Investment Strategies

What Types of Tax Relief are Available for Costs of my Children's Higher Education?

A wide variety of tax relief is available, but you'll need to choose which credit or deduction to claim or which savings plan to use based on your individual tax situation. You also can't use two different kinds of relief for the same item. For instance, you can't take the higher education credit and tuition fees deduction for the same student for the same year. You also can't take the American Opportunity Credit and the Lifetime Learning Credit for the same student for the same year. There may also be limits based on adjusted gross income.

What is the Education Tax Credit?

Two tax credits are available for education costs - the American Opportunity Credit (formerly the Hope Credit) and the Lifetime Learning Credit. These credits are available only to taxpayers with adjusted gross income below specified amounts, see Income Phase-Outs, below. Both credits were extended until December 31, 2017 by the American Taxpayer Relief Act of 2012 (ATRA).

How Do These Credits Work?

The amount of the credit you can claim is either, $0, $2,000, or $4,000 and depends on (1) how much you pay for qualified tuition and other expenses for students and (2) your adjusted gross income (AGI) for the year.

You must report on Form 8863 the eligible student's name and Social Security number on your return to claim the credit. You subtract the credits from your federal income tax. If the credit reduces your tax below zero, you cannot receive the excess as a refund. If you receive a refund of education costs for which you claimed a credit in a later year, you may have to repay ("recapture") the credit.

Caution: If you file married-filing separately, you cannot claim these credits.

Which costs are eligible? Qualifying tuition and related expenses refers to tuition and fees, and course materials required for enrollment or attendance at an eligible education institution. They now include books, supplies and equipment needed for a course of study whether or not the materials must be purchased from the educational institution as a condition of enrollment or attendance.

"Related" expenses do not include room and board, student activities, athletics (other than courses that are part of a degree program), insurance, equipment, transportation, or any personal, living, or family expenses. Student-activity fees are included in qualified education expenses only if the fees must be paid to the institution as a condition of enrollment or attendance. For expenses paid with borrowed funds, count the expenses when they are paid, not when borrowings are repaid.

Tip: If you pay qualified expenses for a school semester that begins in the first three months of the following year, you can use the prepaid amount in figuring your credit.

Example: You pay $1,500 of tuition in December 2015 for the winter 2016 semester, which begins in January 2016. You can use the $1,500 in figuring your 2015 credit. If you paid in January instead, you would take the credit on your 2016 return.

Tip: As future year-end tax planning, this rule gives you a choice of the year to take the credit for academic periods beginning in the first 3 months of the year; pay by December and take the credit this year; pay in January or later and take the credit next year.

Eligible students. You, your spouse, or an eligible dependent (someone for whom you can claim a dependency exemption, including children under age 24 who are full-time students) can be an eligible student for whom the credit can apply. If you claim the student as a dependent, qualifying expenses paid by the student are treated as paid by you, and for your credit purposes are added to expenses you paid. A person claimed as another person's dependent can't claim the credit. The student must be enrolled at an eligible education institution (any accredited public, non-profit or private post-secondary institution eligible to participate in student Department of Education aid programs) for at least one academic period (semester, trimester, etc.) during the year.

No "double-dipping." The tax law says that you can't claim both a credit and a deduction for the same higher education costs. It also says that if you pay education costs with a tax-free scholarship, Pell grant, or employer-provided educational assistance, you cannot claim a credit for those amounts.

Income limits. To claim the American Opportunity Credit for tax years 2013 through 2017 for example, your modified adjusted gross income (MAGI) must not exceed $90,000 ($180,000 for joint filers). To claim the Lifetime Learning Credit, MAGI must not exceed $60,000 ($120,000 for joint filers). "Modified AGI" generally means your adjusted gross income. The "modifications" only come into play if you have income earned abroad.

The American Opportunity Tax Credit

The American Opportunity Tax Credit (AOC) was extended for tax years 2013 to 2017. The maximum credit, available only for the first four years of post secondary education, is $2,500. You can claim the credit for each eligible student you have for which the credit requirements are met.

Special qualification rules. In addition to being an eligible student, he or she:

• Must be enrolled in a program leading to a degree, certificate, or other recognized credential;
• Must be taking at least half of a normal full-time load of courses, for at least one semester or trimester beginning in the year for which the credit is claimed; and
• May not have any drug-related felony convictions.

Amount of credit. The maximum amount of the AOC is $2,500. Generally, 40 percent of the AOC is now a refundable credit for most taxpayers, which means that you can receive up to $1,000 even if you owe no taxes.

The Lifetime Learning Credit

You may be able to claim a Lifetime Learning Credit of up to $2,000 (20 percent of the first $10,000 of qualified expense) for eligible students (subject to reduction based on your AGI). Only one Lifetime Learning Credit can be taken per tax return, regardless of the number of students in the family.

• The credit can help pay for undergraduate, graduate and professional degree courses, including courses to improve job skills.
• For courses taken to acquire or improve job skills, there are no requirements as to course loads, so that even one or two courses can qualify.
• The number of years for which this credit can be claimed is not limited.

Choosing the Credit. You can't claim both credits for the same person in the same year. But you can claim one credit for one or more family members and the other credit for expenses for one or more others in the same year - for example, an AOC for your child and a lifetime learning credit for yourself.

Electing Not to Take the Credit. There are situations in which the credit is not allowed, or not fully available, if some other education tax benefit is claimed - where the higher education expense deduction is claimed for the same student, see below, or where credit and tax exemption (under a Section 529 or 530 program) are claimed for the same expense. In that case the taxpayer - or, more likely, the taxpayer's tax adviser - will determine which tax rule offers the greater benefit and if it's not the credit, elect not to take the credit.

Do any tax planning considerations apply to the education tax credit?

For an academic period (quarter, semester, etc.) beginning in the first 3 months of a calendar year, you can pick which year to pay the expense and take the credit. That is, pay in December 2015 and take the credit in 2015 or pay in, say, February, 2016 and take the credit in 2016.

Your family may be able to save tax by foregoing the education credit and taking an available exemption for program distributions instead.

Do living expenses while in school qualify for tax relief?

Sometimes. Examples are for relief provided for Coverdell Education Savings Accounts (Section 530 programs), for Qualified Tuition Programs (Section 529), for withdrawals from traditional and Roth IRAs, and for student loans.

How does a Coverdell (Section 530) Education Savings Account work?

An education IRA differs from other IRAs in the following ways:

• No more than $2,000 a year can be contributed to any beneficiary of a single 530 account in any year and contributors are subject to income limits. Modified AGI cannot exceed $110,000 ($220,000 joint filers).
• Contributions aren't deductible and excess contributions are subject to penalty.
• Withdrawals are tax-free to the extent used for qualified education expenses.

• Contributions can't be made after the student reaches age 18, and the account generally must distribute all funds by the student's age 30.

Unlike other plans, 530 accounts may be used for primary and secondary education, including paying for room and board of children in private schools, and for computers and related materials whether or not away from home.

How can my family make best use of a Coverdell (Section 530) program?

There can be a number of Section 530 accounts for any student. Various family members, such as grandparents, aunts and uncles, and siblings--and persons outside the family--can contribute to separate accounts for a student.

The original student beneficiary for the Section 530 account can be changed to another family member, such as a sibling--for example where the original beneficiary wins a scholarship or drops out.

Funds can be rolled over tax-free from one family member's Section 530 account to another's--for example, to avoid distribution when the first family member reaches age 30.

The education tax credit (where applicable) can be waived in favor of tax-free treatment for Section 530 account distributions.

What are Qualified Tuition Programs (QTPs)?

Also called Section 529 plans, these college savings plans have been established by almost every state, and some private colleges. You invest now to cover future college expenses, by contributing to a savings account or buying tuition credits redeemable in the future. Investments grow tax-free, and distributions to pay college expenses can also be tax-free. You may choose any state's plan, regardless of where you live.

Tip: Even if a QTP is used to finance a student's education, the student or the student's parents still may be eligible to claim the American Opportunity Credit or the Lifetime Learning Credit.

How do Coverdell Education Savings Accounts (Section 530) and Qualified Tuition Plans (Section 529) differ?

Section 530 plans limit investment to $2,000 a year per student; 529 plans allow a much larger investment. Section 530 plans allow wide choice of investment; 529 investment choices are limited and conservative. Section 530 is a single nationwide program, whereas each 529 program is different. Though both are available for higher education, Section 530 can also be used for primary and secondary education. You are free to use both for higher education for the same student.

Can my traditional IRA be used for education?

Yes. The 10 percent penalty on withdrawal under age 59-1/2 won't apply, but ordinary income tax will apply to at least some of the withdrawal.

Can a Roth IRA be used for education?

Yes, generally under the same terms as traditional IRAs. Also, ordinary income tax is somewhat less likely, or may be smaller in amount, than with traditional IRAs.

What tax deductions are available for college education?

You can choose to take a tax deduction rather than the college tuition tax credits noted above. A tax deduction is usually taken if income is too high for the tax credits. The tax deduction reduces your amount of income. The tax credits reduce the amount of tax you pay.

A $4,000 above the line deduction for qualified tuition expenses was extended through tax year 2014 by ATRA, but starting in 2015, unless extended by Congress, the deduction will no longer be available.

Note: For tax year 2014 a deduction up to $4,000 is allowed on if taxpayer's (modified) adjusted gross income is $65,000 or less ($130,000 or less on a joint return). If taxpayer's modified adjusted gross income is more than $65,000 but not more than $80,000 (more than $130,000 but not more than $160,000 on a joint return), a deduction is allowed up to $2,000.

A business expense deduction is also allowed in tax years 2014 and 2015, without dollar limit, for education that serves the taxpayer's business, including employment. The deduction is also allowed for student loan interest. A taxpayer may not take more than one deduction for the same item.

What tax benefits are available for continuing/adult education for a sideline hobby?

If it's not part of a degree or certificate program, and not work-related, the limited deduction (up to $4,000 in 2014 for qualified tuition and fees) may be your only option. Again, unless reauthorized by Congress, the deduction is not available starting in 2015. The deduction amount depends on your income. Some sideline interests might qualify for exclusion if paid for under an employer-provided education assistance program.

Can I deduct student loan interest?

Since personal interest is generally non-deductible, deductions must meet several tests:

1. You must be the person liable on the debt and the loan must be for education only (not an open line of credit).
2. Your income can't exceed $160,000 on a joint return or $80,000 for single filers in 2015 (same as 2014). Married couples filing separately cannot take the deduction.

3. You can't deduct if you're claimed as a dependent.

4. Deduction ceiling is $2,500 (starting in tax year 2013).

If I take a home equity loan to pay education expenses, can I deduct the interest?

Yes, as home equity loan interest, not as student loan interest. In this case there's no income ceiling on your deduction, and certain other student loan limits don't apply.

What tax treatment applies if my student loan debt is canceled?

Usually you're taxed on the unpaid loan balance. But tax can be waived if the debt is canceled because you participate in some approved government or other program.

What's the tax relief for education savings bonds?

Interest on redemption of Series EE bonds is tax-exempt if you redeem them in a year you have qualified education expenses. Exemption depends on the amount of your income in the year you redeem the bond.

Must I pay tax on my employer's payment or reimbursement of my education expenses?

Maybe not. Starting in 2013, up to $5,250 can be tax-free. Exemption can apply to graduate level courses.

Can I take tax deductions for education I pay for that helps me in my work?

Yes if it's to maintain or improve skills in your present job. No if it's to meet minimum requirements of that job, or to qualify to enter a new business. Employee's deductions are subject to the 2 percent floor on miscellaneous itemized deductions.