Back-to-school season is a good time to review the federal tax breaks that are currently available if you or a loved one will be attending college or graduate school this fall. After all, a higher education degree is one of the biggest investments you’ll ever make.
Applying for Financial Aid
More than 70% of full-time students received grant aid to help pay for higher education costs during the 2016-2017 school year, according to the College Board. Financial aid can substantially reduce college costs, if you apply and qualify. The first step in getting financial assistance is to fill out the Free Application for Federal Student Aid (FAFSA).
The federal college aid formula requires 35% of the assets in your child’s name to be used for college costs. But it only expects about 5.6% of the money in the parent’s name to be spent. So, you may be better off keeping accounts in a parent’s name, especially during the last two years of high school, which is generally when you’ll be asked to start providing tax returns.
One of the biggest mistakes on the FAFSA involves retirement income and home equity. If you’ve included either of these as an asset on the FAFSA or any supplemental financial aid forms, you’ve made a big mistake. For the purposes of financial aid, your home equity and retirement savings generally aren’t considered when aid is calculated.
Important note: Depending on the school, a different methodology or combination of formulas may be used to calculate financial aid awards. Parents must fill out the FAFSA and then fill out another form that asks for additional information.
Many private colleges and universities use the Institutional Methodology, which penalizes families with a great deal of home equity but permits more generous treatment of items such as medical expenses, elementary and secondary school tuition and child support. It also assumes the student will spend some time each year working to earn money.
A third methodology, called the Consensus Approach, is now used by approximately 30 colleges and universities, including Yale, Cornell, Stanford, MIT, Columbia, Wellesley and Duke. Among its principles: Students’ assets and parents’ assets are treated the same to discourage families from moving assets between generations.
To make matters more confusing, even if a college uses one of the formulas described above, it can still be flexible when awarding its own money. In other words, when awarding federal grants, loans and most state aid, the federal formula is used, but when awarding a school’s own money, each school a student applies to may make calculations differently.
Need help applying for scholarships, loans and other types of financial aid? Your tax advisors can help you fill out forms and compare your options.
How much does an advanced degree typically cost? For the 2016-2017 school year, the College Board estimates that the average annual cost (including tuition, fees, and room and board) was $20,090 for in-state students at a public four-year school — and $45,370 for students at a private not-for-profit four-year institution. These estimates don’t include books, supplies, transportation and other expenses a student may incur.
In addition to applying for financial aid (see right), you may be eligible for the following tax breaks to help foot the bill. The eligibility requirements vary for each one, and many are gradually phased out if income is above a certain amount.
American Opportunity Credit
This tax break is well known, probably because it provides the biggest benefit to most taxpayers. Formerly called the Hope credit (which offered more limited benefits), the American Opportunity credit provides a maximum benefit of $2,500. That is, 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 it’s available only to students who attend at least half time.
Basically, tuition, course materials and fees qualify for this credit. Courses involving sports, games or hobbies generally don’t count. The credit is per eligible student and is subject to phaseouts based on modified adjusted gross income (MAGI).
Lifetime Learning Credit
If you don’t qualify for the American Opportunity credit because the student in question is beyond the first four years of postsecondary education or attends less than half-time, the Lifetime Learning 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 to qualify for this credit than for the American Opportunity credit.
The Lifetime Learning credit can be applied to education beyond the first four years, and qualifying students may attend school less than one-half time. The student doesn’t even need to be part of a degree program. So, the Lifetime Learning credit works well for graduate studies and part-time students who take a qualifying course at a local college to improve job skills. This credit applies to tuition, fees and materials. It’s also subject to phaseouts based on MAGI, however.
Above-the-Line Tuition and Fees Deduction
Typically, an education credit will provide 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. But the eligibility requirements vary.
In certain, limited situations, an above-the-line deduction for qualified tuition and fees is more beneficial than the American Opportunity or Lifetime Learning credit. Above-the-line means that this deduction is taken to arrive at adjusted gross income (AGI), not taken from AGI. So, an above-the-line tuition and fees deduction could help reduce your income enough to keep you from having other tax breaks phased out due to income-based limits.
Currently, this deduction has been revived only through 2016, but it could possibly be extended by Congress this fall or retroactively next year. In 2016, the maximum deduction was either $2,000 or $4,000, depending on your MAGI — or, if your MAGI exceeded the limit for the $2,000 deduction ($80,000 for single filers and $160,000 for joint filers in 2016), you were ineligible for this tax break. Tuition and fees required for enrollment in or attendance at an eligible postsecondary educational institution generally qualify for this deduction.
Important note: The deadline for individual extended returns is October 16, 2017. If you qualify and you haven’t filed your 2016 income tax return yet, you can take advantage of these breaks on that tax return.
Deduction for Student Loan Interest
Got student loans? You also 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. In addition, the loan must have been incurred to cover qualified expenses, including tuition, books and fees. It also may cover transportation and room and board, with certain restrictions.
While not as beneficial as a credit, this deduction may be available as long as you’re still paying interest on a loan. Like the other higher education tax breaks, however, it’s subject to a phaseout based on MAGI.
Employer-Provided Educational Assistance
Each year, you can exclude from your income up to $5,250 of educational assistance provided by your employer. Qualifying expenditures include tuition, fees, books, supplies and equipment. Courses can include any academic studies, except for courses involving sports, games or hobbies. 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.
In order for the expenses to qualify, the employer must have a written plan for providing educational assistance. Also be aware that IRS rules are designed to prevent discrimination and favorable treatment for owners and related parties.
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 footing the bill. If an employer pays for job-related classes to maintain or improve an employee’s skills, they’re deductible by the employer. But they’re not income to the employee. Instead, they’re considered a “working condition” fringe benefit.
However, no deduction is allowed for courses that qualify an individual for a new trade or business. Education to maintain or improve skills needed in your present work isn’t qualifying education if it also qualifies you for a new trade or business. The definition of trade or business has been narrowly interpreted by the IRS and courts.
If you pay for courses to improve or maintain your 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 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 for these accounts is $2,000 per beneficiary. Contributions aren’t deductible, but amounts in the account grow tax-deferred. Plus, there’s no tax on distributions used for qualified education expenses. Again, there’s a phaseout based on MAGI.
Section 529 plans. The concept is similar to Coverdell ESAs — contributions to a 529 savings plan aren’t deductible but grow tax-deferred, and distributions for qualified education expenses are tax-free. But 529 plans are more popular because they have no federally mandated contribution limits. These plans are state-sponsored, and the rules vary by state. For example, some require residency, but many don’t. Some provide a deduction or credit for contributions made by residents. Most follow the federal rules on withdrawals. Ask your tax advisor for the rules in your state. Sec. 529 prepaid tuition plans are also worth exploring with your tax advisor.
Savings bond interest. You may be able to cash in qualified U.S. savings bonds and exclude some (or all) of the interest on the bonds if the funds are used for educational purposes. 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. This benefit is also phased out based on MAGI.
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.
Maximize Your Benefits
Understanding the ins and outs of higher education tax breaks is complicated. The phaseout rules only add to the complexity, because they apply at different levels, depending on the tax break. Multiple factors should be reviewed with a tax advisor before determining which higher education tax breaks to claim.