Paying for higher education expenses is challenging and stressful, even for families that have done a respectable job of saving and planning ahead. The good news is that there are a number of tax benefit provisions that can help ease the burden, but understanding these benefits and how to take advantage of them can be tricky.
The first step is to determine whether your child (or children) will qualify as a dependent on your tax return. For most college students that haven't earned significant amounts of income on their own, being a dependent usually yields the most tax advantages for parents. To be considered a dependent, a child must be a U.S. citizen or a resident of the U.S., Canada or Mexico, be a full-time student under the age of 24, and get at least half of his/her financial support from the family member claiming them as a dependent.
There are four types of tax benefits for college education expenses, each with its own set of rules and exceptions:
- Tax Credits - reduces the actual amount of income tax owed
- Tax Deductions - reduces the amount of income that is subject to income taxes, thereby reducing the amount of taxes owed
- College Savings Plans - allows earnings on savings deposited to grow tax-free until money is taken out, or allows the distribution to be tax-free, or both
- Exclusion for Income - allows certain education benefits (such as a scholarship) to be excluded as income for tax purposes
The American Opportunity Credit is available for the first four years of college education and offers a credit of up to $2,500 on annual educational costs. The credit pays 100 percent of your eligible expenses up to $2,000, and then adds another 25 percent for the next $2,000 in costs. To qualify, your student must have been enrolled at least half-time in a degree or certificate program. If you have little or no tax liability, you can get as much as $1,000 back in a tax refund. The full credit is available for single filers with $80,000 or less in modified adjusted gross income (MAGI) or $150,000 for joint filers. A reduced benefit is provided to those with a MAGI of over $80,000 but less than $90,000 (over $160,000 but less than $180,000 for married filing jointly).
Another option for those that may not qualify for the American Opportunity Credit is the Lifetime Learning Credit, which offers a maximum credit of $2,000 per year. This can be used for graduate education or other educational courses or programs. The income limits are considerably lower, as the full credit is available to single filers making less than $52,000 in AGI, or $104,000 for joint filers. Keep in mind that you may only claim one of these credits per year, so no double dipping.
Some filers may be eligible to deduct tuition and fees for qualified education expenses, which can reduce the amount of your income subject to tax by up to $4,000. This deduction, reported on Form 8917, is taken as an adjustment to income so the deduction can be claimed even you do not itemize your deductions. This deduction may be beneficial if you do not qualify for the American opportunity or lifetime learning credits. However, if you do qualify, a tax credit might be more favorable, as you cannot claim the tuition and fees deduction as well as an education credit for the same expense.
There also is a special deduction allowed for interest paid on student loans that were used for higher education for those with MAGI of less than $80,000 ($160,000 if filing jointly). The deduction can reduce the amount of income subject to tax by up to $2,500. Similar to the qualified education expense deduction, it can be claimed even if you do not itemize deductions.
College Savings Plans
Contributions to 529 college savings plans and/or Coverdell college savings accounts grow tax-free from federal and state income tax. Funds withdrawn from these accounts are not taxable as long as they are used for qualified education expenses, including tuition, fees, books, supplies and equipment, and room and board. However, for those considering taking advantage of tax credit as well, keep in mind that there is no double dipping here either, as the credit would only apply to qualified education expenses not paid for with 529 or Coverdell money. You should check with your tax advisor to determine whether withdrawing less from your 529 and paying some of the education expenses in cash would make more sense.
Exclusion for Income
If your student receives a scholarship or fellowship, the taxability question may become a little trickier. If all of the money received was used for tuition, fees, books and required course-related expenses, it's considered tax-free, but if some funds were used to pay room, board, travel or other non-required expenses, these amount are taxable. In other words, any amounts received that exceed the prescribed definition of education expenses--which is different from the definition of qualified education expenses for tax credit, deductions or college savings account distributions--have to be reported as taxable income. Students who receive scholarships or fellowships are advised to keep fee statements, receipts and other records of their expenses to back up their calculations.
While college expenses can be overwhelming, knowing these potential tax benefits may help you make the financial burden of higher education less taxing.