College Planning—Part II – Education Tax Savings

Education Tax Savings

Our most recent posting discussed several tax-advantaged accounts that were introduced by Congress to assist in the savings process for funding education. There may also be opportunities for tax savings when qualified education expenses are incurred, even if the aforementioned savings accounts are not utilized. Today’s posting will review these tax breaks which are claimed when filing your tax return. It must be noted that in general, the IRS code does not permit “double-dipping”, that is, using the same education expense to claim two different tax breaks. Occasionally, an education expense may qualify for more than one tax break and a decision must be made as to which is most advantageous. Once again, a qualified financial planner and/or CPA can provide guidance in this area.

The American Opportunity Tax Credit (AOTC) allows a tax return to claim a credit of up to $2,500 for adjusted qualified education expenses paid for each student who qualifies. Tax credits are very desirable because they offset income tax due “dollar-for-dollar”. This is in contrast to deductions which merely reduce the amount of income subject to taxation. In addition, 40% of the AOTC is refundable, meaning that even if the taxpayer has no income tax liability to offset with the AOTC, 40% of the eligible AOTC will be paid to the taxpayer. In essence, those with no tax liability are receiving a subsidy from Uncle Sam.

The AOTC can be claimed for the same student on up to four tax returns. The educational institution will usually provide a Form 1098 T that lists the expenses qualifying for the AOTC. The student must be enrolled at least half-time for at least one of the academic periods coinciding with the tax year. There are income limitations and phase outs that apply with the AOTC not being claimable if modified adjusted gross income exceeds $90,000 for single taxpayers and $180,000 for married filing jointly. Obviously, the taxpayer(s) claiming the credit must have paid the qualifying expenses for the eligible student. Another qualification peculiar to this credit is that the student must not have been convicted of a felony possession or distribution of a controlled substance.   

An alternative tax break for education is the Lifetime Learning Credit (LLC). Eligible taxpayers can claim a credit of up to $2,000 for qualified education expenses and unlike the AOTC, this credit can be claimed with no limit of four income tax returns. The income limitations for the LLC are lower, with the phase out range for single taxpayers at $58,000-68,000 and $116,000-$136,000 for married filing jointly. Taxpayers who are eligible under both credits can only claim one and will always prefer the AOTC since it represents a larger amount. In addition, the LLC is not refundable so lower income filers should always select the AOTC. Students enrolled less than half-time still qualify for the LLC and they do not have to be pursuing a degree or credential as is required for the AOTC. The Lifetime Learning Credit is calculated by multiplying qualified education expenses (up to $10,000) by 20% with the result being the claimable credit.

There are also tax breaks available to individuals who are paying interest on student loans. Unlike the previous two credits, this allowance takes the form of a deductible adjustment to income. Fortunately, this means that qualifying student loan interest can still be deducted, even for taxpayers who do not itemize deductions. As with the other programs, there are income phase out ranges of $70,000-85,000 for single taxpayers and $140,000-170,000 for married filing jointly. Up to $2,500 of student loan interest, which is reported to you by the lender on Form 1098 E can be deducted under this plan.

Yet another possible tax break is the Tuition and Fees deduction which like the Student Loan Interest Deduction, is taken as an adjustment to income (itemization not required). Taxpayers who are not eligible under the American Opportunity Tax Credit or the Lifetime Learning Credit, can sometimes benefit under this program.  This subtraction from income can be as much as $4,000. As with the other programs, eligibility is subject to income limitations but unlike the others, there is not a linear phaseout calculation. Rather, a table is used to identify the maximum Tuition and Fees Deduction permitted for various income levels.

Lastly, the tax code permits the interest paid on U.S. Savings bonds to be tax exempt if the bonds are cashed in to pay qualified education expenses. The income limit eligibility qualifiers are $96,100 for single taxpayers and $151,600 for married filing jointly.

As we see, there are a myriad of potential education tax savings possibilities written into the tax code. Unfortunately, there is no consistency and limited commonality within the terms, conditions and qualifiers. IRS Special Publication 970, Tax Benefits for Education has 93 pages with all the gory details. As mentioned earlier, CPA’s and Financial Planning practitioners are also good sources of guidance in this complex, but potentially fruitful area of income taxes.

If you would like to have more information regarding income tax breaks for education, please contact us through our Level 5 Financial website or via phone at 719-323-1240.