03/19/2012 03:32 pm ET Updated May 19, 2012

Tax Breaks For College Students: Choosing The Best Break

By Amy Feldman
NEW YORK, March 19 (Reuters) - It's too bad colleges don't
offer a class in "advanced tax strategies" to all freshmen,
along with those study skills, health and diversity sessions.
That extra expertise would come in handy for anyone trying to
sort through the profusion of education credits and deductions
that can help offset college costs.
With the annual cost of board and tuition topping $50,000 at
some private colleges, and expenses dramatically rising at
public universities, it's worth learning how to maximize those
breaks. Here's a brief guide:
There are three main educational tax breaks, as follows: (1)
the tuition and fees deduction allows you to deduct up to $4,000
from your taxable income; (2) the lifetime learning tax credit
allows you to reduce your taxes by up to $2,000 per return; and
(3) the American Opportunity Tax Credit offers a $2,500 tax
credit per student.
The catch is that you have to choose which one to take:

Since you cannot take more than one of these tax breaks per
student, apply them in this order: First, the American
opportunity credit, then the lifetime learning credit and
finally the tuition and fees deduction.
That's because, in general, a credit is more valuable than a
deduction since it reduces your taxes, while a deduction merely
lowers the amount of income that is taxed.
In the 28 percent tax bracket, both the $2,000 and $2,500
credits trump the $4,000 deduction (which will lower your
federal tax bill by just $1,120).
For those who have saved in a 529 college savings plan --
which, when used for qualified education expenses, is free of
federal tax -- there's the added complication of coordinating
those 529 plan withdrawals with these education tax breaks. The
basic rule is that you can't count the same educational expense
twice, so if any part of it was already covered by tax-free
scholarships, Pell grants, or these tax credits, using money
from a 529 plan to cover the same expenses may trigger a tax on
that withdrawal.
Here's one scenario. Say that you have one child in college,
and you incur total qualified educational expenses of $21,000.
First, you'd reduce that figure by any tax-free assistance, such
as scholarships, fellowships and Pell grants; if you got $12,000
in tax-free assistance, you'd now have $9,000 in educational
expenses remaining. You could then claim the American
opportunity credit. It works on a formula in which you get 100
percent of the first $2,000 in expenses, but only 25 percent of
the next $2,000, for a total of $2,500 in credits for $4,000 in
expenses. So you would then subtract $4,000 (of eligible
expenses) from the $9,000 figure.
Do the math, and what you have left is $5,000 of expenses
that you have paid and for which you have not received any tax
breaks. That is the amount you can take out of your 529 plan
tax-free. If you go above that amount, you'll owe tax on the
earnings, but not on the principal, of that withdrawal; you'll
see those numbers on your 1099-Q, the tax form you'll receive
for taking money out of a 529 plan.
Whether or not it's worth taking that tax hit depends, in
part, on whether you are burning through your 529 balance
quickly or you expect to have cash left over once your kids are
all done with school.
Lower-income taxpayers can qualify for an education tax
benefit even if they owe no tax. In fact, the American
Opportunity Tax Credit is particularly valuable to low-income
taxpayers because it is partially "refundable," as it's known
in tax lingo, meaning you can claim a piece of it regardless of
whether you owe tax or not. That's unusual -- most credits are
only available if you owe tax.

Once you're out of school -- and repaying those student
loans -- there's an additional tax benefit. While personal
interest payments (other than for your mortgage) are generally
not deductible, student loan interest of up to $2,500 is. The
caveat here, again, is the income limitations; to claim the
deduction, your modified adjusted gross income must be below
$75,000 if you're single, or $150,000 if you're married filing
The deduction can only be taken by the person legally
obligated to make the loan payments. Most new graduates paying
off loans would qualify based on those income limits, and even
those who don't itemize can claim it since it's technically
taken as an adjustment to income rather than as a deduction on
Schedule A. Even if the new grad repays the debt with a gift
from her parents or grandparents, she could take the deduction
-- but if her parents continue to claim an exemption for her on
their tax return, neither could take that break.
While there are no changes for this tax season, the tuition
and fees deduction expired at year-end 2011, and the American
opportunity credit is slated to expire at the end of 2012,
though President Barack Obama's budget calls for making that
credit permanent.
That means if you've got a high school student in your house
this year, you'll need to save a little more than you were
planning to -- unless Congress extends those breaks at the last
minute, as it so often does.