Education Tax Breaks Require Serious Studying

The federal government offers plenty of tax breaks to help Americans pay for college. The problem: You almost need a PhD to figure out which ones work best for you.

Just ask Mark Van Durme, a single dad with two kids in college. The resident of upstate New York asked his accountant whether he could write off some of the $5,000 he spent on college bills last year.

Sorry, he was told, you earn too much money.

In fact, Van Durme does earn too much to claim education tax credits. But as he discovered after doing further research, he was eligible for a new tax deduction aimed at those who are paying college bills.

Thanks to an amended return, Van Durme’s refund grew by $500.

The confusion is understandable.

In 2001, Congress created tax breaks that applied to Americans who paid expenses for higher education last year. The new breaks, though welcome, only added to what was already a very complex area of the tax code.

Education-related tax breaks come in three varieties -- deductions, credits and income exclusions -- and each has limitations and restrictions. Some can be used together; some are mutually exclusive. And some change incrementally each year.

“There are so many changes on an annual basis that it’s a nightmare to keep up,” said Michael O’Brien, chief executive of FinancialAid.com, a San Diego-based firm that focuses on student loans.

Here’s a look at some of the changes for the 2002 tax year and beyond:

Deductions

Starting in the 2002 tax year, single filers earning up to $65,000 and married couples earning up to $130,000 can claim a deduction of as much as $3,000 for college tuition and fees paid during the year for themselves or a dependent. This is the deduction that Van Durme, who earns about $52,000 a year, used.

Taxpayers don’t have to itemize to claim the higher- education deduction, which is shown on Line 26 of Form 1040. The $3,000 write-off rises to $4,000 for the 2004 and 2005 tax years, then disappears in 2006.

Deductions for interest paid on student loans became slightly more generous in 2002. These deductions, previously available only for loans less than 5 years old, are now available regardless of the age of the loan.

Limitations: The maximum amount of student loan interest that can be deducted is $2,500 a year. The deduction begins to phase out for those earning more than $50,000 when single or $100,000 when married filing jointly.

Credits

There are two college-related tax credits. Credits are more valuable than deductions because they reduce the tax owed on a dollar-for-dollar basis. Deductions simply reduce the amount of income subject to tax.

The Hope tax credit provides a credit of up to $1,500 for those paying up to $2,000 in tuition and fees for a freshman or sophomore in college.

The lifetime learning credit provides as much as $1,000, or 20%, of the first $5,000 in tuition and fees paid for any student, regardless of class year. Starting in 2003, this credit rises to a maximum of $2,000, calculated as 20% of the first $10,000 in tuition and fees paid for a qualifying student.

Both credits phase out for those earning more than set thresholds -- for the 2002 tax year, $41,000 when single or $82,000 when married. Once single income reaches $51,000 and married income $102,000, the credit is eliminated.

Income Exclusions

Income exclusions exempt taxpayers from reporting the profit -- or income -- realized from certain types of investments or payments.

Four types of income become exempt from tax when the money is used for higher education and the taxpayer meets other requirements:

* Withdrawals from a 529 plan or Coverdell account. These savings vehicles allow individuals to accumulate investment returns on a tax-deferred basis. If the money is used for a qualified purpose -- college for a 529 plan, any qualified education expense for a Coverdell account -- both principal and investment returns are tax-free when withdrawn.

Maximum contribution limits to a 529 plan are set by the individual states that offer the plans. The maximum contribution amounts to Coverdell accounts rose to $2,000 in 2002 from $500 in previous years.

Any taxpayer can contribute to a 529 plan. However, the ability to contribute to a Coverdell account depends on the donor’s taxable income. Singles earning more than $95,000 and married couples earning more than $190,000 begin to lose their ability to save through a Coverdell plan.

* Interest on savings bonds. Parents who own savings bonds can exclude the interest earned when cashing them in to pay college tuition and fees. But to qualify for the tax-free treatment, the bonds must have been bought after 1990 by someone who was at least 24 years old, and the owner must earn less than set amounts.

To completely exclude savings bond interest, the owner must earn less than $57,600 when single or less than $86,400 when married. Partial exclusions are available for singles earning up to $72,600 in 2002 and for married couples earning up to $116,400.

* Education assistance. Employers can provide up to $5,250 in tuition assistance payments tax-free to their workers. In the past, this assistance was tax-free only to those attempting to obtain undergraduate degrees. But in 2002, the break was extended to graduate students.

Times staff writer Kathy M. Kristof, author of “Investing 101” (Bloomberg Press, 2000), welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes .com. For past Personal Finance columns, visit The Times’ Web site at www.latimes.com/perfin.