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With college costs rising -- undergraduate tuition and fees at a private, nonprofit institution will top $32,000 for the 2015-2016 school year according to the CollegeBoard, compared to $21,000 a decade ago -- it's now more important than ever to plan for these costs and use whatever savings plans and tax breaks you can to maximize your money.

Student loans can certainly help parents and students defray some of these costs, but every dollar you save through college savings plans or student tax credits is money you won't have to borrow and later repay. Scholarships are another way to cover college costs, but most students find that they only cover a portion of their higher education costs. Understanding how to use a combination of scholarships, student loans, college savings plans and tax breaks will help you make an informed decision about paying for college, Here, we look at several college savings plans and student tax breaks.

Savings Plans and Tax Breaks

Savings Plans

Parents can help get a jump on the cost of a college education by setting up savings plans well before their kids leave high school. Not everyone has the same financial aid needs, however, so it's important to choose the college savings plan that is right for you and your family. Here is a rundown of some popular college savings plans that can help you handle education costs.

Qualified Tuition Program (QTP) or 529 Plans

Qualified Tuition Programs (also called 529 savings plans) allow a parent or other relative to save for a student's qualified education expenses. States administer 529 plans, and you don't have to open a plan in your home state; however, some states offer state tax incentives for doing so.

Payments to a QTP are not deductible for federal tax purposes but there is no tax on a distribution from a QTP as long as the amount does not exceed the student's qualified education expenses. These expenses can include not just tuition but also computer software used for studying, room and board costs (assuming you're enrolled at least half-time), textbooks, supplies and other equipment.

If money in a 529 plan is not used for undergraduate studies, the beneficiary can later use it for graduate study or change the beneficiary to another family member who will use it for qualified educational expenses. Otherwise, if you withdraw money from a 529 and don't spend it on eligible expenses, you will owe income taxes on that money.

Coverdell Education Savings Account (ESA)

Money saved and interest earned in a Coverdell Education Savings Account (ESA) can be used for eligible education expenses. Unlike a 529 plan, which can only be used to fund college tuition and expenses, Coverdell ESAs can also be used to fund the costs of attending eligible elementary or secondary schools.

Families whose modified adjusted gross income (MAGI) is less than $110,000 (if $220,000 if filing a joint return) may be eligible to set one up. The beneficiary of the account must be under age 18 or be a special needs beneficiary when the account is established.

If a student winds up not needing all the funds in an ESA, you can change the beneficiary to another relative. ESA beneficiaries can have multiple accounts, but total contributions to all Coverdell ESAs cannot exceed $2,000 per year per beneficiary. Contributions are not tax-deductible, but the funds grow tax free and distributions are not taxed when they're used to pay for qualified educational expenses.

Education Savings Bond Program

Interest earned on qualifying U.S. savings bonds (series EE or series I) may not be taxable if it is used to pay qualified education expenses, so this is another potential college savings vehicle. However, you may not qualify for this deduction if your income exceeds certain thresholds.

Individual Retirement Account

Rather than saving in an ESA or 529 plan and paying taxes if the money is not needed for college and there's no other beneficiary options, some people set aside money in an Individual Retirement Account (IRA for short) as a more flexible option. If you don't use the money for college, you'd just keep saving it for retirement. While IRAs are intended as a retirement savings vehicle, the Internal Revenue Service allows you to take penalty-free early distributions before age 59½ to cover qualified educational expenses for yourself, your spouse, or your child. You can withdraw contributions but not earnings. For 2015 and 2016, the contribution limit is $5,500 (or $6,500 for those over age 50). IRA contributions cannot exceed your earned income in a given year.

Tax Breaks

Tax breaks can help students and their families offset some of their educational costs. The information below is general in nature and may not apply to every individual's situation. Consult IRS publication 970, Tax Benefits for Higher Education, for specific and detailed information and be sure to consult with a qualified tax preparer for information on how to maximize tax benefits for education.

You can qualify for only one of the first tax benefits for each qualified student -- American Opportunity Tax Credit, the Lifetime Learning Credit, or the Tuition and Fees Deduction. (For example, you may claim the Hope Credit for one student and either the Lifetime Learning Credit and the Tuition and Fees Deduction for another student. Calculate the different benefits and use the most advantageous one for each student.)

But first, an important distinction to understand. A tax deduction reduces the amount of income subject to tax (and based on your tax bracket, you'd owe less in taxes), but a tax credit directly reduces the amount of income tax you have to pay, so credits (if you qualify for them) are generally more valuable than deductions.

American Opportunity Tax Credit

Under the American Opportunity Tax Credit, you may be able to claim a credit of up to $2,500 for adjusted qualified education expenses paid for each qualifying student. Forty percent of this credit may be refundable, which means if this portion exceeds your tax liability, you'll get the excess as a refund.

To qualify for this credit, you must pay qualified post-secondary educational expenses for an eligible student who is yourself, your spouse, or a dependent you claim on your tax return. The income limit on this credit is $90,000 in modified adjusted gross income for an individual filer or $180,000 if married filing jointly. The credit is only available for four tax years for each eligible student, including any years in which you claimed the Hope scholarship credit (which is no longer available).

Lifetime Learning Tax Credit

Independent students and parents of dependent students may be able to claim a Lifetime Learning tax credit of up to $2,000 per return for qualified educational expenses for an unlimited number of years of postsecondary education or for coursework to obtain or improve job skills. The qualifying student does not have to be enrolled in a degree or credential program and individual courses qualify. Even if you use a QTP to fund your education, you may still be eligible to claim this tax credit. However, the income limits are lower for this credit than for the American Opportunity credit: $65,000 in modified adjusted gross income for individual filers or $130,000 if married filing jointly.

Tuition and Fee Deduction

Independent students and parents of dependent students may be able to deduct up to $4,000 in qualified tuition and fee charges from their taxable income in each tax year. Because this deduction is claimed as an adjustment to income, you can take this deduction even if you don't itemize deductions on your tax return. This is a good option if you don't qualify for one of the credits explained above. The income limit is $80,000 for individual filers or $160,000 if married filing jointly. However, keep in mind that you cannot claim this deduction is you file taxes as married filing separately or if another person claims you as a dependent on his or her tax return.

Student Loan Interest Deduction

Independent students and parents of dependent students may also be able to deduct up to $2,500 per year in interest they paid on student education loans for themselves, a spouse, or a dependent. The student loan must have been taken out solely to pay qualified educational expenses and the loan cannot be from a relative or made through a qualified employer plan. The income limit for the student loan interest deduction is the same as the tuition and fee deduction: $80,000 for individual filers or $160,000 if married filing jointly.

Sources:

  1. Average Published Undergraduate Charges by Sector, 2015-16, http://trends.collegeboard.org/college-pricing/figures-tables/average-published-undergraduate-charges-sector-2015-16
  2. Coverdell Education Savings Account (ESA), https://www.irs.gov/publications/p970/ch07.html
  3. Qualified Tuition Program (QTP), https://www.irs.gov/publications/p970/ch08.html
  4. Education Exception to Additional Tax on Early IRA Distributions, https://www.irs.gov/publications/p970/ch09.html
  5. Retirement Topics - IRA Contribution Limits, https://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics-IRA-Contribution-Limits
  6. IRS Publication 970, Tax Benefits for Education, https://www.irs.gov/pub/irs-pdf/p970.pdf