(MONEY Magazine) – HOW THE IRS CAN HELP WITH COLLEGE COSTS

If you have kids, you know how expensive college can be. What you may not know is that tax credits and deductions can offset the pain. Yet as the IRS' national taxpayer advocate, Nina Olson, says, "You practically have to have a Ph.D. to figure them out." A brief education:

The basics. On April 15, education tax breaks come in four forms: the Hope credit (100% of the first $1,000 you pay in tuition and related costs, 50% of the next $1,000, for the first two years of college); the lifetime learning credit (up to 20% of $10,000 in costs, or $2,000); the tuition-and-fees deduction (up to $4,000 a year); and the student-loan interest deduction (up to $2,500, once you're repaying the loan). All are subject to income limitations (see the table below).

The twists. You are only allowed to claim one credit per child, and you cannot take either the Hope or the lifetime credit along with the tuition deduction for the same student during the same year. If you have two children in college at the same time, you may be able to mix and match credits and write-offs.

The strategy. Use credits before deductions. A $1 credit reduces your taxes by $1; a $1 deduction, in the 25% tax bracket, saves you only 25¢. The exception: If you qualify only for a partial credit, the deduction may be worth more.

Which credit to start with? That depends on how much school costs. If your child attends an expensive private university that runs at least $10,000 a year, the full $2,000 lifetime learning credit is more valuable than the $1,500 Hope credit. If tuition doesn't reach $10,000 at your child's school, the Hope may be worth more.

In the case of the Wang family (pictured on page 74), their $110,000 income means that they can't claim either credit. But they do qualify for the tuition deduction. And once daughter Connie graduates, she should be able to deduct interest on her student loan.

Notes: Benefits not available if married filing separately. Both credits are partial with income at $85,000 if married, $42,000 if single. Tuition deduction reduced to $2,000 at incomes over $130,000 married, $65,000 single. Student-loan deduction phases out at $100,000 if married; $50,000 if single. Source: IRS.

WHAT'S THE PROBLEM

The April surprise. A higher tax bill The culprit. The alternative minimum tax (AMT), a separate tax system with its own rates and rules. Designed to prevent the ultrawealthy from avoiding taxes through loopholes, the AMT now threatens to snare one in three taxpayers by decade's end. Under the AMT, you can't deduct state and local income taxes or property taxes. Gone too are exemptions for your kids. Instead, you calculate what's called your alternative minimum taxable income—which excludes many common deductions—lop off a sizable dollar exemption, and apply a 26% rate to the first $175,000 that's left, 28% above that. If your AMT is higher than your regular income tax bill, that's what you owe.

WHAT PUTS YOU AT RISK

If you have kids, live in a high-tax state such as New York or California and own a home, you're at risk. See the table at right for an idea of whether your disallowed deductions and exemptions might trigger the AMT. Or estimate how close you are by using H&R Block's calculator at hrblock.com/taxes/tools/amt/index.html.

WHAT YOU CAN DO

If you itemize or take several exemptions, you should calculate the AMT so you don't find out later from the IRS that you should have paid and now owe hefty penalties (software does Form 6251 automatically). If deductions or exemptions are the reason you're paying the AMT, there's not much you can do. In some cases, taking the standard deduction rather than itemizing can keep you out of the AMT and lower your tax bill. If you see that you'll fall under the AMT in 2005 for a one-time reason like incentive stock options, it's not too late to plan. You could, say, push property tax payments or other deductions into 2006. Consult a pro for help.

It's easy to see why the Rinaldis have had to pay the alternative minimum tax on and off over the years. Thomas and Francine, both 39, have all the common AMT triggers: They live in high-tax Katonah, N.Y., and state and local taxes aren't deductible for AMT purposes; they own a home, and the AMT doesn't allow for real estate tax write-offs; and they have kids (Jesse, 8, Jenna, 5, and Jordan, 3), and you can't claim exemptions for your children under the AMT.

The Rinaldis live comfortably, but they aren't rich. Thomas owns a business that builds commercial kitchens—which pays him about $100,000 in annual income. But, as the Rinaldis have found, the AMT isn't just for the rich.

What makes matters even worse for them is that they buy and sell real estate on the side, and depreciation is treated less favorably under AMT rules. Their profitable sale of a rental property in 2004 could make the AMT calculation even harder this year.

Will the Rinaldis be snared again? Thomas says he thinks not, but the possibility is one reason the couple work with a tax pro. "All I know about the AMT is that it is one of the most confusing things in the world," he says, "so I leave it up to my accountant to make it work."

Notes: [1] Under the AMT, disallowed deductions include state, local and real estate taxes and miscellaneous expenses. [2] Filing jointly. Source: Martin Nissenbaum, Ernst & Young.