Attending college or graduate school is one of the biggest investments you'll ever make — and spring is the time schools normally announce who's in and who's out. If you or your child (or grandchild) plans to attend an institution of higher learning in the fall, May 1 is often the deadline for selecting a school.
Finances are a key deciding factor for most students. For the 2015-2016 school year, the College Board estimates that the average annual cost (including tuition, fees, and room and board) was $19,548 for in-state students at a public four-year school — and $43,921 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, you may be eligible for a variety of tax breaks to help foot the bill. Some have been around for years. Others are obscure and provide limited benefits. The eligibility requirements vary, and many are gradually phased out if income is above a certain amount. Here's a rundown of the tax breaks that may be available for high education investments.
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.
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 for these education breaks vary.
In certain, limited situations, however, the above-the-line tuition and fees deduction can be more beneficial. This could be the case if it reduces your income enough to keep you from having other tax breaks phased out due to income-based limits.
This deduction has been revived through 2016 and is retroactive to 2015. The maximum deduction is either $2,000 or $4,000, depending on your MAGI — or, if your MAGI exceeds the limit for the $2,000 deduction, you won't be eligible for the deduction at all. Tuition and fees required for enrollment in or attendance at an eligible postsecondary educational institution generally qualify for this deduction.
Deduction for Student Loan Interest
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 the 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 beware 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 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 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 adviser for the rules in your state. 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 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. In fact, there's a 90-page IRS publication dedicated to this topic. Some benefits overlap, but you also may qualify for more than one benefit, if you're lucky. 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 adviser before determining which higher education tax breaks to claim.
