Tax Credits, Deductions, and Deferrals

Tax credits directly reduce the amount of taxes owed to the federal government. There are two types of tax credit programs. The first is called Hope Scholarship and can provide up to $1,500 for a child's first and second years of college. The second is called the Lifetime Learning tax credit and can provide as much as $1,000 a year after the first two years of college. The actual amount of the credit depends on the amount of college expenses and on parent or student income. Parents can take the tax credit if they claim the student as an exemption on their return. The student can take the tax credit if he files a separate return and claims himself as an exemption.

When deciding about student loans, student should also remember that some of the annual interest payments may be deductible on their tax returns during the first five years of loan repayment.

The federal government also encourages families to save in advance for their education by allowing taxes to be deferred or forgiven on accumulated earnings. One provision is the Education IRA or individual retirement account. This allows total contributions of not more than $500 a year to the account of a child under 18. These contributions cannot be deducted from taxes. However, the taxes on the earnings in the account are deferred. If the withdrawals from the account are used for qualified higher education expenses, the student will not owe any tax on the accumulated earnings.

Certain states and agencies also have programs that allow people to buy credits or certificates or make contributions to accounts that can be used to pay higher education expenses. These programs are usually referred to as state tuition programs or pre-paid tuition programs. The contributions are not tax deductible but the earnings from the accounts are not taxed when used for higher education expenses.

Many families have used EE savings bonds as a way to accumulate funds for college. The interest on these bonds, if they were used after 1989 and used to pay qualified college expenses, can be excluded from gross income on your tax return. This exclusion depends on the family's income and other financial aid and tax benefits that the student or parents may have received.

Eligibility for tax credits, deductions, and deferrals involves complex rules and calculations. You should seek the advice of someone who has experience with these provisions. You can also read IRS Publication 970, Tax Benefits for Higher Education.