Education is one of the most important gifts you can give a child. The federal government and some state governments reward parents and grandparents who help pay for a child’s education. These rewards come in the form of tax breaks, making it more appealing than ever for you to put your child or your grandchild through college.
Step 1: Establish and contribute to a Section 529 plan. The money contributed to this plan can be withdrawn tax-free to pay for college expenses. Contributions may be tax-deductible on a state level. To qualify for the state tax deduction, you usually must contribute to plan in your state of residence.
Some states permit anyone to take the tax deduction for his or her contributions, while others only allow the account owner to utilize the deduction. If the second case is true in your state, parents and grandparents should open separate accounts for the child so they can both take the deduction. The number of Section 529 accounts that can be opened for the same child is unlimited.
Step 2: In 2011, up to $13,000 can be provided to a single person before gift-tax rules apply. However, five years ($65,000 per child or a contribution of $130,000 from a married couple) of 529 contributions can be made in one year without the gift tax being triggered, as long as you do not provide that person with any other money during those five years.
Step 3: The American Opportunity credit provides a maximum tax deduction of $2,500 per student for those who pay tuition for the first four years of college. Tuition plus qualified expenses (books, fees, and related course materials) must total at least $4,000 and the contributor’s modified adjusted gross income has to be $80,000 if single or head of household or $160,000 if married and filing jointly in order to receive the full credit. Singles and heads of household who earn up to $90,000 and couples with incomes of up to $180,000 can receive partial credit. The student must be considered a dependent, so this credit usually applies only to parents.
Step 4: When tuition is paid directly to the college, the annual gift tax limit is waived. This holds true for whoever makes the tuition payment, so grandparents can provide their grandchildren with some extra money without incurring the gift tax. Only the direction tuition payments are exempt from the tax, not room and board.