You could be eligible for some tax breaks in the form of a deduction or, better yet, a tax credit. Unfortunately, most of these tax breaks phase out based on income so be aware that filing status and income can limit the tax benefits.
The American Opportunity Credit (AOC): This is one of the most generous of the education benefits. A credit is better than a deduction because it reduces the taxes that you pay and not the income on which you are taxed. In the case of this credit, there could be a benefit even if you owe no tax. It applies to the costs of the first four years of post-secondary education at an eligible educational institution. Costs include tuition and academic fees, nonacademic fees like student activity fees, and course related books and supplies. Note, the cost of room and board is not applicable to this credit.
The credit can be as much as $2,500 per student. The student can be the taxpayer, spouse or dependent of the taxpayer. The credit is claimed by the person who claims the dependency exemption for the student or the student himself, but only if the student is not claimed as a dependent by someone else. The student must take at least half the normal full time work load in a program that leads to a degree, certificate or other recognized educational credential. Moreover, the student must not have a felony conviction for possessing or distributing a controlled substance.
The credit is 100% of the first $2,000 of eligible expenses and 25% of the next $2,000. The credit offsets regular taxes and the alternative minimum tax but is not available to taxpayers who are married filing separately. Also, it begins to phase out when modified adjusted gross income reaches $160,000 when married filing jointly or $80,000 for other filing statuses.
40% of the credit is refundable, meaning that after the credit reduces your tax liability dollar for dollar, up to $1,000 of the remaining credit will be refunded to you. Students claiming the credit who are subject to the “kiddie tax” are not eligible for the refundable portion of the credit.
Lifetime Learning Credit: This credit is equal to 20% of education expenses up to $10,000. The maximum credit is $2,000 per return. It applies to the same expenses as the AOC as well as courses taken to acquire or improve job skills. There is no workload requirement and it’s not limited to the first four years of postsecondary education. However, the education institution must be an eligible educational institution. The credit is nonrefundable and is not available when married filing separately. It begins to phase out at $110,000 when married filing jointly and $55,000 for all other filing statuses.
Tuition and Fees Deduction: This above-the-line deduction reduces the amount of your income subject to tax by up to $4,000. It applies to expenses paid for you, your spouse, or dependent as a condition to attend an eligible education institution. It again does not apply when married filing separately and begins to phase out when modified income reaches $80,000, $160,000 if married filing jointly.
The student should receive a 1098-T from the educational institution documenting tuition and fees billed and received for the tax year. For the purpose of the credits and deduction above, expenses are deducted in the year paid. You can’t use any of the above for education expenses deducted somewhere else on your return (for example, as a business expense) and you can’t use the same expenses more than once. Also, expenses must be reduced by any scholarship received, the tax-free interest on US Savings Bonds or the tax-free portion of a Coverdall education program or 529 Plan. However, expenses paid with the proceeds of a loan do count.
Many parents and grandparents are funding 529 plans, also known as Qualified Tuition Programs. These can be savings accounts or prepaid tuition programs. There is no income limits for either the student or the funders. Contributions are not tax deductible, but the funds in the accounts grow tax free and the income is never taxed if used for the beneficiary’s tuition and fees; books, supplies and required equipment; or room and board if at least a half-time student. These funds can be used for undergraduate or graduate education. If not used for the intended beneficiary, the beneficiary can be changed to a sibling or other relative to preserve the tax benefits. However, if the funds are used for other than the intended purpose, taxes and a penalty will be imposed. These are similar to Education Savings Accounts which are used far less often and are beyond the scope of this article.
Series EE or Series I Savings Bonds: The interest on certain of these bonds is tax free when used to pay the expenses of graduate or undergraduate education. Here again, this tax benefit is not available when married filing separately and there is a phase out starting at $115,750 when filing jointly, $77,200 for the other filing statuses.
Also, did you know that:
- The 10% penalty on IRA withdrawals is waived in the year of the withdrawal when the proceeds are used to pay qualified education expenses (graduate and undergraduate) for yourself, your spouse, your child or a descendant of any of them.
- Scholarships are not taxable up to the cost of tuition and course-related expenses. Amounts received in excess of those costs, including a stipend for housing, could be taxable.
- Interest on student loans is another above-the-line deduction. The payer must be legally responsible for the interest on a loan incurred to pay the qualified education expenses of a student enrolled at least half-time in a degree program (graduate or undergraduate). The student must be the taxpayer, the spouse, or dependent of the taxpayer at the time the debt is incurred. The deduction is up to $2,500 and is not available to taxpayers filing as married filing separately. The deduction phases out beginning at $130,000 of modified adjusted gross income when filing jointly, $65,000 for all other taxpayers.
These benefits provide some planning opportunities to help fund the costs of education. Please contact us if you have any questions.