune your education savings plan.

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This calculator is specifically designed to help students understand their expenses and income while attending a university, college or other full-time educational institution.

This calculator allows you to input your expenses and income for an eight-month school year running from September through April.

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What types of tax relief are available for costs of my children's higher education?

A wide variety of relief is available. In some cases you'll have to choose which to claim, based on what each is worth in your tax situation. There are tax exclusions, tax deferrals, tax credits, tax deductions, and relief from tax penalties.

You can't take two different kinds of relief for the same item. You can sometimes take one type of relief for one education item and another type for another item.

Some benefits have income ceilings that bar or limit the relief as taxpayer's income rises.

What's the education tax credit?

There are two types of education credit, and you must choose. Briefly: the Hope credit is for the first 2 years after high school, so it fits community college or the first 2 years of a 4 year college. It must be for at least half-time study. The credit ceiling is $1,500 per student per year (100% of the first $1,000, 50% of the next $1,000).

The lifetime learning credit fits any undergraduate or graduate study, but study less than half- time must be work-related. The credit ceiling is $2,000 (20% of expenses up to $10,000) per taxpayer per year.

Do any tax planning considerations apply to the education tax credit?

For an academic period (quarter, semester, etc.) beginning in the first 3 months of a calendar year, you can pick which year to pay the expense and take the credit. That is, pay in December 2007 and take the credit in 2007 or pay in, say, February, 2008 and take the credit in 2008.

Your family may be able to save tax by foregoing the education credit and taking an available exemption for program distributions instead.

Do living expenses while in school qualify for tax relief?

Sometimes. Examples are for relief provided for Coverdell education expense accounts (Section 530 programs), for qualified tuition (section 529) programs, for withdrawals from traditional and Roth IRAs, and for student loans.

How does a Coverdell (section 530) program work?

An education IRA differs from other IRAs in the following ways:

  • No more than $2,000 a year can be contributed to any single 530 account in any year, and contributors are subject to income limits.
  • Contributions aren't deductible and excess contributions are subject to penalty.
  • Withdrawals are tax-free to the extent used for qualified education expenses.
  • Contributions can't be made after the student reaches age 18, and the account generally must distribute all funds by the student's age 30.

Unlike other plans, 530 accounts may be used for primary and secondary education, including paying for room and board of children in private schools, and for computers and related materials whether or not away from home.

How can my family make best use of a Coverdell (Section 530) program?]

There can be a number of Section 530 accounts for any student. Various family members, such as grandparents, aunts and uncles, and siblings--and persons outside the family--can contribute to separate accounts for a student.

The original student beneficiary for the Section 530 account can be changed to another family member, such as a sibling--for example where the original beneficiary wins a scholarship or drops out.

Funds can be rolled over tax-free from one family member's Section 530 account to another's--for example, to avoid distribution when the first family member reaches age 30.

The education tax credit (where applicable) can be waived in favor of tax-free treatment for Section 530 account distributions.

What are qualified tuition programs?

These, also called Section 529 programs, are college savings programs established by almost every state, and some private colleges. You invest now to cover future college expenses, by contributing to a savings account or buying tuition credits redeemable in the future. Investments grow tax-free, and distributions to pay college expenses can also be tax-free. You may choose any state’s plan, regardless of where you live.

How do Coverdell Section 530 plans and qualified tuition Section 529 plans differ?

In several major ways. Section 530 plans limit investment to $2,000 a year per student; 529 plans allow much larger investment. Section 530 plans allow wide choice of investment; 529 investment choices are limited and conservative. Section 530 is a single nationwide program; each 529 program is different. Though both are available for higher education, Section 530 can also be used for primary and secondary education. You are free to use both for higher education for the same student.

Can my traditional IRA be used for education?

Yes. The 10% penalty on withdrawal under age 59-1/2 won't apply, but ordinary income tax will apply to at least some of the withdrawal.

Can a Roth IRA be used for education?

Yes, generally under the same terms as traditional IRAs. Also, ordinary income tax is somewhat less likely, or may be smaller in amount, than with traditional IRAs.

What tax deductions are available for college education?

A limited deduction is allowed through 2007 for higher education tuition and related expenses. Deduction up to $4,000 is allowed on if taxpayer’s (modified) adjusted gross income is $65,000 or less ($130,000 or less on a joint return). If taxpayer’s modified adjusted gross income is more than $65,000 but not more than $80,000 (more than $130,000 but not more than $160,000 on a joint return), deduction is allowed up to $2,000.

Business expense deduction is allowed, without dollar limit, for education that serves the taxpayer’s business, including employment. Deduction is also allowed for student loan interest. A taxpayer may not take more than one deduction for the same item.

What tax benefits are available for Continuing/Adult Education for a sideline hobby?

Not much, if it's not part of a degree or certificate program, and not work-related, the limited deduction (up to $4,000 for tuition and fees) may be your only option. Deduction is available through 2007, depending on your income. Some sideline interests might qualify for exclusion if paid for under an employer-provided education assistance program.

Can I deduct student loan interest?

Since personal interest is generally non-deductible, deductions must meet several tests:

  1. You must be the person liable on the debt and the loan must be for education only (not an open line of credit).
  2. Your income can't exceed $140,000 on a joint return or $70,000 (2007 amounts) on a single return; married couples filling separately cannot deduct.
  3. You can't deduct if you're claimed as a dependent.
  4. Deduction ceiling is $2,500.

If I take a home equity loan to pay education expenses, can I deduct the interest?

Yes, as home equity loan interest, not as student loan interest. In this case there's no income ceiling on your deduction, and certain other student loan limits don't apply.

What tax treatment applies if my student loan debt is canceled?

Usually you're taxed on the unpaid loan balance. But tax can be waived if the debt is canceled because you participate in some approved government or other program.

What's the tax relief for education savings bonds?

Interest on redemption of Series EE bonds is tax-exempt if you redeem them in a year you have qualified education expenses. Exemption depends on the amount of your income in the year you redeem the bond.

Must I pay tax on my employer's payment or reimbursement of my education expenses?

Maybe not. Up to $5,250 can be tax free. Exemption can apply to graduate level courses.

Can I take tax deductions for education I pay for that helps me in my work?

Yes if it's to maintain or improve skills in your present job. No if it's to meet minimum requirements of that job, or to qualify to enter a new business. Employee's deductions are subject to the 2% floor on miscellaneous itemized deductions.

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Many tax benefits are available to help you pay higher education costs, whether for your children or yourself. Because of the variety of benefits and programs, the amounts often involved — and the fact that the use of some benefits can preclude others — this area is one of the most complex an individual can face.

This Financial Guide discusses, first, the programs which are in essence plans for building savings for higher education, and then the benefits available as and after the higher education takes place. In this area more than most, professional guidance is necessary.

The eligibility rules vary for each tax benefit, with many limited to taxpayers whose income falls below certain levels.

Coverdell Education Savings Accounts (Section 530 Programs)

You can contribute up to $2,000 each year to a Coverdell education savings account (Section 530 program) for a child under 18. These contributions are not deductible, but they grow tax-free until withdrawn. Contributions for any year (say 2007) can be made through the (unextended) due date for the return for that year (April 15, 2008).

Only cash can be contributed to a Section 530 account and you cannot contribute to the account after the child reaches his or her 18th birthday.

Anyone can establish and contribute to a Section 530 account, including the child, as long as the contributor's modified AGI doesn't exceed $220,000 for a joint return or $110,000 for a single filer. You may establish 530s for as many children as you wish, and the child need not be a dependent — in fact, he or she need not be related to you. But the amount contributed during the year to each account cannot exceed $2,000. This maximum contribution amount for each child is phased out for AGI between $190,000 and $220,000 (joint) and $95,000 and $110,000 (single).

Note: A 6% excise tax applies to excess contributions. These are amounts in excess of the applicable contribution limit ($2,000 or phase out amount) and contributions for a year that amounts are contributed to a qualified tuition program for the same child. A qualified tuition program, sometimes called a Section 529 program, is a tax-favored state program to prepay education costs, see below. The 6% tax continues for each year the excess contribution stays in the 530 account.

The child must be named (designated as beneficiary) in the Coverdell document, but the beneficiary can be changed to another family member (for example, to a sibling where the first beneficiary gets a scholarship or drops out). And funds can be rolled over tax-free from one child's account to another's. Funds must be distributed not later than 30 days after the beneficiary's 30th birthday (or 20 days after the beneficiary's death if earlier). For "special needs" beneficiaries the age limits (no contributions after age 18, distribution by age 30) don't apply.

Withdrawals are taxable to the person who gets the money, with these major exceptions: Only the earnings portion is taxable (the contributions come back tax-free). Also, even that part isn't taxable income, as long as the amount withdrawn doesn't exceed a child's "qualified higher education expenses" for that year. The definition of "qualified higher education expenses" includes room and board and books, as well as tuition. In figuring whether withdrawals exceed qualified expenses, expenses are reduced by certain scholarships and by amounts for which tax credits (see Educational Credits, below) are allowed. If the amount withdrawn for the year exceeds the education expenses for the year, the excess is partly taxable under a complex formula. There's another formula if the sum of withdrawals from this 530 program and from the qualified tuition (Section 529) program exceed education expenses.

You as the person who sets up the Section 530 account may change the beneficiary (the child who will get the funds) or roll the funds over to the account of a new beneficiary, tax-free, if the new beneficiary is a member of your family. But funds you take back (for example, withdrawal in a year when there are no qualified higher education expenses, because the child is not enrolled in higher education) are taxable to you, to the extent of earnings on your contributions, and you will generally have to pay an additional 10% tax on the taxable amount. However, you won't owe tax on earnings on amounts contributed that are returned to you by June 1 of the year following contribution.

Investment policy

You may choose and change Section 530 investments freely — in contrast to Section 529 programs and, of course, Series EE bonds.

Tip: Check with your financial adviser about using both the Section 530 program, which has wide investment options but limited ($2,000 or less) contribution/investment amounts, and the Section 529 program, which has limited investment options but allows higher contribution/investment amounts.

Elementary and secondary schools

Section 530 programs can be used to build up funds for primary and secondary education. The tax rules are similar to those for higher education: withdrawals taxable to the extent of earnings on contributions, except tax-free up to the child's qualified elementary and secondary education expenses. These expenses qualify whether the child attends a private, religious or public school. Expenses such as room, board, tuition, transportation and uniforms will qualify only where connected with private or religious schools, but some expenses — books, computers, educational software and internet access — apply as well to children in public school living at home.

The age limits for higher education apply here too: no contribution after child reaches age 18, distribution at age 30 except for special needs beneficiaries. Withdrawals in excess of qualified education expenses are taxable under a special formula.

Qualified Tuition Programs (Section 529 Programs)

Every state now has a program allowing persons to prepay for future higher education, with tax relief.  There are two basic plan types, with many variations among them:

  1. The prepaid education arrangement. Here one is essentially buying future education at today's costs, by buying education credits or certificates. This is the older type of program, and tends to limit the student's choice to schools within the state. Private colleges and universities may now offer this type.
  2. Education savings accounts. Here, contributions are made to an account to be used for future higher education.

In approaching state programs one must distinguish between what the federal tax law allows and what an individual state's program may impose.

You may open a Section 529 program in any state. But when buying prepaid tuition credits (less popular than savings accounts), you will want to know to what institutions the credits will be applied.

Unlike certain other tax-favored higher education programs, such as the Hope and lifetime learning tax credits, federal tax law doesn't limit the benefit to tuition, but can also extend it to room, board, books, etc. (Individual state programs could be narrower.)

The two key individual parties to the program are the Designated Beneficiary, the student-to-be, and the Account Owner, who is entitled to choose and change the beneficiary and who is normally the principal contributor to the program. There are no income limits on who may be an account owner. There's only one designated beneficiary per account. Thus, a parent with three college-bound children might set up 3 accounts. (Some state programs don't allow the same person to be both beneficiary and account owner.)

Contributions must be in cash, and must not total more than reasonably needed for higher education (as determined initially by the state). Neither account owner nor beneficiary may direct investments, but the state may allow the owner to select a type of investment fund (e.g., fixed income securities), and to change the investment annually, and when the beneficiary is changed. The account owner decides who gets the funds (can pick and change the beneficiary) and is legally allowed to withdraw funds at any time, subject to tax and penalty discussed later.

Funds in the account not yet distributed at the account owner's death pass as part of the probate estate under state law-though this is not the result for federal estate tax purposes, see below.

Federal Tax Rules

Income tax. Contributions made by the account owner or other contributor are not deductible for federal income tax purposes. Earnings on contributions grow tax-free while in the program.

Distributions from the fund are tax-free to the extent used for qualified higher education expenses. Distributions used otherwise are taxable to the extent of the portion which represents earnings.

A Section 529 distribution can be tax-free even though the student is claiming a Hope or lifetime learning credit, or tax-free treatment for a Section 530 Coverdell distribution, if the programs aren't covering the same specific expenses.

Distribution for a purpose other than qualified education is taxed to the one getting the distribution. In addition, a 10% penalty must be imposed on the taxable portion of the distribution, comparable to the 10% penalty in Section 530 Coverdell plans.

The account owner may change beneficiary designation from one to another in the same family. Funds in the account roll over tax-free for the benefit of the new beneficiary.

Gift Tax. For gift tax purposes, contributions are treated as completed gifts even though the account owner has the right to withdraw them. Thus they qualify for the up-to-$12,000 annual gift tax exclusion ($11,000 before 2006). One contributing more than $12,000 may elect to treat the gift as made in equal installments over the year of gift and the following 4 years, so that up to $60,000 can be given tax-free in the first year.

A rollover from one beneficiary to another in a younger generation is treated as a gift from the first beneficiary, an odd result for an act the "giver" may have had nothing to do with.

Estate tax. Funds in the account at the designated beneficiary's death are included in the beneficiary's estate, another odd result, since those funds may not be available to pay the tax. Funds in the account at the account owner's death are not included in the owner's estate, except for a portion thereof where the gift tax exclusion installment election is made for gifts over $12,000. For example, if the account owner made the election for a gift of $60,000 in 2007, a part of that gift is included in the estate if he or she dies within 5 years.

Tip: A Section 529 program can be an especially attractive estate-planning move for grandparents. There are no income limits, the account owner giving up to $60,000 avoids gift tax, and estate tax by living 5 years after the gift, yet has the power to change the beneficiary.

State Tax: State tax rules are all over the map. Some reflect the federal rules, some quite different rules. For specifics of each state's program, see http://www.collegesavings.org.

Professional guidance: Considering the wide differences among state plans, the federal and state tax issues, and the dollar amounts at stake, professional guidance is advised.

Traditional and Roth IRAs

You can use a traditional or Roth IRA as a savings plan to pay qualified higher education expenses. With a traditional IRA you will owe income tax on at least part of the withdrawal; since Roth IRA investments are already tax-paid, withdrawals are less likely to be taxable. Withdrawals before age 59 1/2 to pay qualified higher education expenses are not subject to the additional 10% tax on early withdrawals.

To escape the 10% tax, you must pay education costs that at least equal your withdrawal amount. The education costs must be "qualified," — i.e. for tuition, fees, books, room and board, supplies, or equipment at a qualified institution of learning — and they must be for yourself, your spouse, or the children or grandchildren or yourself or your spouse. The qualified institution of learning may be any college, university, vocational school, or other post-secondary school that is eligible to participate in federal Department of Education aid programs.

Tip: You do not actually have to use the IRA funds to pay education costs. That is, the tax relief doesn't require you to trace the IRA withdrawal dollars to a specific education expense payment.  You can pay the costs with your own earnings or savings, with a loan, or with a gift or inheritance received by the student or the person making the withdrawal. You can use savings accumulated in a Section 529 (state sponsored) program.

However, you cannot count education costs paid with proceeds from the following in determining whether your IRA withdrawal is to be free of the 10% tax:

  • Tax-free distributions from a Coverdell education savings account (Section 530 program);
  • Tax-free scholarships, such as a Pell grant;
  • Tax-free employer education assistance program;
  • Any tax-free payment (other than a gift or bequest) that is due to enrollment at the qualified institution.

Education Savings Bonds

You can exclude from your gross income interest on qualified U.S. savings bonds if you have qualified higher education expenses during the year in which you redeem the bonds. The exclusion phases out where the bondholder has (modified) adjusted gross income over a specified amount in the year the bond is redeemed. The amount, indexed for inflation, is $65,600 in 2007 ($98,400 on a joint return; unavailable to married filing separately).

The education must be of the bondholder, his or her spouse or dependent. Qualified higher education expenses are tuition and fees, and contributions to Section 529 and 530 programs, reduced for tax-free scholarships and other relief.

A qualified U.S. savings bond means a Series EE bond issued after 1989. The bond must be either in your name or in the names of both you and your spouse, and you must be at least 24 years old before the bond's issue date.

Education Credits

Two tax credits are available for education costs — the Hope credit and the lifetime-learning credit. These credits are available only to taxpayers with adjusted gross income below specified amounts, see Income Phase-Outs, below.

How These Credits Work

The amount of the credit you can claim depends on (1) how much you pay for qualified tuition and other expenses for students and (2) your adjusted gross income (AGI) for the year.

You must report the eligible student's name and Social Security number on your return to claim the credit. You subtract the credits from your federal income tax. If the credit reduces your tax below zero, you cannot receive the excess as a refund. If you receive a refund of education costs for which you claimed a credit in a later year, you may have to repay ("recapture") the credit.

CAUTION: If you file married-filing separately, you cannot claim these credits.

Which costs are eligible. Qualifying tuition expenses mean tuition and fees required for enrollment or attendance at an eligible education institution. They do not include books, room and board, student activities, athletics (other than courses that are part of a degree program), insurance, equipment, transportation, or any personal, living, or family expenses. For expenses paid with borrowed funds, count the expenses when they are paid, not when borrowings are repaid.

Tip: If you pay qualified expenses for a school semester that begins in the first three months of the following year, you can use the prepaid amount in figuring your credit.

Example: You pay $1,500 of tuition in December 2007 for the winter 2008 semester, which begins in January 2008. You can use the $1,500 in figuring your 2007 credit. If you paid in January instead, you would take the credit on your 2008 return.

Tip: As future year-end tax planning, this rule gives you a choice of the year to take the credit for academic periods beginning in the first 3 months of the year; Pay by December and take the credit this year; pay in January or later and take the credit next year.

Eligible students. You, your spouse, or an eligible dependent (someone for whom you can claim a dependency exemption, including children under age 24 who are full-time students) can be an eligible student for whom the credit can apply. If you claim the student as a dependent, qualifying expenses paid by the student are treated as paid by you, and for your credit purposes are added to expenses you paid. A person claimed as another's dependent can't claim the credit. The student must be enrolled at an eligible education institution (any accredited public, non-profit, or private post-secondary institution eligible to participate in student Department of Education aid programs) for at least one academic period (semester, trimester, etc.) during the year.

No "double-dipping." The tax law says that you can't claim both a credit and a deduction for the same higher education costs. It also says that if you pay education costs with a tax-free scholarship, Pell grant, or employer-provided educational assistance, you cannot claim a credit for those amounts.

Income phase-outs. Your education credits are gradually phased out if your modified AGI for 2007 is between $47,000 and $57,000 ($94,000 and $114,000 for joint returns) ($45,000, $55,000, $90,000 and $110,000, respectively, for 2006). Once your modified AGI reaches the top limit of these ranges, you cannot claim any education credit. "Modified AGI" generally means your adjusted gross income. The "modifications" only come into play if you have income earned abroad.

The Hope Credit

You may be able to claim up to $1,650 of the Hope credit for 2006 and 2007. You can claim the Hope credit for each eligible student you have for which the Hope credit requirements are met. The credit can be claimed for only two years per eligible student.

Special qualification rules. In addition to being an eligible student, he or she:

  • Must be a freshman or sophomore;
  • Must be enrolled in a program leading to a degree, certificate, or other recognized credential;
  • Must be taking at least half of a normal full-time load of courses, for at least one semester or trimester beginning in the year for which the credit is claimed; and
  • May not have any drug-related felony convictions.

Amount of credit. The amount of the Hope credit is 100% of the first $1,000 plus 50% of the next $1,000 you pay for each eligible student.  These $1,000 amounts are indexed for inflation and are $1,100 for 2006 and 2007, and so can total $1,650. The maximum you can claim is $1,650 times the number of eligible students. Thus, you will benefit from the maximum $1,650 amount for each eligible student for whom you pay at least $2,200. Remember, however, that the credit may be reduced based on your AGI.

The Lifetime Learning Credit

You may be able to claim a Lifetime Learning credit of up to $2,000 (20% of the first $10,000 of qualified expense) for eligible students (subject to reduction based on your AGI). The eligibility rules for the Lifetime Learning credit are broader than those that apply to the Hope credit:

  • Unlike the Hope credit, students need not be in the first two years of undergraduate education; all undergraduate and graduate programs qualify.
  • Further, for courses taken to acquire or improve job skills, there are no requirements as to course loads, so that even one or two courses can qualify.
  • The number of years for which this credit can be claimed is not limited.

Choosing the Credit. You can't claim both credits for the same person in the same year. But you can claim one credit for one or more family members and the other credit for expenses for one or more others in the same year — for example, a Hope credit for your child and a lifetime learning credit for yourself.

Electing Not To Take the Credit. There are situations in which the credit is not allowed, or not fully available, if some other education tax benefit is claimed — where the higher education expense deduction is claimed for the same student, see below, or where credit and tax exemption (under a Section 529 or 530 program) are claimed for the same expense. In that case the taxpayer — or, more likely, the taxpayer's tax adviser — will determine which tax rule offers the greater benefit and if it's not the credit, elect not to take the credit.

Qualified Tuition and Related Expenses Deduction

A limited deduction is allowed for "qualified higher education expenses" — tuition and related expenses under the same definition as for tuition credits, above. Business deduction is allowed already, without dollar limit, for education that serves the taxpayer's business, including employment. The new deduction for "qualified higher education expenses" scheduled to end after 2007, extends to expenses having no business connection, which is the usual case with higher education expenses. Where the taxpayer claims another education-related deduction, such as a business or interest deduction, this deduction can't be claimed for the same items.

The law doesn't prescribe who the expense must be paid for — self, dependent, etc. — but it precludes deduction for one who is another's dependent or who is married filing separately. And it can't be claimed where a tuition credit is claimed (by anyone) for the same student.

Deduction up to $4,000 is allowed if taxpayer's (modified) adjusted gross income (AGI) is $65,000 or less ($130,000 or less on a joint return). Deduction up to $2,000 is allowed taxpayers with AGI between $65,000–$80,000 ($130,000 — $160,000 on a joint return).

"Qualified higher education expenses" must be reduced by any such expense paid with an amount treated as tax-free under the rules for excluding income from Series EE bonds, or Section 529 or 530 programs.

The deduction is above the line — meaning it's not subject to the 2% floor on itemized deductions and is allowed whether or not the standard deduction is claimed.

Employer-Provided Education Assistance

If your employer paid education assistance benefits (e.g., reimbursements of tuition), part or all of them may be tax-free. You can exclude up to $5,250 per year of the benefits you receive under a qualified education assistance program. But you can't both exclude and deduct the same item, even if it's otherwise deductible. In order to qualify your employer must have established an educational assistance plan that does not discriminate in favor of highly paid employees or owners. The exclusion applies to undergraduate level courses other than those involving sports, game and hobbies. The courses do not need to relate to your job. The exclusion is available for tuition, fees, books and supplies but not meals, lodging or transportation. And it applies to benefits for graduate level courses.

In addition to the exclusion for qualifying education plans, your employer can provide reimbursement for business related courses, including graduate courses. If your employer does not reimburse you for these expenses, you may be entitled to deduct them as a miscellaneous itemized deduction subject to the 2% deduction floor. To qualify, the expense must meet the requirement of your employer or the law or maintain or improve skills in your current job. The course must not meet minimum education requirements for your job or qualify you for a new trade or business.

Student Loans

You may be able to deduct interest on student loans. You may also be able to exclude income that you would otherwise have to report if a student loan is cancelled.

Interest Deduction. You may deduct student loan interest you pay, including interest paid that's not currently due because payment is deferred.

Deduction is allowed even though it would otherwise be nondeductible personal interest. But you may deduct only if you are the one legally bound to pay the interest, and only on loans solely for qualified expenses (so not under open credit lines).

The student-loan deduction is available only to taxpayers whose AGI is below $140,000 (joint amount) or $70,000 (single amount). Married couples filing separately can't deduct. The deduction is phased out for those whose AGI is above $55,000 (single amount) or $110,000 (joint amount). The dollar amounts are indexed for inflation; these are the amounts for 2007 (for 2006, the respective amounts were $135,000, $65,000, $50,000 and $105,000). The student-loan interest deduction is an "above the line" deduction — you don't have to itemize to claim it. The loan must have been taken out to cover education expenses of at least half-time study for yourself, your spouse, or a person who was your dependent when you took out the loan. The maximum deduction is $2,500.

Caution: You cannot deduct interest on a loan from a related person — e.g. a relative, or a business entity in which you have an ownership interest as defined by the tax law. And you can't deduct if you are claimed as a dependent.

Tip: Where interest fails to qualify under these tests, consider a home equity loan, interest on which is generally deductible.

Cancellation of Student Loan. If certain requirements are met, cancellations of student loans that are intended to induce students to perform certain services do not increase the student's gross income. This relief extends to certain private programs, as well as government and public programs.

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With the costs of a college education rising every year, the keys to funding your child's education are to plan early and invest shrewdly. However, there are steps you can take if you get a late start. Moreover, there are a number of effective techniques for increasing financial aid opportunities and reducing taxes.

Savings And Investment Strategies

The thought of funding your child's education—the cost of which has grown at about 6% a year—can be staggering. However, proper planning can lessen the financial squeeze considerably, especially if you start when your child is young.

Here are some guidelines--geared to parents whose children are no older than elementary school age--for funding your child's education.

Start Saving Early

We cannot emphasize enough that getting an early start is basic to funding your child's education. The earlier you start, the more you'll benefit from the compounding of interest.

Planning Tool:: For an estimate of the amount of money you would have at the time your child enters college if you begin saving now, see the Financial Calculator: College Savings Calculator.

When should you start saving? This depends on how much you think your children's education will cost. The best way is to start saving before they are born. The sooner you begin, the less money you will have to put away each year.

Example: Suppose you have one child, age six months, and you estimate that you'll need $120,000 to finance his college education 18 years from now. If you start putting away money immediately, you'll need to save $3,500 per year for 18 years (assuming an after-tax return of 7%) . On the other hand, if you put off saving until the child is six years old, you'll have to save almost double that amount every year for twelve years.

Another advantage of starting early is that you'll have more flexibility when it comes to the type of investment you'll use. You'll be able to put at least part of your money in equities, which, although riskier in the short-run, are better able to outpace inflation than other investments after time.

Find Out How Much You'll Need To Save

How much will your child's education cost? It depends on whether your child attends a private or state school. In the late-90s, the total expenses--tuition, fees, board, personal expenses, and books and supplies--for the average private college are about $21,000 per year and about $10,000 per year for the average public college. However, these amounts are averages: the tuition, fees, and board for some private colleges can cost more than $25,000 per year, whereas the costs for a state school can be kept under $10,000 per year.

Planning Tool: To find and select the best college's) for your child from a database of over 3,200 two-and four-year colleges, see College Search.

Don't forget to add the costs of graduate or professional school to the amount your child will need.

Planning Tool: If you're trying to estimate future costs, you can estimate that school costs will grow by about two percentage points above the inflation rate. To be on the safe side, we suggest you assume costs will grow by at least 7% per year. For the most recent increases, refer to College Costs.

Choose Your Investments

As with any investment, you should choose those that will provide you with a good return and that meet your level of risk tolerance. The ones you choose should depend on when you start your savings plan—the mix of investments if you start when your child is a toddler should be different from those used if you start when your child is age 12.

The following are often recommended as investments suitable for education funds:

Series EE Bonds are extremely safe investments.

U.S. Government Bonds are also safe investments that offer a relatively higher return. If you use zero-coupon bonds, you can time the receipt of the proceeds to fall in the year when you need the money. A drawback of such bonds is that a sale before their maturity date could result in a loss on the investment. Further, the accrued interest is taxable even though you don't receive it until maturity.

CDs are safe, but usually provide a lower return than the rate of inflation. The interest is taxable.

Municipal Bonds, if they are highly rated, can provide an acceptable return from the tax-free interest if you're in the higher income tax brackets. Zero-coupon municipals can be timed to fall due when you need the funds and are useful if you begin saving later in the child's life.

Tip: Be sure to convert the tax-free return quoted by sellers of such bonds into an equivalent taxable return. Otherwise, the quoted return may be misleading. The formula for converting tax-free returns into taxable returns is as follows:

Divide the tax-free return by 1.00 minus your top tax rate to determine the taxable-return equivalent. For example, if the return on municipal bonds is 5% and you are in the 30% tax bracket, the equivalent taxable return is 7.1% (5% divided by 70%).

Stocks contained in an appropriate mutual fund or portfolio can provide you with a higher yield at an acceptable risk level. Stock mutual funds can provide superior returns over the long term. Income and balanced funds can meet the investment needs of those who begin saving when the child is older.

Deferred Annuities provide you with tax deferral, but the yield may not be acceptable because of the relatively high cost of these investments. Further, amounts withdrawn before you reach age 59-1/2 may be subject to a 10% premature withdrawal penalty.

If You're Caught Short

If you have insufficient savings for your child's education when he or she is close to entering college, there are ways to generate additional funds both now and when your child is about to enter school:

  1. You can start saving as much as possible during the remaining years. However, unless your income level is high enough to support an extremely stringent savings plan, you will probably fall short of the amount you need.
  2. You can take on a part-time job. However, this will raise your income for purposes of determining whether you are eligible for certain types of student aid. In addition, your child may be able to take on part-time or summer jobs.
  3. You can tap your assets by taking out a home equity loan or a personal loan, selling assets or borrowing from a 401(k) plan.
  4. You (or your child) can apply for various types of student aid and education loans (discussed below and in InfoSources).

Tip: Sources of student aid and education loans should be exhausted before other types of loans are used, since the former make better sense financially. In some cases, however, a home equity loan can be advantageous because of the deductibility of interest.

Sources Of Financial Aid

Here is a summary of the possible sources of financial aid. The types of aid and tax implications change frequently, so consult your financial advisor for specifics when you're approaching the time to seek financial aid.

Grants, the best type of financial aid because they do not have to be paid back, are amounts awarded by governments, schools, and other organizations. Some grants are need-based and others are not.

  • Pell grants are federal aid based on need.

    Tip: Don't assume that middle class families are ineligible for needs-based aid or loans. The assessment of whether a family qualifies as "in need" depends on the cost of the college and the size of the family.

  • State education departments may make grants available. Inquiries should be made of the state agency. Employers may provide subsidies.
  • Private organizations may provide scholarships. Inquiries should be made at schools.
  • Most schools provide aid and scholarships, both needs-based and non-needs-based.
  • Military scholarships are available to those who enlist in the Reserves, National Guard, or Reserve Officers Training Corps. Inquiries should be made at the branch of service.

    Tip: Try negotiating with your preferred college for additional financial aid, especially if it offers less than a comparable college.

Loans may be need-based, and others are not. Here is a summary of loans:

  • Stafford loans (formerly guaranteed student loans) are federally guaranteed and subsidized low-interest loans made by local lenders and the federal government. They are needs-based for subsidized loans; however an unsubsidized version is also available.
  • Perkins loans are provided by the federal government and administered by schools. They are needs-based. Inquiries should be made at school aid offices.
  • Parent loans for undergraduate students (PLUS) and supplemental loans for students are federally guaranteed loans by local lenders to parents, not students. Inquiries should be made at college aid offices or by calling 800-333-4636.
  • Schools themselves may provide student loans. Inquiries should be made at the school.

Work-Study Programs. This is a program that is federally funded and based on the family's financial need. The student works on-campus and receives partly subsidized pay. The receipt of work-study funds does not affect the level of "need" for purposes of need-based grants and loans.

To make a thorough investigation, you should fill out the financial aid application, which you can obtain from the school's financial aid office. You will have to provide tax returns. The amount you are determined to be eligible for depends on your income, the size of your family, the number of family members currently attending college, and your assets.

Planning Techniques - How To Increase The Amount Of Financial Aid

Here are some strategies that may increase the amount of aid for which your family is eligible:

  1. Try to avoid putting assets in your child's name. As a general rule, education funds should be kept in the parents' names, since investments in a child's name can impact negatively on aid eligibility. For example, the rules for determining financial aid decrease the amount of aid for which a child is eligible by 35% of assets the child owns and by 50% of the child's income.

Example: If your child owns $1,000 worth of stock, the amount of aid for which he or she is eligible for is reduced by $350. On the other hand, the amount of aid is reduced by (effectively) only 5.6% of your assets and from 22 to 47% of your income.

  1. Reduce your income. Income for financial aid purposes is generally determined based upon your previous year's income tax situation. Therefore, in the years immediately prior to and during college, try to reduce your taxable income. Some ways to do this include:
    • Defer capital gains.
    • Sell losing investments.
    • Reduce the income from your business. If you are the owner of your own business, you may be able to reduce your taxable income by taking a lower salary, deferring bonuses, etc.
    • Avoid distributions from retirement plans or IRAs in these years.
    • Pay your federal and state taxes during the year in the form of estimated payments rather than waiting until April 15 of the following year.
    • Since a portion of discretionary assets is included in the family's expected contribution from income, reduce discretionary assets by paying off credit cards and other consumer loans.
    • Take advantage of vehicles which defer income, such as 401(k) plans, other retirement plans or annuities.
  1. Detail your financial hardships. If you have any financial hardships, let the deciding authorities know (via the statement of financial need) exactly what they are, if they are not clear on the application. The financial aid officer may be able to assist you in explaining hardships.
  2. Have your child become independent (if feasible). In this case, your income is not considered in determining how much aid your child will be eligible for. Students are considered independent if they:
    • Are at least 24 years old by the end of the year for which they are applying for aid,
    • Are veterans,
    • Have dependents other than their spouse,
    • Are wards of the court or both parents are deceased,
    • Are graduate or professional students or
    • Are married and are not claimed as dependents on their parents' returns.

How To Reduce Taxes

As noted above, education funds should generally be kept in the parents' names because of financial-aid considerations. However, in specific cases, it may be better to keep the investments in your child's name since the tax rate on the income will be less than if they are held in your name. Professional advice should be sought in making this decision.

In the past, parents would invest in the child's name in order to shift income to the lower-bracket child. However, the addition of the "kiddie tax" mostly put an end to that strategy. Now, investment income over $1,700 for 2007 (the same as for 2006) of children under the age of 18 is taxed at the parents' rate. (This threshold is indexed annually for inflation.) Once the child reaches age 18, however, all income is taxed at the child's rate. Of this $1,700, one-half probably won't be taxed due to the availability of the standard deduction while the other half would be taxed at the child's rate.

Note: These rules apply to unearned income. If a child has earned income, this amount is always taxed at the child's rate. If you decide to invest in your child's name, here are some tax strategies to consider:

  1. You can shift just enough assets to create $1,700 in taxable income to an under-18 child.
  2. You can buy U.S. Savings Bonds (in the child's name) scheduled to mature after your child reaches age 18.
  3. You can invest in equities that pay small dividends but have a lot of potential for appreciation. The income earned when your child is under 18 will be minimal, and the growth in the stocks will occur over the long term.
  4. If you own a family business, you can employ your child in the business. Earned income is not subject to the "kiddie-tax," and is deductible by the business if the child is performing a legitimate function. Additionally, if your business is a sole proprietorship and your child is under 18, then he or she will not pay social security taxes on the income.

There are also a number of tax incentives that you might be able to take advantage of.

NOTE: Before 2006, the kiddie tax applied only where the child was under age 14. The change from 14 to 18, effective starting in 2006, made some who had "outgrown" the kiddie tax subject to it again for up to 4 more years. This disrupts education-funding plans under which funds for college were intended to be distributed at age 16 or 17 for tax at the child's rate.

WARNING: Reporting the kiddie tax on the child's return using the required Form 8615 calls for showing the parents' taxable income. A parent reluctant to show that item to a teenager may instead report the child's investment income of the parent's return, on Form 8814. But this is not allowed, and the Form 8615 route must be followed, where the child has taxable earned income, as many teenagers would.  

Government and Non-Profit Agencies

  • U.S. Department of Education (for information on financial aid): 800-433-7327

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