The U.S. tax code provides multiple tax-saving opportunities related to higher education costs for yourself and your dependents. To take advantage of these breaks, you must first know what is available and which may apply to you. While the tax code has a marvelous way of complicating even the simplest concepts, making every situation unique, you and your school-aged child may find a crash course in the basics helpful.
American Opportunity Credit
The American Opportunity Credit would have expired at the end of 2012, but the passage of the American Taxpayer Relief Act extended the credit until 2017. An improved version of the Hope Credit, the American Opportunity Credit is calculated as 100 percent of the first $2,000 of qualified expenses plus 25 percent of the next $2,000, for a maximum benefit of $2,500.
The credit is allowed for the first four years of post-secondary education and is phased out between a modified adjusted gross income (MAGI) of $80,000 and $90,000, for single taxpayers, and $160,000 and $180,000, for married taxpayers filing jointly in 2013 and 2014.
The biggest advantage of the American Opportunity Credit is that 40 percent of the unused amount is refundable. This means that a taxpayer who qualifies for the full $2,500 of credit but has no tax liability can request a cash refund of up to $1,000 (40 percent of $2,500).
Tuition and fees are qualified expenses, and required supplies and books are now included as qualified expenses. This is an improvement over the credit’s predecessor, the Hope Credit. To be eligible, a student must be considered enrolled at least part-time. Room and board are never considered qualified.
Lifetime Learning Credit
The Lifetime Learning Credit has a maximum value of $2,000 per year, calculated as 20 percent of the first $10,000 of qualified expenses. Unlike the American Opportunity Credit, which can be taken only for the first four years of post-secondary education, the Lifetime Learning Credit can be used during any year. And the student does not have to be enrolled part-time or be in the process of earning a degree or educational credential. This makes the credit particularly valuable to graduate students.
The Lifetime Learning Credit is not refundable, meaning it can be used only to offset a tax liability. Any amount not used in the current year is lost. The costs of books and supplies are considered qualified expenses only if they are purchased directly from the eligible institution. This requirement differs from the American Opportunity Credit, which allows them to be purchased anywhere.
For 2013 tax returns, the credit phases out between MAGI of $53,000 and $63,000, for single taxpayers, and $107,000 and $127,000, for married taxpayers filing jointly. For 2014 returns, the credit phases out between MAGI of $54,000 and $64,000 for single taxpayers and $108,000 and $128,000 for married taxpayers filing jointly.
One important item to note is that the Lifetime Learning Credit is available up to a maximum of $2,000 per return. Even if there are three students included on one tax return and all have education expenses, the maximum credit remains $2,000. It is a per-return limitation, not a per-student limitation. In contrast, the American Opportunity Credit, including the refundable portion, is available on a per-student basis.
Tuition and Fees Deduction
For 2013 returns, the deduction for tuition and fees can be taken dollar for dollar up to a maximum of $4,000 of qualified expenses. The good news: This deduction is considered an “above-the-line deduction,” which means it is available whether you itemize or take the standard deduction.
There are MAGI phaseout issues to consider. The 2013 limits are:
- $65,000-$80,000 for singles
- $130,000-$160,000 for married couples filing jointly
The deduction is not allowed for married taxpayers filing separately.
Like the Lifetime Learning Credit, the costs of books and fees paid directly to the college or university are considered qualified, but personal expenses such as room and board are not. The tuition and fees deduction was set to expire after 2011 but was extended through 2013 by the American Taxpayer Relief Act. The deduction expired at the end of 2013.
The tuition and fees deduction cannot work in conjunction with education credits. You must choose one or the other for each student.
If you paid qualified expenses for more than one student, you can claim a credit for one and the deduction for the other – but never both for the same student. However, you can choose between the credit and the deduction based on which produces the largest benefit to you.You can’t claim both the American Opportunity Credit and the Lifetime Learning Credit for the same student. You must choose one or the other.
Remember: A credit is more valuable than an equivalent amount of deduction. If you’re eligible for both, the American Opportunity Credit has a larger benefit than the Lifetime Learning Credit.
Student Loan Interest Deduction
If you have a loan to pay for qualified higher education expenses for yourself or a dependent, you may be able to deduct the interest paid on the loan. A deduction is available for the lesser of $2,500 or the amount of interest paid. Like the tuition and fees deduction, the student loan interest deduction is considered an above-the-line deduction, making it available to taxpayers who do not itemize their deductions.
For 2013 returns, the benefit is available only at certain income levels. It phases out between MAGI of $125,000 and $155,000 for married couples filing jointly and $60,000 and $75,000 for single filers. For 2014, the phaseout ranges are $130,000-$160,000 for married couples filing jointly and $65,000-$80,000 for single filers. No benefit is available for a married person filing separately.
The IRS has allowed for certain savings plans that can provide tax benefits if the proceeds are used for qualified education expenses upon distribution. But the same qualifying expenses can’t be used for both an education credit and an education savings plan.
Contributions to a 529 plan, also known as a QTP (qualified tuition plan), are not deductible. However, the principal and earnings are allowed to grow tax-free. The distributions aren’t taxable if they’re used for qualified education expenses. This offers a tremendous tax-planning opportunity since there are no income limits for either the contributor or the beneficiary. Qualified education expenses include post-secondary tuition, books and supplies. Room and board is also qualified if the student is enrolled at least part-time in postsecondary education. There are no limitations on the amount that can be contributed, but any amounts not used for education will be taxable upon distribution.
It’s important to note that contributions to a 529 plan for someone other than yourself or your spouse are considered gifts. Therefore, the contributions may have gift tax implications if the amount is more than $14,000, which is the annual per-person gift tax exclusion for both 2013 and 2014. Another savings plan available is the Coverdell Education Savings Account. Like the 529 plan, contributions to a Coverdell are not deductible, and the distributions, including growth in the account, are tax-free if used for qualified education expenses.
This plan differs from a 529 plan in that the proceeds can be used to pay expenses for K-12th-grade education as well as graduate level education. In return for this amazing benefit, the Coverdell plan is substantially more restricted. Contributions are limited to $2,000 per beneficiary and generally can’t be made once the beneficiary reaches age 18. There are also income limitations to be considered. The ability to contribute is phased out when the contributor’s MAGI reaches amounts between $95,000 and $110,000 for singles and $190,000 and $220,000 for married taxpayers filing jointly.
Typically, distributions made from an IRA account before the account owner reaches age 59½ are subject to income tax and a 10 percent early withdrawal penalty. However, an exception to the early withdrawal penalty exists if the proceeds are used for qualified education expenses. Since this option subjects the distributions to income taxation, it would likely be the least favorable method of funding education from an income tax perspective. These tax savings opportunities have been summarized for simplicity. These options can be subject to further restrictions based on every taxpayer’s unique situation.