Stay Up-to-Date to Claim Deductions, Credits for College Costs

"Leaving money on the table" is a common tax mistake for parents of college students. Picking up those funds requires staying up-to-date on the latest rules on deductions and credits aimed at helping parents pay for higher education.

That's advice from Joe Orsolini, owner of College Aid Planners, Glen Ellyn, Ill. Orsolini explains that parents "leave money on the table" when they fail to take a legitimate tax credit or deduction.

As a result, the state or federal government gets to keep money that the parent or student could have used to cover college costs. A recent study by the U.S. Government Accountability Office (GAO) reported that 27% of eligible tax filers failed to take advantage of deductions and credits designed to help parents pay for higher education costs.

These taxpayers could have saved an average of $169, while one out of 10 could have saved $500 or more, according to the GAO.

Hope and Lifetime Learning Credits

One reason parents sometimes fail to select the best tax option for their situation is that credits and deductions overlap. It's up to parents or accountants to pick the right deduction or credit and confirm eligibility.

Orsolini advises parents to start by reading IRS (Internal Revenue Service) Publication 970, Tax Benefits for Education.

Parents typically can achieve their greatest tax savings with the Hope and Lifetime Learning Credits. To qualify for the Hope Credit, students must be enrolled at least halftime to allow parents to claim a tax credit of up to $1,650 per student.

"The Hope Credit is great, but it's limited in that it's only available for the first two years of college," Orsolini says.

The Lifetime Learning Credit can be taken throughout the course of the student's higher education, but requires at least $10,000 of eligible expenses each year. The Lifetime Learning Credit also limits parents to claiming one $2,000 tax credit per return.

Both credits are reduced after parents hit certain income levels, with a maximum adjusted gross income of $110,000 for eligibility for parents filing jointly in 2006.

Making the right choice

Choosing the right credit can make a big difference during the child's first two years of college. The GAO study noted that a married couple filing jointly with an adjusted gross income of $50,000, with qualified expenses of $10,000 in 2004 and tax liability greater than $2,000, would save $2,000 by claiming the Lifetime Learning Credit. That same couple would save only $1,500 if they claimed the Hope Credit.

It can be even trickier when families have multiple children in college. In general, Orsolini says that when more than one child is in college at the same time, it typically is better to use the Hope Credit for the younger student and the Lifetime Learning Credit for the older student.

If parents earn too much to qualify for Hope and Lifetime credits, they still can take advantage of the Tuition and Fee Deduction. In 2006, having an adjusted gross income between $130,000 and $160,000 reduced this deduction from $4,000 to $2,000, with the deduction eliminated for incomes of more than $160,000.

For both credits and deductions, Orsolini notes that parents can take steps to stay within eligibility limits. For example, making additional deposits in an IRA or 401(k) can reduce the adjusted gross income to help parents qualify.

Choices also come into play when parents and students pay expenses using money saved in qualified education plans, such as "529 plans" and Coverdell accounts. These plans allow parents to pay qualified educational expenses with tax-free earnings.

"You need to make sure you pay enough expenses out-of-pocket to take deductions or credits before you start using the 529 plan," Orsolini adds. "The IRS doesn't let you double-dip, tax-wise."

Working together

Parents keep the ability to claim students as dependents as long as they are in college, which also reduces income taxes. They may have to persuade students to cooperate at tax time, however.

"Generally, claiming the student as a dependent works in the parent's favor because they are in a higher income bracket than the student," Orsolini says. The IRS defines a student as a dependent as long as she is younger than age 24 and receives at least half of her support from the parent.

Students may balk at allowing their parents to claim this deduction, preferring instead to get a bigger tax refund on their own earnings. In that situation, it can be valuable to show the student how much the dependent deduction saves the parents, sometimes even offering to pay the student part or all of the difference. Reminding students that their parents' health insurance policies typically provide coverage only while they remain a dependent also can be helpful.

When parents are divorced, families should determine who benefits the most from claiming the child, assuming that both families are giving equal support to the college student.

Finally, Orsolini says parents and students should work together to claim deductions for payments on student loans. Parents benefit from making payments on PLUS loans that parents can take out to pay for the student's college expenses.

But if parents make payments on loans held in the student's name, there is no deduction on either the parents' or the student's taxes. In that situation, Orsolini advises parents to give the money to the student to make the payments, since student loan payments are deductible from earnings even if the student doesn't file an itemized return.

Parents who purchased savings bonds after 1989 can gain from cashing them in while their children are in college, since the interest is tax-free as long as the bond was purchased in the parent's name.

Check the latest rules

Higher education deductions continually are shifting, so it pays to check the latest rules online. For example, the tuition and fee deduction has been extended by Congress through 2007, but will have to be reauthorized after that point.

Accountants and software packages typically remain up-to-speed on the latest developments, but parents may have to be careful to educate themselves. Orsolini notes that the 2006 extension of the tuition and fee deduction was made so late that it was left off the IRS' tax forms for that year.

"It pays to do the prep work and get yourself up to speed," Orsolini says. "Otherwise, you can end up leaving money on the table. If you don't take advantage of it, it goes away and you've missed out."

Published September 17, 2007