Tax breaks that help you get ahead

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In 1758, Benjamin Franklin said, “It would be a hard government that should tax its people one-tenth part of their income.”

Imagine what Citizen Ben would think if he were transported to the 20th century, during which the top marginal rate exceeded 50 percent much of the time, peaking at 94 percent in 1944-45 for taxpayers with incomes of more than $200,000. Today, income tax rates range from a relatively benign 10 percent to 35 percent — still more than Ben would have liked.

The tax code is not only designed to generate revenues for government programs. Uncle Sam provides some pretty nice tax breaks that provide Americans incentives to get a college education, buy a home and save for retirement.

These breaks typically come in the form of tax deductions or tax credits. A tax credit is usually a dollar-for-dollar sum that can be directly deducted from taxes owed. A tax deduction is a sum that reduces your taxable income.

Identifying the breaks that you qualify for is the first step toward lowering your overall tax burden, which helps build your bottom line.

Tax breaks that advance your best interests
  1. Tax deductions for homeowners
  2. Deductions for higher education
  3. Tax credits for higher education
  4. Tax-advantaged college savings plans
  5. Retirement savings for individuals
  6. Tax-deferred retirement plans

1. Tax deductions for homeownership

Mortgage points. According to the Office of the Comptroller of the Currency, there are more than 34.7 million mortgage loans worth more than $6.1 trillion as of June 2008.

That means a lot of people are eligible to reduce their overall tax bill if they know where to look.

The Internal Revenue Service generally allows mortgage points, also known as discount points, to be deducted from your tax return. Mortgage points are upfront fees paid to a lender for the loan.

One mortgage point equals 1 percent of the loan amount. Points are usually paid at closing and generally result in a lower interest rate on the loan.

IRS rules allow homeowners to deduct points over the term of the loan or all at once in the year they were paid. To deduct points all at once, you must meet certain IRS eligibility tests. In general, the home must be your main residence. In addition, the points you paid must not be considered exorbitant, must be computed as a percentage of the mortgage and must be clearly identified as points on your settlement sheet.

“The key thing to remember about this is all of these things need to be itemized,” says Kay Bell, a tax expert who writes Bankrate’s “Eye on the IRS” tax blog. “You can’t use Form 1040-A or 1040-EZ.”

Points that don’t meet IRS eligibility tests or points paid on loans secured by a second home can be deducted only over the life of the loan. In general, the loan period must not be longer than 30 years and the number of points must be six or less.

Mortgage interest. Generally, the IRS will allow a deduction for interest paid on a home loan. That includes loans for the mortgage on your primary residence and a vacation property and, under certain conditions, interest on a second mortgage, a home equity line of credit or a home equity loan.

The IRS requires that you claim the deduction on a Form 1040 and that you — not someone else — are legally liable to repay the loan.

The IRS also places restrictions on whether the interest is fully deductible. In general, the combined mortgage total (including both first and second mortgages) cannot exceed $1 million.

As you pay down your loan, you’ll probably pay less in interest and more in principal. In some cases, taking the mortgage interest deduction may not pay off.

“If the mortgage interest is less than the standard deduction, which is around $10,700 for a married couple, it might not be worth it to deduct the mortgage interest depending on the taxpayer’s other itemized deductions,” says George Saenz, a certified public accountant and Bankrate’s “Tax Talk” columnist.

Tax blogger Kay Bell, a member of the Taxpayer Advocacy Panel, agrees that in some cases, the standard deduction may be a better deal.

“The standard deduction amounts have been going up, so you need to pay close attention to what those are,” she says. “Some people might not have enough (interest to deduct), so it makes no sense itemizing.”

2. Tax deductions for higher education

Tuition and fees. The U.S. Census Bureau estimates more than 18 million students are enrolled in American colleges. Many of those students, or their parents, will qualify for tuition and fees deductions or student loan interest deductions.

If you, your spouse or a dependent attends a qualified educational institution, you may be eligible to take a tuition and fees deduction of up to $4,000.

The IRS makes it easier to claim this deduction because you can file the slightly less complicated 1040A form. And the modified adjusted gross income, or MAGI, limits are higher than those allowed for the two major federal educational tax credits: the Hope Credit and the Lifetime Learning Credit.

The IRS calculates MAGI by taking your adjusted gross income, or AGI, and adding back such items as foreign income, foreign-housing deductions, student-loan deductions, IRA-contribution deductions and deductions for other education-related costs.

You must have a MAGI of no more than $80,000 ($160,000 if filing a joint return) to qualify for the tuition and fees deduction. Further, you cannot take this deduction if your filing status is “married filing separately” or if someone else can claim you as a dependent on their tax return.

George Saenz, a certified public accountant and Bankrate’s “Tax Talk” expert, offers another caveat.

“You can’t double up and take both the tuition deduction and the Hope or Lifetime Learning credit(s) at the same time,” Saenz says.

You also cannot claim this deduction for room and board — a costly part of higher education.

Student loan interest. Once you’ve graduated college and left behind the final exams and toga parties, it’s time to start repaying college loan debt.

Fortunately, the government provides relief. Borrowers can reduce their tax burden by up to $2,500 for qualified educational expenses. As long as your modified adjusted gross income is under $55,000 ($110,000 for a joint return), you qualify for the full deduction.

If your MAGI is higher than those amounts, the deduction gradually phases out. You’re out of luck and won’t qualify for the deduction if your MAGI is $70,000 or more ($140,000 or more if you file a joint return).

You also must file a joint return if you’re married, and you cannot claim the deduction if you’re a dependent of someone else.

One of the key concerns of families is who gets to claim the deduction: the parent or the child? “In cases where parents and children are both paying for school with loans, the family needs to determine which taxpayer gets the tax benefit,” says Kay Bell, a tax expert who writes Bankrate’s “Eye on the IRS.”

“The first thing to keep in mind is that the taxpayer who can claim this deduction must be personally liable for the loan. Essentially, if the loan is taken out by a parent to pay for a child’s education, the interest on that loan may be deducted by the parent as long as the child was the parent’s dependent when the loan was received. When a parent pays a loan taken out by the child but the parent is not legally liable, the child, not the parent, gets the deduction. If both the parent and the child obtain education loans and, for example, it’s in the child’s name but the parent is a cosigner on the loan, the determination of who gets the deduction depends on whether the child was a dependent.”

You generally can continue to take this deduction for the life of the loan as long as you are making interest payments and remain within the income guidelines.

3. Tax credits for higher learning

Hope credit. The federal government provides two tax credits for students and parents to help offset the increasing costs of higher education. These credits reduce the amount of income tax you owe at the end of the year.

“You need to sit down if you have a kid in college and see who’s going to benefit the most from taking that credit,” says Kay Bell, a tax expert who writes Bankrate’s “Eye on the IRS” blog. “They’re different amounts and for different situations.”

You can take a Hope credit of up to $1,650 for qualified educational expenses paid for you, your spouse or an eligible dependent for whom you claim an exemption on your tax return. However, a student with a felony drug conviction cannot take the credit.

You can claim the credit for tuition, books and certain student fees, but not for room and board. The maximum tax credit is $1,650 per eligible student.

The Hope credit is limited to the first two years of enrollment at an eligible educational institution. The student must be enrolled at least half-time in a program that leads to a degree, certificate or other recognized education credential. The credit can be used only twice for the same student.

In addition, if your tax filing status is “married filing separately” or your modified adjusted gross income (MAGI) is $57,000 or more ($114,000 for a joint return), you won’t be able to claim the credit.;

Lifetime Learning credit. The Lifetime Learning credit provides a maximum tax credit of $2,000 per return. Unlike the Hope credit, it’s available for all years of postsecondary education and can even be applied for courses to improve job skills — you don’t need to be pursuing a formal degree.

The income limits are the same as with the Hope credit (MAGI of $57,000 or $114,000 for a joint return), but the felony-drug-conviction rule does not apply.

IRS rules do not allow you to double up on benefits. For example, you cannot claim the Lifetime Learning credit and a Hope credit for the same student. Likewise, if you claim one of the credits, you can’t claim the tuition and fees deduction for the same student.

In some cases, the tuition and fees deduction may be a better payoff.

“Even if you can’t take the credits, because they phase out at certain level of income, you may be able to take the tuition and fees deduction, which also phases out but at higher levels of income,” says George Saenz, a certified public accountant and Bankrate’s “Tax Talk” columnist.

“So just because you’re not eligible for either credit doesn’t mean you shouldn’t look at the tuition and fees deduction.”

Fortunately, for parents with more than one student in school, the IRS provides a little breathing room. You can claim the Hope credit for one child’s expenses and the Lifetime Learning credit for the other child.

4. Tax-advantaged college savings plans

Prepaid tuition plans. A 529 plan is an education savings plan directed by either a state or an educational institution.

There are two types: prepaid tuition plans and college savings plans. Prepaid tuition plans allow savers to lock in predetermined prices for future college tuition costs. They are fairly restrictive in that they generally have residency requirements, age restrictions for the beneficiary and limited enrollment periods. They may or may not have a “room and board” option.

However, hikes in college tuition in recent years have far exceeded inflation rates, making these an affordable option for those parents who don’t mind sending their children to a public university in their home state. The payment is usually a fixed monthly amount to be paid over a period of several years and generally comes with a guaranteed number of credit hours.

529 savings plans. College savings plans are more flexible than prepaid tuition plans. In most savings plans, you can choose to go to school in any state regardless of where your 529 savings plan is from, according to

These plans generally offer a number of investment options including stock mutual funds, bond mutual funds and money market funds. The can be used to pay for all “qualified” expenses, including books, room and board and fees.

There are a few caveats however. Unlike a prepaid tuition plan, investments in a college savings plan are subject to market risks, and there is no lock on future college costs.

Both prepaid and 529 savings plans provide a “double whammy” effect regarding tax breaks. That’s because not only are earnings tax-deferred, but they are also tax-exempt when distributed for qualified educational expenses.

“The big tax advantage is the money grows tax-free,” says Kay Bell, a Bankrate tax expert and blogger. “You don’t get an immediate tax break, but you get an eventual tax break.”

While 529 plans are a great way for parents to save for their children’s education, they are not deductible on federal income tax returns. However, contributions to a 529 plan may be deductible on your state income tax return.

“Some states will give a tax break in either the form of a deduction or a credit,” says George Saenz, a CPA and Bankrate’s “Tax Talk” expert. “You have to look into it based on the state you live in.”

Learn more about 529 plans at

5. Retirement savings for individuals

Traditional IRAs. Individual retirement accounts, or IRAs, are personal savings plans that offer tax advantages as you save for retirement.

Depending on your income, you may be able to take a tax deduction for some or all of your contributions to a traditional IRA. You pay taxes later during retirement, when making withdrawals from your account.

The amounts in these accounts generally are not taxed until you take a distribution.

Withdrawals made prior to age 59 1/2 could be subject to a 10 percent penalty tax. You also may owe a hefty excise tax if you do not begin withdrawing minimum distributions by April 1 of the year after you reach age 70 1/2.

For 2008, you generally can contribute up to $5,000 to a traditional IRA — $6,000 if you are 50 or older and making catch-up contributions.

Roth IRAs. Unlike traditional IRAs, you can’t deduct contributions to another type of IRA — the Roth IRA.However, the benefit of Roth IRAs is that the contributions are made with today’s after-tax money as opposed to some future tax rate, which may be higher. You get the benefit at the time you take withdrawals, since qualified distributions are tax free.

Unlike with traditional IRAs, contributions can be made to your Roth IRA after you reach age 70 1/2 and you don’t have to withdraw money from your Roth IRA at all during your lifetime.

For 2008, you generally can contribute up to $5,000 to a Roth IRA — $6,000 if you are 50 or older and making catch-up contributions. If you wish to contribute to both a Roth and a traditional IRA, the total contribution amount cannot exceed these limits.

6. Tax-deferred retirement plans

SEPs, SIMPLE plans. The IRS provides incentives for self-employed individuals and small companies to help their employees save for retirement through SEP (simplified employee pension) plans, SEP 401(k)s and SIMPLE (savings incentive match plan for employees) plans.

The contribution amounts are generally much higher than with IRAs and are usually tax-deductible.

For example, the maximum contribution to a SEP-IRA in 2008 is 25 percent of compensation or $46,000, whichever is less. The annual compensation limit for 2008 is $230,000.

SEP 401(k)s offer similar benefits. For 2008, you can defer up to $15,500 in pretax income. If you’re older than 50, you can save up to $20,500. You also can save an additional 25 percent of your compensation for a total $46,000 (or $51,000 if age 50 or older).

Contributions to SIMPLE plans max out at $10,500.

“SEPs are exciting because they are a great opportunity for small businesses with little or no employees,” says George Saenz, a certified public accountant and Bankrate’s “Tax Talk” expert.

Saenz says the government essentially pays these taxpayers to save money and put it in their own pockets, “so part of your immediate return is not so much the amount that’s invested. It’s the 30 to 35 percent tax that you get to save right away.”

401(k) plans. According to the most recent statistics the U.S. Department of Labor provided, almost 64 million Americans have 401(k) plans. That’s a lot of people taking advantage of a tax-deferred retirement plan.

With 401(k) plans, employees contribute a portion of their wages on a pretax basis. That means the deferred wages are not subject to income tax withholding.

These plans are an increasingly common way to save for retirement now that fewer companies are offering defined benefit plans, or traditional pensions.

At many companies, employers match a certain percentage of your contributions to a 401(k) plan; in essence your employer gives you free money toward your retirement.

“If you have a job where an employer offers a 401(k), put (enough) money into it to at least meet their match,” says Kay Bell, a tax expert who writes Bankrate’s “Eye on the IRS” blog. “If you don’t, you’re just leaving money on the table.”

The money you contribute toward your 401(k) plan reduces your taxable income at the end of the year and generally is not taxed until you take a distribution upon retirement.

Distributions received before age 59 1/2 are subject to an early distribution penalty tax of 10 percent unless a qualified exception applies.

If you leave your company and decide to take a lump sum distribution from your 401(k) instead of rolling it over, you will be subject to a 20 percent withholding tax.

Contribution amounts vary based on how much employees elect to defer into their 401(k) plan and limits based on the terms of your 401(k) plan. The limit on elective deferrals is $15,500 for 2008 with an additional catch-up contribution limit of $5,000 per year for those 50 years of age or older.