Tax Deductions / Credits for College Costs

Phillip GoldsteinYou don’t need to be reminded about the high cost of higher education. But you may not know that in addition to applying for financial aid, there are a variety of tax breaks to help you. Eligibility requirements vary and many are gradually phased out if income is above a certain amount (MAGI or modified adjusted gross income.) Understanding the ins and outs of higher education tax breaks is complicated–there’s an entire IRS publication dedicated to this topic. Some benefits overlap, but you also may qualify for more than one benefit.

Here’s a brief rundown of some potential tax breaks.

American Opportunity Credit

This tax break, the biggest benefit to most taxpayers, provides a maximum benefit of $2,500. You may qualify for a credit equal to 100% of the first $2,000 of expenses for the year and 25% of the next $2,000 of expenses. It applies only to the first four years of postsecondary education and is available only to students who attend at least half time.

Lifetime Learning Credit

Beyond the first four years of postsecondary education or for students attends less than half-time, this credit is generally the next best option. It equals 20% of qualified education expenses for up to $2,000 per tax return. There are fewer restrictions than for the American Opportunity credit. Qualifying students don’t need to be part of a degree program. This credit applies to tuition, fees and materials.

Tuition and Fees Deduction

An education credit typically provides greater tax savings than a deduction, because it reduces taxes dollar for dollar. A deduction reduces only the amount of income that’s subject to tax. Eligibility requirements vary. In some situations, the above-the-line tuition and fees deduction can be more beneficial—if, say, it reduces your income enough to keep you from having other tax breaks phased out due to income-based limits. The maximum deduction is either $2,000 or $4,000, depending on your MAGI

Deduction for Student Loan Interest

You may be eligible to deduct up to $2,500 per year of interest paid on a qualified student loan. The loan can’t be from a related party and must have been disbursed within 90 days before the start (or within 90 days after the end) of an academic period. The loan also must have been incurred to cover qualified expenses, including tuition, books and fees, transportation and room and board, with certain restrictions. This deduction may be available as long as you’re still paying interest on the loan.

Employer-Provided Educational Assistance

You can exclude from your income up to $5,250 of educational assistance annually provided by your employer. The courses don’t necessarily have to be job-related or part of a degree program. Any amount received over the $5,250 limit is taxable income. The employer must have a written plan for providing educational assistance.

Business-Related Education Expenses

There’s no dollar limit to the deduction for business-related education expenses, but you must follow certain rules depending on who’s paying. If an employer pays for job-related classes to maintain or improve an employee’s skills, they’re deductible by the employer. They’re not income to the employee. They’re considered a “working condition” fringe benefit. If the courses are to improve or maintain skills (not to qualify you for a new trade or business) and your employer doesn’t reimburse these costs, you may be able to deduct them on Schedule A of your tax return as a miscellaneous itemized deduction. But the deduction is subject to the 2% of adjusted gross income (AGI) threshold — only eligible miscellaneous expenses in excess of 2% of your AGI are deductible.

Other Education-Related Breaks

There are a number of education-related tax breaks that can help fund higher education expenses, such as:

Coverdell Education Savings Accounts (ESAs). The annual contribution limit here is $2,000 per beneficiary. Contributions aren’t deductible, but amounts in the account grow tax-deferred. There is no tax on distributions used for qualified education expenses.

Section 529 plans.  These contributions aren’t deductible but grow tax-deferred, and distributions for qualified education expenses are tax-free. 529 plans have no federally mandated contribution limits. They are plans are state-sponsored, and the rules vary by state. Most follow the federal rules on withdrawals. Sec. 529 prepaid tuition plans are also worth exploring with your tax adviser.

Savings bond interest. You may be able to cash in qualified U.S. savings bonds and exclude some (or all) of the interest. To qualify, you must pay qualified education expenses for yourself, your spouse or a dependent for whom you claim an exemption on your tax return.

IRA penalty exception. Generally, you can’t take a distribution from a traditional or Roth IRA before age 59 1/2 without incurring a 10% penalty. One exception applies to distributions used for qualified education expenses. Although you won’t incur a penalty, you’ll still have to pay income tax on distributions from traditional IRAs. However, earnings on qualified distributions from Roth IRAs are income-tax-free.

The phaseout rules are complicated because they apply at different levels, depending on the tax break. Multiple factors should be reviewed with a tax adviser.

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