New Back-to-School Tax Breaks

As you or family members return to the classroom, remember that federal income tax breaks may help you pay for tuition and other costs of education. As a result of the American Recovery and Reinvestment Act of 2009 and cost-of-living adjustments, there are some new rules in effect for 2009 that can help you save for future education costs or pay for current obligations.

New Tax Credit

The Hope Credit, which had been a way to pay for the first two years of higher education, has been replaced with a new and improved tax credit for 2009 and 2010. The new credit, called the American Opportunity Credit, can be used to cover eligible costs for the first 4 years of higher education.

The credit amount is 100% of the first $2,000 of tuition and other eligible costs, plus 25% of the next $2,000 of such costs, for a total credit of $2,500 each year. (The Hope Credit had been limited to $1,800). The beauty of the revised credit is that 40% of the credit amount can be refundable; Uncle Sam sends you a check even though this is more than the taxes you owe.

The credit, however, phases out when your modified adjusted gross income (MAGI) exceeds a set limit. The following is the phase-out range in which you can claim a partial credit; fall below and you get the full credit, but exceed the limit and there’s no credit allowed:

• Singles: MAGI of $80,000 to $90,000.
• Joint filers: MAGI of $160,000 to $180,000

If you are pursuing higher education beyond 4 years, there is still the Lifetime Learning Credit to help with education costs. This credit remains at 20% of the first $10,000 of eligible expenses, for a top credit of $2,000. However, the MAGI phase-out range for this credit is substantially lower than the one for the American opportunity credit. For 2009, the range is:

• Singles: $50,000 to $60,000
• Joint filers: $100,000 to $120,000

529 Plans

These plans (their name comes from the section of the Internal Revenue Code governing them) allow you either to prepay tuition or save for future education costs; both types of plans provide key tax incentives. While there is no federal tax deduction or credit for putting money into a plan (there may be state-level tax breaks), the contributions grow on a tax-deferred basis. Withdrawals to cover eligible expenses are tax free. For 2009, there are three important changes for 529 plans:

1. Withdrawals to pay for computer technology, including the purchase of computers and software and Internet access, are treated as eligible expenses. This treatment applies only for 2009 and 2010.
2. Usually, if you have a 529 savings plan, you can change the investment selections once a year (or whenever there is a change in beneficiary). However, because of stock market performance in the past year or so, the IRS has said it will permit two changes to be made in 2009.
3. Contributors who can afford to add substantial sums to a plan may use a special gift tax rule to avoid any gift tax liability. Contributions qualify for the annual gift tax exclusion; for 2009, the exclusion is $13,000 (up from $12,000 in 2008). A contributor can elect to treat $65,000 in contributions (5 times the annual gift tax exclusion) as if the contributions were made ratably over 5 years. For a married contributor whose spouse consents to make a split gift, these amounts are doubled, so a person could potentially add $130,000 to a 529 plan in 2009.

Tax-Free Interest on Savings Bonds

If you bought savings bonds after you were 24 years old and redeem them now to pay for higher education costs for yourself, your spouse, or your dependent, interest on Series EE or I bonds can be tax free. There is no ceiling on how much interest can be tax free; it depends on your MAGI. If you are below the phase-out range, then all interest is tax free; if you exceed the ceiling, no interest is tax free.

For 2009, the phase-out range in which some interest may be tax free has been increased over the 2008 limits; the range is:

• Singles: $69,950 to $84,950
• Joint filers: $104,900 to $134,900

Interest on Student Loans

Many people finance higher education by borrowing money. Interest on student loans is deductible up to $2,500 annually. The deduction is claimed as an adjustment to gross income, so you don’t have to itemize deduction in order to claim this tax break. However, the full deduction applies only if MAGI is below a set limit; a partial deduction applies for those with MAGI within a phase-out range. For 2009, the phase-out range has been increased over the 2008 limits; the range is:

• Singles: $60,000 to $75,000
• Joint filers: $120,000 to $150,000

Final Word

There are many other tax breaks that can be used to help you pay for higher education. For example, the above-the-line deduction for tuition and fees continues to apply for 2009. It will not be available in 2010 unless Congress extends this break.