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Clearing the hurdles
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Some drawbacks exist to Coverdell accounts. Married couples with modified adjusted gross income (MAGI) over $190,000 cannot contribute the full $2,000 to Coverdell accounts; for single taxpayers, that MAGI limit is $95,000. With MAGI up to $220,000 or $110,000, respectively, your ability to make partial Coverdell ESA contributions phases out altogether. Even if your income is over those limits, however, you can give $2,000 per student to a lower income relative, including the child who will be the Coverdell beneficiary. Then the recipient of that gift can use the money to open a Coverdell account and make a full Coverdell ESA contribution with MAGI below $190,000 (joint returns) or $95,000 (single).
Also, Coverdell ESAs must be liquidated within 30 days after the beneficiary turns age 30 (unless the beneficiary is a special needs beneficiary). Distributions not used for qualified higher education expenses by then will be subject to income tax plus a 10% penalty. To avoid this, you can roll over the amount in one beneficiary’s Coverdell ESA to a younger relative’s Coverdell ESA, tax free.
Example 2: Ron and Jan Hansen set up a Coverdell ESA for their son Craig. When Craig finishes his education at age 29, he has $5,000 left in the account. Craig withdraws the $5,000 and contributes to a Coverdell ESA established for his younger sister Lucille. No tax is due on these transactions.
In reality, you should be able to spend down all the amounts in a Coverdell ESA before the original beneficiary reaches age 30.
Do these maneuvers make sense? Any tax savings can help families bear the increasing costs of college.
There are drawbacks, however. Some asset transfers may have to be reported on a gift tax return. Holding assets in a student’s name might reduce eligibility for need based financial aid. Perhaps most important, assets transferred to a youngster eventually will be controlled by that youngster, who may spend the money on things other than higher education. Our office can help you quantify the tax savings available through income shifting so you can decide whether these tactics are worthwhile. 
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Back to Top
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Taking Credits for Higher Education
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In 2009, Congress replaced the Hope Scholarship tax credit with the more valuable American Opportunity tax credit. The latter credit was scheduled to expire after 2010 but was extended at year-end, along with many other tax benefits. Therefore, the American Opportunity credit remains the primary tax creditavailable for higher education in 2011 and 2012.
The maximum American Opportunity tax credit is $2,500 per student. To qualify for the maximum credit, you must spend at least $4,000 per student in 2011. You must spend this money for a student in his or her first four years of post-high school education. The money you pay for tuition and related fees counts for calculating the tax credit, along with outlays for necessary books, supplies, and equipment. Room and board costs do not count.
Example 1: Carl and Diane Hunter have a son who is a sophomore in college this year and a daughter who is a college senior. They spend $12,000 on each student’s qualifying expenses in 2011. Thus, they can claim two American Opportunity credits of $2,500 each, for a total of $5,000. For most taxpayers, the American Opportunity credit is 40% refundable.
Credit constraints
High income taxpayers can’t use the American Opportunity tax credit. To get the full credit, your MAGI must be no more than $80,000 if you are a single taxpayer or $160,000 if you are married and file a joint tax return. The American Opportunity tax credit phases out with MAGI up to $90,000 (single) or $180,000 (joint returns). In addition, any money you withdraw from a Coverdell Education Savings Account or a 529 plan won’t count for calculating the credit.
Example 2: Jennifer Thomas pays $10,000 for her son Nick’s college bills in 2011. Jennifer’s MAGI is $75,000, so she qualifies for a full American Opportunity tax credit. However, Jennifer withdraws $8,500 from a 529 plan in 2011. If Jennifer counts that as a tax-free withdrawal, she will have only $1,500 of expenses that can be offset by the American Opportunity tax credit. If Jennifer counts $4,000 of expenses to be offset by a full American Opportunity tax credit, she will have only $6,000 of expenses that can count as a qualified 529 withdrawal.
As you can see, the interplay between a 529 plan, Coverdell account withdrawals, and the American Opportunity tax credit might not be simple. Our office can help you calculate the most taxefficient amounts to withdraw and the most tax-efficient way to claim education related benefits on your tax return.
Later learning
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You may be able to use a Lifetime Learning tax credit instead of the American Opportunity tax credit; however, the Lifetime Learning credit is less valuable. The American Opportunity tax credit can save as much as $2,500 per student, but the Lifetime Learning credit saves no more than $2,000 per tax return. Moreover, the income limits for the Lifetime Learning credit are stricter.
Why bother with the Lifetime Learning credit? It may be the only education-related tax credit you can use. The American Opportunity tax credit can be used only during a student’s first four years of post-high school education, and only if that student is pursuing an undergraduate degree or a similar credential. The Lifetime Learning credit can be used if you incur other expenses at any time, such as outlays for graduate school or career advancement courses. A taxpayer cannot take an American Opportunity credit and a Lifetime Learning credit for the same child in the same year; however, it’s possible to take an American Opportunity credit for one child and a Lifetime Learning credit for another child on the same tax return.
As mentioned, the Lifetime Learning credit also has income requirements. For 2011, the maximum $2,000 credit phases out with MAGI of $51,000–$61,000 (single) or $102,000–$122,000 (joint returns).
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Finding a Use for the Tuition and Fees Deduction
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The tax code offers multiple ways to offset the costs of higher education. As explained in the previous article “Taking Credits for Higher Education,” taxpayers can use the American Opportunity or the Lifetime Learning tax credit this year. As another choice, you might be able to take the tuition and fees deduction. However, if you send a child to college and claim either the American Opportunity or Lifetime Learning tax credit for a student’s expenses, you cannot take the tuition and fees deduction for the same student’s expenses that year.
For most taxpayers, the tuition and fees deduction will be the third choice. The maximum deduction is $4,000. To take that deduction, you must spend at least $4,000 on post-high school tuition, fees, books, supplies, and so forth. You also must have MAGI that’s not more than $65,000 as a single taxpayer, or not more than $130,000 if you’re married and file a joint return.
If your MAGI is even $1 over the $65,000 or $130,000 thresholds, your maximum deduction drops to $2,000. With MAGI over $80,000 (single) or $160,000 (joint), you can’t take this deduction at all. With those requirements, taxpayers who qualify for the maximum $4,000 will not be in a tax bracket higher than 25%. Therefore, the maximum federal income tax saving with the tuition and fees deduction is $1,000: 25% of $4,000. You can save up to $2,000 with the Lifetime Learning credit and up to $2,500 per student with the American Opportunity credit.
Consequently, taxpayers will claim this deduction only when they don’t qualify for either higher education tax credit. When might that occur? You might be paying the expenses for a student (including yourself ) who is not in the first four years of post-high school education, not pursuing an undergraduate degree, and not going to school at least part time. All of those conditions must be met to qualify for the American Opportunity credit, so you can’t take that credit if the student doesn’t meet those criteria.
You can claim the Lifetime Learning credit without having to meet the conditions required for the American Opportunity credit; however, the Lifetime Learning credit phases out with MAGI of $51,000–$61,000 (single) or $102,000–$122,000 (joint returns). If your income is just a little too high to meet the requirements for the Lifetime Learning credit and you spent money for education at an accredited institution, you may be able to use the tuition and fees deduction.
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Coping With the Kiddie Tax
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You may believe that shifting income from parent to student is a tax-efficient way to build an education fund. You might, for instance, give taxable bonds to your children so they can receive interest in a low tax bracket. Similarly, you might give appreciated assets to youngsters, who can sell them and owe little or no tax on the gains.
Such tactics can be useful, but they are limited by the so-called “kiddie tax.” This tax code provision caps the amounts of unearned income that can be taxed at a youngster’s rate. Excess amounts are taxed at the parents’ rate, so there may be no family tax benefit.
Kid stuff
Recent legislation has changed the kiddie tax rules. In 2011
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everyone under age 18 is considered a "kiddie."
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the same is true for full-time students under age 24, if their earned income is less than half of their support. Here, support is the total spent on a student’s behalf during the year.
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18-year-olds are still considered kiddies even if they are not fulltime students, as long as their earned income is less than half of their support.
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In 2011, individuals subject to those rules owe no tax on unearned income up to $950. The next $950 of unearned income will be taxed at the child’s rate, which will be no more than 10%. Over $1,900, all unearned income will be taxed at the parents’ rate. The kiddie tax limits change periodically to keep up with inflation, so the $1,900 limit might move up to $2,000, $2,100, and so forth in the future.
Weighing the tradeoffs
Even with the kiddie tax limits in place, some families might find tax benefits in income shifting.
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Example 1: John and Karen Jackson hold $35,000 in a taxable bond fund yielding 5%. When their daughter Sarah is born, they transfer their shares in that fund to the newborn. If Sarah receives $1,750 (5% of $35,000) this year, she will owe no tax on the first $950 and $80 on the next $800, at a 10% rate. This can go on every year, permitting Sarah to build up an education fund at a very low tax rate.
Example 2: Brett and Caroline Morgan plan to sell some mutual funds this year to raise money for their son Tyler’s college bills. They hold ABC Fund, bought for $10,000 in 2009 and now trading at a price that will bring $11,500 on a sale. They give those shares to Tyler, who can sell them and report the $1,500 long-term capital gain. Tyler has minimal other taxable income this year and qualifies for the 0% tax rate, so no tax is due on the sale.Coverdell ESA tax benefits are scheduled to be reduced in 2013. However, Congress just extended those tax benefits, so there may be a further extension in the future. If Congress does not act, and Coverdell ESA tax breaks are trimmed to the point where you’re dissatisfied, you can roll over the amount in a Coverdell ESA to a 529 plan of your choice.
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TAX CALENDAR
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AUGUST 2011
August 1
Employers. For Social Security, Medicare, and withheld income tax, file Form 941 for the second quarter of 2011. Deposit any undeposited tax. (If your tax liability is less than $2,500, you can pay it in full with a timely filed return.) If you deposited the tax for the quarter in full and on time, you have until August 10 to file the return
For federal unemployment tax, deposit the tax owed through June if more than $500.
If you maintain an employee benefit plan with a calendar year end, file Form 5500 or 5500-EZ for calendar year 2010.
August 10
Employers. For Social Security, Medicare, and withheld income tax, file Form 941 for the second quarter of 2011. This due date applies only if you deposited the tax for the quarter in full and on time.
August 15
Employers. For Social Security, Medicare, withheld income tax, and nonpayroll withholding, deposit the tax for payments in July if the monthly rule applies.
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SEPTEMBER 2011
September 15
Individuals. If you are not paying your 2011 income tax through withholding (or will not pay in enough tax during the year that way), pay the third installment of your 2011 estimated tax. Use Form 1040-ES.
Employers. For Social Security, Medicare, withheld income tax, and nonpayroll withholding, deposit the tax for payments in August if the monthly rule applies.
Corporations. File a 2010 calendar year income tax return (Form 1120) and pay any tax, interest, and penalties due. This due date applies only if you timely requested an automatic 6-month extension.
Deposit the third installment of estimated income tax for 2011. Use the worksheet Form 1120-W to help estimate tax for the year.
S corporations. File a 2010 calendar year income tax return (Form 1120S) and pay any tax due. This due date applies only if you timely requested an automatic 6-month extension. Provide each shareholder with a copy of Schedule K-1 (Form 1120S) or a substitute Schedule K-1.
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