Published January 31, 2012
With undergraduate tuition at all-time highs, the government provides some relief for taxpayers with dependents in college. Understanding which credit or deduction works best for you can help to reduce your tax bill.
When considering how to pay for a post-secondary education, experts recommend knowing which tax credits and deductions you qualify for before deciding whether to use a combination of monies in a 529 plan, personal savings, federal student loans, and private student loans. Expenses paid with distributions from a 529 plan do not qualify for education tax credits and deductions, according to IRS guidelines. Scholarships and fellowships are not taxable if used for tuition, fees and supplies, but are taxable when used for travel expenses and room and board, according to IRS guidelines.
For the 2010 academic year, the average cost for undergraduate tuition, fees, and room and board was $17,131 for public four-year in-state schools, $29,657 for public four-year out-of-state schools, and $38,589 for private four-year schools, according to the College Board. To pay for education expenses, students used a combination of savings and $235 billion in loans, grants, and tax benefits totaling $14.8 billion.
Taxpayers can use one of the American Opportunity Tax Credit, the Lifetime Learning Credit, or the tuition and fees deduction per student, according to the IRS. “If you have multiple children in college, you can use more than one credit or deduction on your return,” says Sue Tirukonda, certified financial planner and certified college planning specialist at Financial Benefits, Inc.
Choosing the right payment method can reap big rewards come tax season. “Figure out what will get you ahead the most and determine whether it’s more beneficial to pay using a 529 plan or a combination of 529 plan money and other sources like regular savings or student loans,” suggests certified public accountant Stephen Aponte, who is also the director at accounting firm Holtz Rubenstein Reminick.
According to Tirukonda, the education credits and deductions are very much tied to the income level of a family. “To reduce your overall taxable income so you can qualify for tax benefits, parents can look to any deductible health savings accounts and 401(k)s that their employers may offer.” She recommends maximizing contribution amounts to help qualify for deductions and credits if your income is on the border.
“Anytime you qualify for a credit rather than a deduction, take the credit because it’s a dollar for dollar reduction in taxes,” she says. A deduction reduces the income that you’re taxed, according to the IRS. For example, if you deduct $4,000 from your income, your taxes will be reduced by $4,000 times your tax rate.
American Opportunity Tax Credit
The American Opportunity Tax Credit--a modified version of the Hope Credit--provides up to a $2,500 credit per student, according to IRS guidelines. “The first $2,000 of the credit is based on 100% of the first $2,000 of expenses, and the next $500 of the credit is based on 25% of the next $2,000 of expenses,” says Aponte. “You get the full credit at $4,000 of expenses such as tuition, books, and supplies but not room, board, or transportation.”
For example, if you have $3,000 of eligible expenses paid for with savings or student loans, you can claim $2,250 of this credit ($2,250 is the sum of 100% of $2,000 and 25% of $1,000) provided you meet the income requirements.
The maximum credit a taxpayer can claim is $2,500 times the number of eligible students listed as dependents on a return, according to IRS guidelines.
Taxpayers with an adjusted gross income less than $80,000 for single filers and $160,000 for married, filing jointly, can claim the full $2,500, while the credit is phased out for incomes above $90,000 if single and $180,000 if married filing jointly, according to IRS guidelines. If you claim this credit and owe no tax, you will be refunded 40% of the credit, or $1,000.
The credit is available for undergraduate students pursuing a degree at least halftime during the first four years of study. Unless extended by Congress, the American Opportunity Tax Credit is slated to expire in December 2012.
Lifetime Learning Credit
Taxpayers can claim up to $2,000 per return for the Lifetime Learning Credit, according to IRS guidelines. This credit is available for anyone pursuing an undergraduate or graduate degree or just taking a class, and does not have a year limit like the American Opportunity Tax Credit.
The amount of the credit is up to 20% of the first $10,000 of expenses. Similar to the American opportunity credit, the Lifetime Learning Credit covers tuition, books, and supplies but not room, board, or transportation, according to IRS guidelines.
For example, if you have $8,000 of eligible expenses paid for with savings or student loans, you can claim a credit of $1,600.
You can claim the full credit if your adjusted gross income is less than $50,000 if filing single and $100,000 if married filing jointly. The credit is phased out for incomes above $61,000 if filing single and $122,000 if married filing jointly, according to IRS guidelines.
Tuition and Fees Deduction
You can deduct $4,000 in tuition and fees if your income is below $65,000 if filing single or $130,000 if married filing jointly, or $2,000 if your income is between $65,000 and $80,000 if filing single or $130,000 and $160,000 if married filing jointly, according to IRS guidelines.
“It’s an above the line exclusion from income, meaning it reduces your adjusted gross income,” says Mark Kantrowitz, publisher of FinAid.org. You can still take the deduction even if you don’t itemize.
“Since this deduction lowers your income, it can possibly help you qualify for other deductions, like medical expenses exceeding 7.5% of your income or unreimbursed employee expenses exceeding 2% of your income,” says Aponte. “Generally, the credits are more beneficial, but if you have someone who’s not eligible for the other credits, your income is too high, or they’re in school for longer than four years, you may be eligible for this deduction.”
529 accounts are generally operated by each state and provide tax benefits and incentives to save for the beneficiary’s post-secondary education, according to the IRS. Each state has its own contribution limits, and contributions made by anyone other than the beneficiary are considered gifts. “Anything above $13,000 is subject to the gift tax system,” says Aponte.
Although some states do not give any tax benefits for contributions, “in 34 states and the district, you get a state income tax deduction for contributions,” says Kantrowitz.
“529s are a good way to pay for education,” says Tirukonda. “This money grows tax deferred.” The funds can be used to pay for education expenses like tuition, fees, books, and room and board, and any unused funds can be transferred to another beneficiary, such as a sibling, cousin, or other relative, without tax consequences, according to the IRS.
Some states that provide state income tax benefits have different requirements as to when you can withdraw money that range from a day to a year after making a deposit, according to FinAid.org. Other states provide matching grant programs depending on your income level, according to FinAid.org. Experts recommend checking your state’s 529 plan to see what benefits are offered.
Student Loan Interest Deduction
If you have student loan payments and your adjusted gross income is less than $75,000 if filing single or $150,000 if married filing jointly, you can deduct $2,500 in federal or private student loan interest, according to IRS guidelines. To take this deduction, student loans can only be used to pay for tuition, fees, room and board, and supplies, according to IRS guidelines.
“This deduction can be taken regardless of whether you itemize or take one of the three credits or the deduction for tuition and fees,” says Aponte.
The Coverdell Education Savings Accounts can be used to pay for k-12 and post-secondary tuition, fees, supplies, and room and board. Parents can contribute up to $2,000 a year, and the money grows tax-deferred. “The one benefit of these accounts is that you can use it for k-12 education but they have low contribution limits,” says Aponte.
Experts recommend that you first determine whether you qualify for one of the education credits or the tuition and fees deduction and how each affects your tax bill. Once you know your tax savings, experts recommend using the combination of money from 529 plans, savings, or loans to pay for the education expenses that will give you the most tax benefits.
Before deciding which strategy works best, “you absolutely need to run the numbers to see if a strategy is right for you,” says Tirukonda.