Tax breaks to get your youngster through Yale

If you hired your kid and he put the money in a traditional IRA, withdrawals would be taxable. He won't pay the 10% penalty, however, if the money is used for qualified educational expenses, even if it is withdrawn before age 59 1/2.

If you hired your kid and the money was put into a Roth IRA, the after-tax dollars contributed can be withdrawn free of tax and penalty. You can use these dollars for any reason, including funding your child's education.

The easiest way to get subsidized tuition payments is with the U.S. Savings Bond exclusion. The bond must be in your name, not your kid's, and there are limits based on your modified adjusted gross income (your adjusted gross income less the bond income). For 2008, those ceilings were $130,650 for joint returns and $82,100 for all others. But if you qualify, you can exclude all or a portion of the interest paid on those bonds.

Use Section 529 plans

My favorite accumulation vehicle is the Section 529 plan. There are no income limitations to qualify for a 529 plan, and a married couple may contribute as much as $12,000 per beneficiary in a single year without being subject to the gift tax. If one kid doesn't go to college, the funds can be allocated, tax free, to another child.

The biggest advantage to the 529 Plan is that the dollars contributed grow tax-free if used for qualified college expenses such as tuition, fees, room and board. (States often add their own benefits.) Check out the College Savings Plans Network site or Savingforcollege.com for a listing of plans for each state and their contact information. Some programs are available to citizens of other states and allow families to spend the money on colleges outside their own state.

When she's in college

So you've accumulated the money with a little help from the IRS, but there are some more benefits to go after once your child starts college.

For the freshman and sophomore years, we have the Hope Scholarship Tax Credit. A credit is a dollar-for-dollar reduction in your tax. A $100 deduction in the 30% tax bracket saves you $30; a $100 credit reduces your tax by $100.

For 2008, the Hope credit was 100% of the first $1,200 plus 50% of the next $1,200, or a total credit of $1,800 on $2,400 of qualified educational expenses.

Once your college student is past her sophomore year, she qualifies for the Lifetime Learning Credit. You can use this for the third and fourth years of undergraduate education, or for any professional or graduate courses taken. The credit is 20% of the first $10,000 paid for qualified tuition and related expenses for all students in the family.

The maximum Lifetime Learning Credit for the family is $2,000. The maximum Hope Credit is $1,800 per student. If you have more than one kid in college, you can claim the Hope Credit for one kid and the Lifetime Learning Credit for another.

Both credits are subject to income limitations. They're phased out as your income increases from $94,000 to $114,000 on a joint return, and $47,000 and $57,000 on all others.

Starting with the 2009 tax year, Hope and Lifetime Learning credits are undergoing major changes on income limits, the number of years they can be claimed and other areas. For an overview, see IRS Hope and Lifetime Learning Credits page.

If your income is too high to qualify, consider whether your kids can file independently. With all the income that they earn, they may be able to be considered self-sufficient, and you don't then claim them as your dependents. You may lose the $3,500 personal exemption for them, but, even in the 33% bracket, that's only a $1,155 tax savings, as opposed to as much as $1,800 or $2,000 in tax-credit savings -- and that doesn't count the savings to the child from being able to claim his own personal exemption.

Once school is done

We saved for college on a tax-advantaged basis and took all the credits while in school. Now that graduation has come and gone, are there any more education-related tax breaks?

If you took out a student loan, you can now deduct the interest on those loans, up to $2,500 per year. This is an "above the line" deduction -- you don't even have to itemize to get it. For 2008, this deduction was phased out for joint returns with adjusted gross income between $115,000 and $145,000, and between $$55,000 and $70,000 for others.

You don't have to be the student to take the deduction, either. You qualify if the loan was used to pay for qualified education expenses for yourself, your spouse or anyone who was a dependent when the money was borrowed.

Congress has really stretched the envelope to stimulate higher education. You can't make a better investment in your kid's future, and, with three kids in college myself, I personally appreciate the IRS's help in financing the cost.

Updated May 20, 2009

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