Tax breaks to help you pay educational expenses are some of the most commonly overlooked federal tax breaks. They shouldn't be. Getting the most from the education tax incentives requires careful planning, particularly because of the interrelationship between many of the rules. Although the IRS provides guidance, some of the IRS' explanations have actually complicated matters in some circumstances.
American Opportunity Tax Credit. The American Opportunity Tax Credit (AOTC) provides a maximum credit amount of $2,500 per year for four years of post-secondary education The AOTC is computed as 100 percent of up to $2,000 qualified higher education expenses plus 25 percent of the next $2,000 of eligible expenses. The AOTC begins to "phase out" for married couples filing jointly with adjusted gross income (AGI) between $160,000 and $180,000. The AOTC begins to phase out for single individuals with AGI between $80,000 and $90,000. Forty percent of the AOTC is refundable for those lower-income taxpayers with a tax liability smaller than the credit amount.
To qualify for the AOTC, the tuition must be paid on behalf of the taxpayer, the taxpayer's spouse or the taxpayer's dependent. An eligible student for purposes of the credit is an individual who is enrolled in a degree, certificate or other program leading to a recognized educational credential at an eligible educational institution. The student must be enrolled at least half-time and must not have been convicted of a federal or state felony for possession or distribution of a controlled substance. Study at many types of post-secondary institutions qualifies for the credit, such as programs for a bachelor's degree, associate's degree or another recognized post-secondary credential.
Lifetime Learning credit. The Lifetime Learning credit can be claimed for an unlimited number of tax years. The Lifetime Learning credit equals 20 percent of up to $10,000 in eligible education costs during the tax year. The Lifetime Learning credit is subject to phase-out rules based on adjusted gross income.
The Lifetime Learning credit may be applied to a non-degree program. For example, an individual who is enrolled in a non-degree program to improve job skills may be eligible for the credit. Moreover, the Lifetime Learning credit may be claimed even if the student is not enrolled at least half-time. An individual who is taking just one class at a community college, for example, may be eligible for the credit.
Higher education deduction. Eligible taxpayers can claim an above-the-line deduction for qualified tuition and related expenses. Eligible expenses include those spent on behalf of the taxpayer, his or her spouse or dependents at a post-secondary institution. The college or school must be eligible to participate in the federal student loan program. The amount of the deduction depends on your AGI.
As an above-the-line deduction, the deduction for qualified tuition and related expenses could be taken even if the taxpayer does not itemize deductions, and it is not subject to the two-percent floor.
Unless this tax benefit is extended again, it is not available after 2016.
Section 529 plans. The Tax Code allows states and some educational institutions to offer "529" plans (known for the section of the Tax Code that governs them). They are also sometimes called qualified tuition programs (QTPs). They allow you to either prepay or contribute to an account for paying a student's post-secondary education expenses. An eligible educational institution generally includes colleges, universities, vocational schools or other post-secondary educational institutions. In addition, distributions from state programs, even to the extent of earnings, are now entirely tax-free to the extent used for qualified higher education expenses.
Qualified higher education expenses include tuition, fees, books, supplies, and equipment required for the beneficiary's enrollment at an eligible educational institution, which includes most institutions that participate in federal student aid programs. The cost of computers or peripheral equipment, computer software, and internet access and related services also qualify as higher education expenses. If the student is attending an institution at least half-time, room and board is treated as a qualified expense.
Coverdell education savings accounts. Coverdell education savings accounts (also sometimes called education IRAs) are similar to IRAs. You can save today for future educational expenses and not just higher educational expenses. Funds in a Coverdell ESA can also be used for K-12 and related expenses. The American Taxpayer Relief Act made permanent some temporary enhancements to Coverdell ESAs. The maximum annual Coverdell ESA contribution is $2,000 per beneficiary. Contributions are not deductible by the donor and are not included in the beneficiary's income as long as they are used to pay for qualified education expenses.
Contributions generally must stop when the beneficiary turns age 18 except for individuals with special needs. Parents can maximize benefits, however, by transferring older siblings' accounts for use by a younger brother, sister or first cousin, thereby maximizing the tax-free growth period. Excess contributions are subject to an excise tax.
The phase-out amounts of adjusted gross income allowed for a contributor to a Coverdell ESA are generous. The annual contribution starts to phase out for married couples filing jointly with modified AGI at or above $190,000 and less than $220,000 and at or above $95,000 and less than $110,000 for single individuals.
Many individuals find Coverdell education savings accounts attractive because distributions can be used for room and board (if the designated beneficiary is enrolled at least half-time) as well as for qualified tuition and the costs of books and supplies required for enrollment. Beneficiaries who have special needs may also find these expenses qualify.
Education savings bond interest exclusion. When you use U.S. savings bonds to pay qualified higher education expenses, the interest may be excluded from income if your income is below a certain range. Qualified education expenses include the cost of tuition and fees at an eligible educational institution for the taxpayer, the taxpayer's spouse or the taxpayer's dependent at an eligible educational institution. Colleges, universities and vocational schools that participate in federal student aid programs generally qualify for the incentive.
For bond interest to be excluded, the taxpayer must have attained the age of 24 before the issue date of the bonds. Qualified bonds must also be issued in the name of the taxpayer as sole owner or in the name of the taxpayer and the taxpayer's spouse as co-owners. Married taxpayers must file a joint return to exclude bond interest.
Employer-provided educational assistance exclusion. When an employer pays an employee's education expenses, the tax consequences depend on the reason for the education. Your employer may have a plan under which it pays for qualified education expenses for college or graduate studies. If it has such a plan, up to $5,250 of education benefits can excluded from the recipient's gross income each year. Employer-provided educational assistance can include tuition, fees, books, supplies and equipment.
Job-related educational expenses. If you are taking a course because it is directly related to improving your job performance and your employer does not cover it, you may be able to deduct it as a miscellaneous itemized deduction if you itemized deductions. Under this deduction, tuition, course materials, and even the cost of transportation to and from class may be deductible. There are some restrictions, however: miscellaneous deductions are deductible only in excess of two percent of your adjusted gross income; and any degree program that qualifies you for a "new trade or business" cannot be deducted under this provision no matter how helpful it also may be to your present job.
Deduction for interest on education loans. Student loan interest of up to $2,500 a year is deductible whether or not you itemize your deductions. The deduction is completely phased when a taxpayer’s modified AGI exceeds certain thresholds. Only those legally obligated to make the loan payments may deduct them. Individuals who are claimed as dependents on another person's return cannot take this deduction. Qualified educational institutions for the student loan interest deduction are generally ones that participate in federal student aid programs.
IRAs. The Tax Code also allows individuals under age 59 1/2 to take distributions from an IRA for qualified higher education expenses without having to pay the 10 percent early withdrawal penalty. The qualified education expenses generally must be for the IRA holder, his or her spouse, or a child (including a foster child). Qualified education expenses include tuition, books and supplies. Room and board is also a qualified expense if the individual is at least a half-time student. An eligible education institution is generally one that participates in federal student aid programs.
Coordination. As you have read, there are many federal education tax incentives. All of the incentives must be coordinated; that is, you may not be able to take everyone. You generally cannot use education expenses to claim a double benefit. Many taxpayers make genuine and honest mistakes when trying to coordinate the education incentives without help from a tax professional. These mistakes are very costly. If you are considering claiming any of the education incentives, please contact our office.
IRS Circular 230 Disclosure
Pursuant to U.S. Treasury Department Regulations, information contained in this article is not intended by TOPC Potentia P.C. to constitute a covered opinion pursuant to regulation section 10.35 or to be used for the purpose of (i) avoiding tax-related penalties under Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any tax-related matters addressed herein.