Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)
Part VI. Personal Expenses, Deductions, and Credits
Chapter 30. Education Expenses
You’ll Pay Dearly if You Play Hooky on This Chapter
You may ask why the government gives tax deductions and credits for higher-education expenses. One reason may be that a well-educated society is generally more prosperous, competitive, and successful. A more cynical rationalization might be that higher education generally leads to higher income, which leads to higher tax revenue—so the deductions and credits are a down payment on higher tax revenue for that person’s lifetime. Whatever the reason may be, the result is that there are some great tax benefits available for those who pay for higher education.
If you have had expenses related to higher education during the year, you can likely use those expenses to reduce your tax bill. You can claim your qualified education expenses in a variety of ways, including three deductions, two credits, and a potential tax-free income source. You should consider the value of each of the possibilities every year, because many of the nuances between them can make one option better in a given year and another option better in the next. Compare the benefit of each option on your return by running the calculations for each option before deciding where to claim your expenses. The opportunities that are discussed in this chapter are:
· The Tuition and Fees Deduction
· Education as a Business Deduction
· The American Opportunity Credit
· The Lifetime Learning Credit
· The Student Loan Interest Deduction
· Student loan debt forgiveness
Note With all of these deductions and credits there is no double-dipping allowed. You cannot claim the same expenses under multiple credits. All expenses that you claim must also be net of any tax-exempt assistance (such as a scholarship) as well as net of any withdrawals from qualified tuition savings programs (such as Coverdell or 529 plans).
The Tuition and Fees Deduction
The first way you can utilize your education expenses for tuition and fees is by taking them as an above-the-line deduction, which directly reduces your Adjusted Gross Income (AGI). For some people, the reduction in AGI that comes from taking this deduction is very beneficial because it can have a domino effect on other deductions and credits that would otherwise be reduced or eliminated by phase-outs. In these cases, using the deduction may actually be more beneficial than claiming the education credits (you can’t claim both the Tuition and Fees Deduction and an education credit on the same tax return; you must choose one or the other). It is wise to prepare your tax return using both methods in order to determine the best option.
Note As it currently stands, the Tuition and Fees Deduction will expire at the end of 2013. It is uncertain whether it will be reinstated by Congress after that. Be sure to verify the details (and existence) of the deduction beginning in 2014 before making decisions based on your ability to claim it.
The deduction is limited to a maximum of $4,000 of qualified expenses per tax return (not per student) for those with an AGI of $65,000 or less ($130,000 or less for couples). If your AGI is between $65,000 and $80,000 ($130,000 and $160,000 for couples) the maximum deduction was $2,000. If your AGI is above that range, the deduction is not available to you.
The income stair-step limitations that are placed on this deduction create some dramatic results on a tax return for those who cross over the threshold amounts. Unlike most phase-outs, which have a gradual reduction in their benefit, this deduction is reduced dramatically as soon as your AGI is $1 higher than the phase-out limits. This type of limitation can have a significant effect on your tax planning because just a dollar or two of excess AGI could reduce your deduction by $2,000! If it appears that your AGI will be close to the phase-out levels, it would be worth looking into a broad variety of measures to reduce your AGI to an amount lower than the threshold.
Example Nelson spent $4,000 on tuition for night school while he continued to work full time during the day. Nelson’s current salary is $66,000 per year, his AGI is $65,100, and he is in the 15% tax bracket. Since his AGI is $100 over the income limit for the Tuition and Fees Deduction, his allowable deduction is reduced by $2,000.
It would be extremely beneficial to Nelson if he found a way to reduce his AGI by $100, such as by making a $100 contribution to an IRA. Doing so would restore an additional $2,000 in deductions for his tuition and reduce his AGI by $100 for the IRA contribution. By putting $100 in an IRA he will have saved $315 in taxes! [($100 IRA deduction + $2,000 additional tuition deduction = $2,100) × 15% tax bracket = $315.]
Caution You cannot claim the American Opportunity Credit if the student is married and filing separately from his or her spouse, or if the student is claimed as a dependent on another person’s tax return, if he or she were a non-resident alien for part of the year or if you claimed one of the education credits for that student on your tax return.
Education as a Business Deduction
Another way of deducting your education expenses is as a business expense. Recognizing these costs as a business expense will reduce your AGI as well as your self-employment tax. The added benefit of a lower self-employment tax can make this option very attractive.
Education expenses can be deducted as a business expense if the education maintains or improves the skills required in your business. The expenses cannot be deducted if the education is needed so you can meet the minimum education necessary to qualify for the trade or business based on laws, regulations, or standards of the profession. If the education qualifies as a deduction, all related expenses (including books, fees, and so on) can be deducted as well.
Example Leo is an attorney. To practice law in his state, he is required to have a law degree from a qualified institution and pass the bar exam. In addition, he must take continuing education courses each year to maintain his license. The cost of his law degree would not qualify as a business expense because it is necessary to meet the minimum requirements to qualify for his profession. However, the continuing education does qualify as a business expense because it helps him maintain or improve the skills required for his profession.
There are other ways to deduct education expenses through a business as well, such as with education assistance programs and scholarships. See Chapter 20 for more details.
The American Opportunity Credit
A third possible way to claim a tax benefit from your educational expenses is through the American Opportunity Credit (a modified version of the HOPE Scholarship Credit), which is set to expire (and revert to the HOPE Credit) after 2017. The maximum amount available for this credit is $2,500 per student, per year. (Note that this is different than the Tuition and Fees Deduction, which has a maximum deduction per return).
The credit can be claimed only for expenses incurred during the first four years of a student’s post-secondary education (meaning after high school). Students who “extend” their college education to five or six years are out of luck. However, this is much better that the original HOPE Credit, which covered only the first two years of college education. The expenses that qualify for this credit are tuition, fees, books, supplies, and equipment that are necessary in order to obtain a degree. This is a much broader list of expenses than is available for the other education deductions and credits, in which only tuition and fees are allowable expenses.
The credit is calculated in the following way: 100% of the first $2,000 of qualified expenses, plus 25% of the next $2,000 in expenses.
Example Marcus is a part-time student and has an AGI of $40,000 (well below the phase-out limit for the credit). He spent $3,000 on tuition during the year. Marcus will be able to claim a credit of $2,250 [(100% of $2,000) + (25% of 1,000) = $2,250].
Up to 40% of the credit is refundable, meaning that it can be paid to you in the form of a refund even if you owe no taxes. The credit phases out when your AGI is greater than $80,000 if you’re single, or $160,000 if you’re married.
Example Shannon is in her second year of college. She has paid $12,000 in qualified education expenses during the year. Her income for the year was $25,000—well below the phase-out thresholds. Based on this information, Shannon can claim the maximum credit of $2,500.
In addition, her taxable income is only $8,000, which results in a tax liability of $800. The tax credit will eliminate the $800 in taxes, with $1,700 of the credit left unused. As much as 40% of the credit is refundable, or $1,000 in Shannon’s case, so she will receive $1,000 in additional refunds because of this credit. The remaining $700 of the credit will go unused and will not carry over into future years.
If the American Opportunity Credit is claimed for a student on a tax return, the Lifetime Learning Credit may not be claimed for that same student and the Tuition and Fees Deduction may not be claimed for anyone on that same return in a given year.
You cannot claim the American Opportunity Credit if the student is married and filing separately from his or her spouse, or if the student is claimed as a dependent on another person’s tax return. The student must have not been convicted of a felony drug possession or distribution offense. Finally, the student must also be enrolled at least half-time in a program that leads to a degree, certificate, or other recognized educational credentials.
Tip If parents do not qualify to claim the American Opportunity Credit because their income is too high, they may choose to waive claiming the child as a dependent in order for the child to claim the credit. However, the child is still unable to claim herself as a dependent on her own return. In a narrow set of circumstances, this strategy could result in a lower overall tax burden.
The Lifetime Learning Credit
The fourth option for reducing your tax bill through qualified education expenses is found in the Lifetime Learning Credit. This is a non-refundable credit of up to a maximum of $2,000 per tax return, per year. Unlike the American Opportunity Credit, which is calculated on a per-student basis, the lifetime learning credit is calculated per tax return, no matter how many students you claim. The calculation for this credit is very simple: 20% of the first $10,000 of tuition paid during the year. The $10,000 limit is for all the students claimed on the tax return, added together.
Tip If you have more than one student in your household, it is okay to claim some students under the American Opportunity Credit and others under the Lifetime Learning Credit. However, you cannot claim the same student under both credits.
This credit is much easier to qualify for than the American Opportunity Credit, because the student need only be enrolled in one class per year at a qualified educational institution, and the credit can be claimed for as many years as the student has tuition expenses (as opposed to the four-year limit for the American Opportunity Credit). The classes that are paid for do not even need to lead to a degree.
The lifetime learning credit is phased out when the taxpayer’s AGI is between $50,000 and $60,000 for singles and between $100,000 and $120,000 for married couples.
Tip Because of the income limits, high-income parents who can’t claim the credits and whose income results in the phase-out of the dependency exemptions may consider waiving that exemption so the child can claim the credit. This would be a benefit only if the child has sufficient income tax liability that can be offset by the credit.
The Student Loan Interest Deduction
The interest paid on student loans is deductible as an above-the-line deduction, up to $2,500 per year. The loan must have been used solely for the purpose of paying for higher education expenses (not for doing other things, such as buying stock, as I once did as a risk-taking college student).
The deduction is subject to AGI-based phase-outs. The phase-out occurs when the Modified AGI (MAGI) is between $65,000 and $80,000 for single taxpayers, and is completely eliminated thereafter. For married couples the phase-out is between $130,000 and $160,000 MAGI.
In 2013 the law is also set to revert to a previous rule that allows the deduction to be taken only during the first 60 months of repayment.
Caution In case your tax brain was working overtime and you had come up with a great scheme of dodging taxes through interfamily loans, you need to know that the student loan interest deduction cannot be taken for loans made to the student by family members.
Student Loan Debt Forgiveness
In general, the tax code treats a forgiven debt as income—it is essentially the same thing as receiving income that you use to pay off the debt. However, there is an exception to this rule for the forgiveness of student loan debt in certain circumstances. As an incentive to induce students preparing for certain professions to work in underserved areas, the government has established a program of debt forgiveness in trade for a predetermined number of years in that underserved area. For example, if a medical student agrees to work as a doctor for a certain number of years in an underserved rural community, the government will, in turn, discharge that student’s debt. In these specific, qualified situations the debt forgiveness is not counted as income and is not taxable.