Many families understand the value of higher education and desire to help their college-bound children accomplish this goal. There are numerous ways in which saving and paying for college education also can save income tax.
The most common benefits include tax credits, deductions and savings plans. These incentives have different limitations on the tax benefit, qualifications for education costs and often are limited for higher-income taxpayers.
Two education credits are available: the American Opportunity Tax Credit (AOTC) and Lifetime Learning Credit (LLC). Credits constitute a direct reduction of tax. Sometimes if the credit reduces tax below zero, there’s potential for a refund. Both of these credits are phased out for high-income taxpayers. Taxpayers who qualify for a credit choose one or the other, but not both.
There are specific requirements for each credit, but both require they can only be claimed for qualified education expenses paid by cash, check, credit or debit card or proceeds from a loan for you, your spouse or a dependent in a given year. The individual must be enrolled in an eligible institution. Qualified education costs consist of tuition, fees, books, supplies and equipment required for enrollment or attendance. Room and board, transportation, and personal living expenses don’t qualify. Any qualified costs paid with such tax-free funds as fellowships, grants or scholarships aren’t eligible for credits. An eligible institution is a school that offers higher education beyond high school as well as an accredited public, nonprofit or private institution listed in the U.S. Department of Education accredited database.
The AOTC is limited to a maximum of $2,500 per eligible student per year for the first four years of undergraduate study only. The credit is calculated at 100 percent of costs for the first $2,000 in tuition, fees and books and 25 percent for the second $2,000. The AOTC is 40 percent refundable, which means you will get a refund if the amount of the credit exceeds your tax liability. The AOTC is gradually reduced for married taxpayers with modified adjusted gross incomes between $160,000 and $180,000 for 2015 with zero benefit to those with greater than $180,000 in taxable incomes. For single and head of household taxpayers, the range is $80,000 to 90,000.
The LLC is limited to a maximum of $2,000 per family for each additional year of college or graduate school. This credit is 20 percent for up to $10,000 in tuition and fees. The LLC is not refundable. The LLC is phased out for married taxpayers with modified adjusted gross incomes between $110,000 and $130,000 for 2015 with zero benefit to those with greater than $130,000 in taxable incomes. For single and HOH taxpayers, the range is $55,000 to $65,000.
For tuition and fees incurred for qualified education expenses for which you did not claim an education credit, you could possibly take the tuition and fees deduction. This is a deduction against your gross income, reducing the amount of your income subject to income tax. The deduction is limited to $4,000 per year and is taken as an adjustment to income, which means you’re eligible to take this even if you don’t itemize deductions. The deduction is allowed for single taxpayers with less than $80,000 — $160,000 married — in modified adjusted gross incomes. This deduction is helpful for those who might not qualify for a credit. The provision expired at the end of 2014, and Congress has yet to extend it. An extension is likely, however, and has been common practice to retroactively reinstate the provision.
A deduction is available for taxpayers who paid interest in a given year on a qualified higher education student loan. The deduction is a maximum of $2,500 per year and is allowed only for taxpayers whose income is less than $75,000 — $150,000 if married.
Qualified tuition savings plans, also known as 529 plans, are sponsored by states or private education institutions and authorized under Section 529 of the Internal Revenue Code. The plans allow taxpayers to save money for their children’s higher education by allowing contributions into these accounts in which earnings accumulate tax-free. Furthermore, the eventual distributions from these accounts remain tax-free as long as they’re used for qualified expenses.
Contributions to these accounts are not deductible. However, there are no income limitations for annual contributions. Contributions are treated as gifts to the child who’s the beneficiary of the account. A donor can choose to contribute more than the annual gift exclusion ($14,000) in a given year to a 529 plan. They can make an election on Form 709 to treat the gift as though it were spread out over a five-year period.
There are many scenarios in which taxpayers can plan for college costs and save taxes. For additional advice or to discuss a more sophisticated approach to your own unique situation, consult your tax professional.