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After you have done everything possible to reduce your out-of-pocket costs for education, you then need to determine if there are any ways to reduce the impact of taxes as you go about paying for those costs.
To reduce income taxes it is helpful to start with the types of income first. For all practical purposes there are two types of income that you must be concerned with from the standpoint of taxation: Earned and unearned.
Earned income is the income that you earn from work and includes wages, tips, self-employment, net income and payments for services performed. This income is taxed at ordinary tax rates based on the tax bracket that you fall in as a result of your net taxable income (after deductions, exemptions and credits).
Unearned income consists of capital gains, dividends and interest. Long-term capital gains and qualifying dividends are taxed at special tax rates, while short-term capital gains and interest are taxed at ordinary tax rates.
Capital gains are categorized as long-term or short-term. Short-term capital gains are achieved when an asset that has been held for less than one year is sold for more than it was purchased. Long-term capital gains are achieved when the underlying asset is held for more than one year from purchase and is sold for more than it was purchased for. Capital gains, whether they are long-term or short-term, are only taxable if they have been realized. An asset that has appreciated is not taxed until it is sold and the gain, or appreciation, is realized. This is where the term "paper losses" comes from, because if an investment goes down in value, on paper you have lost money, but it is not a real loss unless you actually sell the investment which would make it a realized loss.
Short-term capital gains are treated as ordinary income and are taxed at the taxpayer's ordinary income tax rate (the same tax rate at which they pay tax on wages) of 10%, 15%, 25%, 28%, 33% or 35% depending on the taxpayer's net taxable income. So short-term capital gains, therefore do not receive any favorable tax treatment, but long-term gains do.
In 2003, Congress lowered the maximum tax rates for most dividends and capital gains to 15 percent. Taxpayers in the 15 percent tax bracket (taxable income for joint filers under $65,100 for 2008) or lower became eligible for an even lower tax rate of 5 percent until 2007. Then starting in 2008, that rate was scheduled to drop down to zero.
As originally enacted, these tax rate cuts were temporary. They were scheduled to expire in 2008, but a different piece of legislation, the Tax Increase and Prevention Act (TIPRA), extended the lower rates through 2010. Long-term gains in 2008-2010 are taxed at a long-term capital gain rate of 0% if the taxpayer is in the 10% or 15% marginal tax brackets.
If the taxpayer's marginal bracket is in the 25%, 30% or 35% tax brackets, the capital gain tax rate is 15% from now through 2010. Capital gains on collectibles are taxed at a rate of 28% for all years through 2010.
Capital gains are commonly associated with stocks, mutual funds, real estate, collectibles and other real property. Stocks and real estate however, sometimes also pay a dividend.
Dividends are a form of unearned income commonly paid to shareholders of stock and also receive favorable tax treatment. Dividends are taxed at the same tax rates as long-term capital gains, but not all types of dividends receive this treatment. In general, dividends that qualify for the lower tax rates are from domestic corporations and qualified foreign corporations. Dividends paid by a life insurance contract, credit union, savings and loan, mutual savings bank or similar financial institution do not qualify for the lower tax rate. Like income from interest, they are taxed at ordinary income rates.
Interest payments on taxable bonds, certificates of deposit, savings accounts and checking accounts are taxed at ordinary income tax rates and do not qualify for the lower tax rates. Thus, they are not as tax-efficient as what long-term capital gains and qualifying dividends can be.
The two types of unearned income that receive favorable tax treatment and qualify for the lower tax rates are qualified dividends and long-term capital gains.
The control of dividends and interest is relatively straightforward. If you don't want to generate a lot of dividends and interest, simply save and invest in products that don't generate them. One way to reduce taxable unearned income is by choosing tax free municipal bonds instead of taxable corporate bonds.
Stocks, mutual funds and ETFs that are more oriented toward growth than income typically pay out smaller dividends to their shareholders and choose instead to put more of their corporate earnings to work for their shareholders by reinvesting the cash back into the company to help it grow. As a result, growth oriented investments tend to have less current income (dividends) than income-oriented investments. For example, tech stocks are generally thought to be more growth-oriented and utility stocks tend to be thought of as income stocks.
Grandparents are famous for purchasing EE savings bonds for their grandchildren, but parents need to be aware that if they don't choose to defer the interest on these bonds, it will be reported annually as unearned income.
Another method of controlling unearned income is to "harvest" capital losses in one tax year and carry them forward for use in offsetting both earned and/or unearned income in future years. For example, if you have a portfolio of stocks and in the current tax year one of the stocks declines sharply in value due to a corporate scandal and the stock is sold at a capital loss, that loss can either be used to offset income in that year or carried forward to future years. The maximum amount of capital loss that can be carried forward in a given tax year is currently $3,000.
Controlling the amount of unearned income that a child receives each year is very important because of the kiddie tax.
The kiddie tax law was originally established to prevent well-off families from abusing the strategy of shifting unearned income to their children where it could be taxed at a lower tax rate than their own.
Under the kiddie tax, in 2009 the first $950 of a dependent child's unearned income, including dividends, interest, and capital gains, is tax-free (i.e., offset by the child's standard deduction). The second $900 of unearned income is taxed at the child's tax rate, and any amount over $1,900 is taxed at the parents' typically higher tax rate.
Until recently, the kiddie tax applied only to children under the age of 14, but in 2005 the Tax Increase Prevention and Reconciliation Act (TIPRA) began to apply to children under the age of 18, and new legislation that was passed in May 2007 expanded it further.
Once Congress realized that they had left the door wide open to the 0% long-term capital gains rate for taxpayers in the lower tax brackets, they passed yet another law that made sweeping changes to the kiddie tax.
Due to the new kiddie tax rules that went into effect January 1, 2008, there are three categories of taxpayers who qualify for the lower capital gains tax rate.
Keep in mind that the kiddie tax only applies to unearned income, and not earned income.
Now that we have talked about the two primary types of income and how they are taxed, let's talk about how you can reduce taxable income and pay less tax.
Most taxpayers are eligible to use a variety of deductions, exemptions and credits on their tax return to reduce their taxable income and the tax that they owe. Deductions and exemptions reduce taxable income, but tax credits reduce tax dollar for dollar and are therefore more favorable.
For 2009 the standard deduction is $11,400 for married individuals filing a joint tax return, $8,350 for heads-of-household filers and $5,700 for single tax filers. A dependent tax filer's standard deduction for unearned income is $950 (remember the kiddie tax) or the amount of their earned income + $300, up to a maximum of $5,700.
The personal exemption for all dependents in 2009 is $3,650. Thus, if you are married with two dependent children (under age 24 at the end of the tax year) then you will get $14,600 in personal exemptions to help reduce your taxable income. Your ability to claim these exemptions phases-out between $250,200 - $372,700 of adjusted gross income (AGI) on joint tax returns and between $199,950 - $322,450 for those filing as a head-of-household. Even if you exceed the maximum phase-out range, you can still receive a minimum exemption of $2,433 per qualifying dependent ($9,732 instead of $14,000 in the example above).
Among other rules laid out in IRS Publication 501, in order to claim someone as a qualifying dependent on your tax return you must provide over half of their support throughout the year.
For the most part, if children use their own income and assets to provide greater than half of their support, they can claim the personal exemption. The IRS definition of support is quite technical and lengthy, but it could be distilled down to the child's ability to pay for the annual cost of attendance at the college, including transportation, room, board, tuition, fees and clothing.
Losing the personal exemption for your child may sound counterintuitive, but when the children can claim the personal exemption for themselves it opens the door to a great tax-saving strategy. In general, children can use their own income and assets to provide more than half of their own support (that is, pay for college) and then they will also be able to take the full standard deduction of $5,700, as well as one of the education tax credits on their own tax return. This gives the child the ability to minimize or eliminate federal tax on earned and unearned income. For parents in a high tax bracket, this tactic can make a lot of sense, especially if the parents don't qualify for the education tax credits because their income is too high.
There are three education-related tax benefits: the Hope Scholarship Tax Credit (Hope Credit), the Lifetime Learning Tax Credit (Lifetime Credit) and the tuition and fees deduction. Each of these can help reduce the overall cost of college and each one has its special place in the tax planning world, but for most families the Hope Credit is likely the best because the Hope Credit got a boost from recent legislation and the other two did not. The Hope Credit previously was worth up to $1,800 per student, but under a special provision in the economic stimulus package called the American Opportunity Credit, the Hope Credit was increased to $2,500. The income limits were raised too, making more families eligible to receive the Hope Credit.
The new Hope Credit doesn't replace the Lifetime Learning Tax Credit or the above the line tuition and fees deduction, but the new Hope Credit definitely goes to the head of the class and deserves the most attention.
The new Hope Credit went into effect for the 2009 tax year. The benefit of claiming the Hope Credit is that it reduces a taxpayer's federal tax bill dollar-for-dollar and puts more money back in the hands of the taxpayer.
To be eligible for the Hope Credit under the new rules married couples filing jointly must have modified adjusted gross income (MAGI) of less than $160,000, or less than $80,000 if filing single or as head-of-household (HOH). Married couples with MAGI over $160,000 ($80,000 for single and HOH) will be able to claim a partial credit up to $180,000 ($90,000), after which their eligibility to claim the credit is completely phased-out.
The new rules will also benefit lower income families by making the Hope Credit 40 percent refundable for those families who don't have any federal tax liability. Under the previous rules it didn't do low income families much good to claim the credit because they don't have any tax due anyway. By making the credit 40 percent refundable it will put up to $1,000 more per student into the hands of lower income families. However, no portion of the credit is refundable if the taxpayer claiming the credit is a child under age 19 or a college student under age 24 who is providing less than one-half of his or her own support solely from earned income; so long as the child has at least one living parent and does not file a joint tax return.
The new rules also expand from two years to four years the number of years that the credit can be claimed for a student. However, this is a bit misleading since most of the provisions in the stimulus package are only good for two years, 2009 and 2010. So what this extension does is add two years of eligibility for the new Hope Credit to the students that are in college today and have already used up their two-year eligibility.
Under the new Hope Credit rules, the amount of the credit equals 100% of the first $2,000 of qualified tuition and expenses that are paid and 25% of the next $2,000 of paid expenses. Therefore, the maximum new Hope Credit is $2,500 per year per eligible student. A family of four with two kids in college could receive as much as $5,000 in Hope Credit.
For married couples filing joint tax returns, the Lifetime Credit phases out between $100,000 and $120,000 of modified adjusted gross incomes in 2009. Taxpayers get a 20% tax credit for the first $10,000 of qualified expenses that they pay, for a maximum of $2,000.
The amount of the Hope and Lifetime Credit that can be claimed is calculated based on the amount of qualifying tuition and related expenses (now including books) that were paid at an eligible educational institution. The expenses must be paid on behalf of a qualified student that is the taxpayer, the taxpayer's spouse or the taxpayer's dependent child. To be a qualified student the student must pursue a course of study on at least a halftime basis. A student is considered to pursue a course of study on at least a half-time basis if the student carries at least one half the normal full-time work load for the course of study at an eligible educational institution.
An eligible educational institution is considered to be any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education. It includes virtually all accredited public, non-profit, and proprietary (privately owned profit-making) postsecondary institutions. According to IRS Publication 970 qualified education expenses are tuition and related expenses required for enrollment or attendance at an eligible educational institution (described below). Related expenses are student-activity fees and expenses for course-related books, supplies, and equipment that are required as a condition of enrollment or attendance.
The amount of qualified educational expenses that can be used in calculating these tax credits is reduced if you pay for the qualified expenses with certain tax-free funds:
It is important to remember that the Hope Credit (or any other education-related tax benefit) cannot be claimed based on expenses that were used to calculate the tax-free portion of a distribution from a 529 college savings plan, 529 prepaid plan or a Coverdell Education Savings Account (ESA). Taxpayer's can claim the Hope Credit in the same year that a tax-free distribution is made as long as the same expenses are not used to calculate the tax-free distribution and the tax credit.
For example, if a child incurs $4,000 in qualified educational expenses attending a state university and the child qualifies for $4,000 in Federal Pell Grant monies, there technically are no remaining qualified educational expenses left with which to calculate the Hope Credit. The same would be true of the same student if she received no Pell Grant monies but took an amount out of a 529 college savings plan equal to the total cost of attendance (including the $4,000 in tuition expenses). There would be no remaining qualified educational expenses with which to claim the Hope Credit.
This coordination of benefits issue is a clear problem for many families now, and will be a bigger problem under the new rules because a greater number of lower income families will qualify for the credit now that it is refundable. The only way under current law that a family can claim the Hope Credit while a student is receiving Pell grant monies is if the student has qualifying tuition and fee expenses in excess of the amount of the Pell grant.
Now, in the real world what student really knows if their Pell Grant went to pay for tuition and fees or a host of other charges? I have never been able to get the financial aid administrators at colleges across the country to provide a consistent answer on how Pell Grants are applied to a students college costs. Nor do I believe that the average American, or their tax preparer, have a clue that it should be a concern. Congress knows they have a problem with this issue because the new legislation requires the Treasury to conduct a study on integrating the new Hope Credit with the Federal Pell Grant. The simple answer is not to require eligible tuition and fees to be reduced by Pell Grant awards when calculating the amount of the Hope Credit that a family can claim. Study complete and more money for something better.
The good news is that before the stimulus legislation expires at the end of 2010, Congressman Chaka Fattah (D) plans to push for the full and permanent adoption of a piece of legislation (HR 106) that he introduced in the House. The legislation addresses the issue of benefits coordination and would make the new Hope Credit permanently good for four years per student.
Only one education tax credit, or the tuition and fees deduction, may be claimed on behalf of a student each year. (See IRS Forms 8863 and 8817 on educational credits, and IRS Publication 970 for details on tax-related education funding topics). However, multiple tax credits can be claimed on a tax return per year. For example, parents with two children might be eligible to claim the Hope Credit for one child and the Lifetime Credit for another one of their children on the same tax return.
If you are having federal taxes withheld from your pay and you typically receive a federal tax refund, it may be a good idea to consult with your tax advisor about decreasing your federal income tax withholding so that you don't end up with an even bigger tax refund when claiming one or more of these tax benefits. This could also increase your net "take home" pay during the year and the extra cash could be used to pay for education costs. This strategy can be even more effective if the school or college offers a monthly payment plan that permits parents to pay its costs over a ten month period with no interest.