Cash In on Expiring Tax Breaks for Education Savings

Is your college student nagging you for a new computer? If you’d like to oblige but think you can’t afford to, you might be surprised to learn that you may have a ready stash of savings you can use to buy that gift -- if you have a 529 college-savings plan.

Normally, you must spend your 529 funds on college tuition and other qualified expenses. The earnings portion of distributions not used for qualified college expenses is taxed and slapped with a 10% penalty.

But an expiring tax break allows you to use money in your 529 college-savings plan tax-free and penalty-free to purchase a computer for students enrolled in college or another post-high school institution. The tax break, which is available through the end of 2010, also applies to computer software and Internet service. To qualify for the tax break, the software must be primarily educational. Sports or gaming software doesn’t qualify.

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This is also your last chance to use funds in a Coverdell Education Savings account to pay for private elementary and high school tuition. Starting next year, only college-related costs will qualify for tax-free distributions. So if you want to pay next spring’s tuition bill from your Coverdell funds, write the check by December 31.

Beginning in 2011, the maximum contribution limit to these tax-deferred savings accounts, sometimes called education IRAs, will be trimmed to $500 per year, down from the current $2,500 per year. Given the combination of lower contribution limits and tighter restrictions on tax-free distributions, you may want to switch your college-savings strategy to a 529 plan. The only drawback is you won’t have as many investment options as you have with a Coverdell account.

The enhanced American Opportunity Credit for undergraduates also expires at year-end. Individuals with incomes up to $80,000 ($160,000 for married couples) who pay at least $4,000 in college tuition in 2010 can claim a tax credit of up to $2,500. So if you haven’t spent enough this year to capture the full credit -- perhaps you have a college freshman at a low-cost community college -- pay your student’s tuition for the spring semester in December.