Tax Benefits Used for Education by Karla Hopkins

Taxpayers must take advantage of any opportunities to reduce their educational costs. The most advantageous tax benefits are the six exclusions for educational benefits that would otherwise be taxable. They are as follows:

Employer-Provided Educational Assistance- An employee's gross income does not include amounts paid for educational assistance to the employee if there is an employer plan. The exclusion is currently limited to $5,250 per year. This does not benefit the employee's spouse or dependents.

Qualified Scholarships and Tuition Reductions- Qualified scholarships include any funds that the individual receives as a scholarship or fellowship grant that are used for qualified tuition and related expenses. It is important to remember that this provision is NOT allowed for scholarships that are designated for room, board, and travel expenses. An employee of an educational organization can receive free or reduced tuition for undergraduate studies. This provision is available for a spouse and dependents of the employee.

Education Savings Bond Program- Interest from Series EE Bonds used to pay qualified higher education expenses can be excluded from income if the bond was issued after December 31, 1989, to an individual who is 24 years old before the date of issuance. The education can be for the taxpayer's spouse and dependents. There is an income limit for this benefit.

Coverdell Education Savings Accounts- Distributions from these accounts are not taxable to the extent they do not exceed the qualified education expenses. This includes the original contribution to the account and the accumulated tax free interest. These accounts can help avoid the “kiddie tax” too since the interest earned on these accounts, while in the student's name, is not subject to the “kiddie tax” reporting requirements.

Exception to Early Withdrawal Penalty of IRA Distributions- Distributions from IRA's if taken before the age of 59 1/2 are generally subject to a 10% penalty. However, if the distribution is used to pay for qualified higher education expenses it is excluded from this penalty provision. With the economic downturn and the rising cost of education, many taxpayers are turning to their retirement savings to fund education and can do so without a penalty under this provision.

529 Plans- Distributions from 529 Plans are exempt from tax if they are used to pay a beneficiary’s qualified higher education expenses. 529 Plans are very flexible and allow anyone to contribute. The plans are a good tool to transfer assets to multiple family members and multiple generations.

In the end, taxpayers should evaluate the alternatives to education funding well before the first day of school in order to make use of tax-saving and cost-saving measures.