Deductions, Credits, Tax-Free
- The high cost of college can often be mitigated through tax provisions
that benefit students and their families. Educational tax benefits
cover three areas: tax deductions, tax credits, and tax-free savings
vehicles. Few individuals can use all of these simultaneously, but
many can benefit from an appropriate combination. These tax benefits
are not just for the parents of college students; grandparents may
also be able to take advantage of some of them.
and fees. Taxpayers filing jointly with a modified
adjusted gross income (MAGI) of less than $130,000 can deduct
up to $4,000 of tuition and fees. If their MAGI is between $130,000
and $160,000, they can deduct up to $2,000 of tuition and fees.
Taxpayers filing single can deduct up to $4,000 of tuition and
fees if their MAGI is less than $65,000, and up to $2,000 if their
MAGI is between $65,000 and $80,000.
is an “above-the-line” deduction taken on the front
of Form 1040. It cannot be taken if the Hope Scholarship Credit
or Lifetime Learning Credit is taken, or if the taxpayer’s
filing status is married filing separately. Under current law,
this deduction will not be available after December 31, 2007.
loan interest deduction. This deduction is phased
out if the taxpayer’s MAGI is between $110,000 and $140,000
and the taxpayer is filing a joint return ($55,000 and $70,000
for taxpayers filing single). The maximum deduction available
to taxpayers is $2,500 per year and the deduction for the student
loan interest is taken on the front of Form 1040 or 1040A. The
deduction cannot be taken if the taxpayer’s status is married
June 2001, the deduction was limited to the first 60 payments
of a student loan. The limit on the deduction was removed by the
Economic Growth and Tax Relief Reconciliation Act of 2001, but
the law’s sunset clause means that it will expire on December
31, 2010, if not extended. In this case, the law will revert to
its prior state and the deduction will again be limited to the
first 60 payments.
Scholarship Credit. In the first two years of post-secondary
education, a taxpayer may elect to claim the Hope Scholarship
Credit. This credit is based on the first $2,200 in required tuition
and fees paid directly to the college. The maximum credit allowed
is $1,650 per year per student, but the amount cannot exceed the
taxpayer’s income tax liability.
is available to the taxpayer, spouse, and dependents, and it can
be used only for the first two years of higher education. The
credit is subject to phaseout limits. For taxpayers who are married
filing jointly, the credit phases out at a MAGI between $94,000
and $114,000. For single and head-of-household taxpayers, the
credit phases out at a MAGI between $47,000 and $57,000. The credit
is not available to taxpayers who are married and filing separately.
the qualifying education expenses, several items must be considered.
First, taxpayers cannot use education expenses that they have
already received a tax benefit for (e.g., expenses used to figure
the tax-free portion of a distribution from a Coverdell Education
Savings Account or from an IRC section 529 plan). Second, taxpayers
may have to adjust the qualified education expenses for tax-free
educational assistance they have received (e.g., the tax-free
portion of a scholarship, employer-provided assistance, or veterans’
assistance). Finally, taxpayers who decide to use the tuition
and fees deduction cannot use the Hope Credit.
Learning Credit. The Lifetime Learning Credit is
available to taxpayers who have qualified education expenses for
tuition and fees of $10,000 or less. The maximum credit is $2,000
per year, per tax return, not to exceed the taxpayer’s income
is available to the taxpayer, spouse, and dependents. The Lifetime
Learning Credit has the same income phaseout limits as the Hope
Scholarship Credit but is available for any year of post-secondary
education. The credit is not available to taxpayers whose filing
status is married filing separately.
rules apply for the Lifetime Learning Credit as for the Hope Scholarship
Credit when determining qualified education expenses. Taxpayers
who elect to use the tuition and fees deduction cannot use the
Lifetime Learning Credit.
Education Savings Accounts. The Coverdell Educational
Savings Account (ESA) is set up for a child under the age of 18.
The child is the beneficiary of the account and must use the funds
before reaching the age of 30. The account owner can change the
beneficiary to another member of the beneficiary’s family
under the age of 30.
Coverdell ESAs can be set up for one child, but the total of all
contributions to all accounts cannot exceed $2,000 per year. The
contributions are nondeductible, must be in cash, and are subject
to income phaseout limits. For taxpayers filing jointly, phaseout
limits for contributions are a MAGI of $190,000 to $220,000. For
taxpayers whose filing status is single, head of household, or
married filing separately, the phaseout limits are a MAGI of $95,000
from these accounts are tax-free if used for K–12 or post-secondary
education expenses. The Economic Growth and Tax Relief Reconciliation
Act of 2001 increased the annual contribution from $500 to $2,000.
But the law’s sunset provisions mean that if it is not extended
or permanently amended by December 31, 2010, the contribution
limits will revert to the old amount of $500.
plans. Qualified tuition programs, or IRC section
529 plans, have become the most popular way to save for college.
Earnings on the accounts are tax-free if used for qualified higher
education expenses. Qualified tuition programs or 529 plans are
established and administered by the individual states and vary
in their investment approach and fees.
owner can set up a 529 plan and name any individual as the beneficiary.
The account owner has control over the account, including the
ability to change beneficiaries and withdraw funds from the account.
At the same time, contributions made to the account are removed
from the account owner’s estate. Contributions must be in
cash and are nondeductible. The account owner may contribute up
to $12,000 per year with no gift tax due. Larger amounts can be
contributed if an election is made to treat them as given over
a five-year period. There are no income limitations on contributions.
The Pension Protection Act of 2006 made the provisions of 529
from a 529 plan impact the ability to take the Hope Scholarship
or Lifetime Learning Credit, as well as the tuition and fees deduction.
Unqualified withdrawals are permitted by the account owner, but
earnings are subject to ordinary income tax plus a 10% penalty.
For a further
discussion of Coverdell ESAs and 529 Plans and how they can work
alongside IRAs, see “Rethinking College Savings Opportunities”
on page 48 of this issue.
savings bonds. U.S. savings bonds issued after December
31, 1989, whose proceeds are used for qualified higher education
expenses may be tax-free. The requirements for the interest on
these bonds to be tax-free are as follows:
- The bonds
can be EE bonds or I bonds, issued after December 31, 1989.
- The purchaser
must be 24 years or older.
- The proceeds
from the bonds must be used for the higher education expenses
of the bondholder, spouse, or dependents.
- The bonds
must be issued in the purchaser’s name as sole owner,
or in the name of both the purchaser and spouse as co-owners.
- The purchaser
is subject to income phaseout limits as follows: married filing
jointly $98,400 to $128,000; all others $65,000 to $80,600.
Another vehicle for saving for college that is often
overlooked is an IRA for the child. If the child has earned income,
she could open a Roth or traditional IRA and, depending upon income,
could contribute up to $4,000 per year.
be withdrawn from these retirement accounts penalty-free if they
are used for qualified higher education expenses. Any taxable
income on these withdrawals would be taxed as ordinary income
(depending on the individual situation of the student and the
amount of taxable income at “kiddie tax” rates).
Next to their
home, college is the second-largest expenditure most families
will make in their lifetime. Knowing what educational tax benefits
are available may help ease that burden.
E. Carpenter, CPA, CCPS, of Syracuse, N.Y., is the owner
of College Planning Services and the CollegeLoan Evaluator, providing
college financial planning to individuals and personal financial
planning advisors nationwide (www.collegeloanevaluator.com).