Tax Incentives for Higher Education

February 24, 2014
Deborah Helton

Deborah Helton

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The federal government provides several tax incentives for college students and their parents.  How to best take advantage of these benefits can be tricky.  In this article, we will outline the possible benefits and the pros-and-cons of each in order to explore a few strategies that might be most helpful.

The American Opportunity Tax Credit is a refundable tax credit for undergraduate college education expenses. This credit provides up to $2,500 in tax credits on the first $4,000 of qualifying educational expenses.

Pros: Up to 40% of the American Opportunity credit is refundable. This means up to $1,000 of the American Opportunity credit can be refunded to you, even if your tax liability is zero. This makes the American Opportunity credit potentially more valuable than the Lifetime Learning credit, which is non-refundable.

Cons:  The credit cannot be claimed if a student has already completed four years of college or if the student has already claimed the credit four times on previously filed tax returns. The credit is available to undergraduate college only, and the student must be enrolled at least half time.  Currently, the credit is scheduled to be available through 2017. The credit is phased down benefits for income from $80,000 to $90,000—or $160,000 to $180,000, if filing jointly—and is not available for people with incomes above the phase-out range.

The Lifetime Learning Credit is a credit worth up to $2,000 or 20 percent on the first $10,000 of expenses.

Pros: The Lifetime learning credit is a tax credit that can help pay for undergraduate, graduate and professional degree courses – including courses to improve job skills.  The student does not have to be enrolled to a certain threshold; they could be taking only one class.  There is no limit on the number of years this credit can be claimed.

Cons: The amount of your lifetime learning credit is phased out (gradually reduced) if your MAGI is between $53,000 and $63,000–$107,000 and $127,000 if filing jointly. You cannot claim a lifetime learning credit if your MAGI is $63,000 or more ($127,000 or more if you file a joint return). The credit is a per return credit, meaning it could encompass more than one student.

The Hope Credit allows for the first $1,200 in qualified expenses as well as half of the qualifying expenses between $1,200 and $2,400.  The maximum credit is $1,800 per student.

Pros: This credit could accumulate a benefit higher than Lifetime learning credit in some instances. It can be used for one student if another student is utilizing the Lifetime learning credit on the same return.

Cons:  Only available in the first two years of post-secondary education and must be enrolled at least half time.  The credit is phased out once a taxpayer’s modified adjusted gross income exceeds between $50,000 and $60,000 ($100,000 and $120,000 if filing jointly).

The Tuition and Fees Deduction is an alternative to the education credits that provides an above-the-line deduction. The deduction is available for any person who paid tuition and other required fees for attending college, or any other post-secondary school on up to the first $4,000 in qualified expenses.

Pros:  The tuition deduction is not restricted based on what year of college you are in, or if you are a part-time or full-time student. Taking even one class can qualify you for this deduction.   You can deduct tuition and other required fees for the year that you are filing your return and for classes starting in the first three months of the year to follow. The IRS provides the following example in Publication 970, “For example, if you paid $1,500 in December 2012 for qualified tuition for the spring 2013 semester beginning in January 2013, you may be able to use that $1,500 in figuring your 2012 deduction.”

Con:  While the tuition deduction has been around since 2002, this deduction is scheduled to expire at the end of the year 2013. The deduction is limited to $4,000 max per student for income up to $65,000 ($130,000 for joint filers); $2,000 max per student for income over $65,000 and up to $80,000 ($160,000 for joint filers); and no deduction for income over $80,000 ($160,000 for joint filers).

College Savings Plans also called Section 529 plans are a tax favored savings account. Colorado has a few plans sponsored by the State.

Pros:  Similar to retirement accounts this type of account will grow and earn income tax free and withdrawals from the account are also tax free as long as they are used for specified higher education expenses.  Colorado offers a deduction dollar-for dollar deductible against Colorado state income tax.  There are no income limitations to this deduction.  A plan can be started anytime, even while the student is already enrolled.

Cons:  Distributions not used for education are subject to a 10% penalty and taxed as income.  Overfunding this plan should be monitored.  Contributions to the plan are subject to gift tax consequences if your contributions and other gifts to a particular beneficiary exceed $14,000 in 2014.  There are special rules to allow higher contributions over a defined time period.

What’s a Qualifying Education Expense?

Qualifying educational expenses for the American Opportunity Credit are tuition and related course materials. By contrast, “qualifying expenses” are restricted solely to tuition for tuition and fees deduction or the Lifetime Learning credit. For the American Opportunity credit, other course materials such as books, lab supplies, software and other class materials can qualify for the tax credit.

In contrast the tuition and fees deduction doesn’t allows expenses for courses related to sports, games or hobbies and non-academic fees such as student activity fees, athletic fees and insurance expenses are not deductible, even if these fees are required by the school. Similarly, the cost of books, supplies and computer equipment cannot be deducted as part of the tuition and fees deduction. Schools report the amount of qualifying expenses to you and to the IRS using Form 1098-T.

Section 529 plans also allow withdrawals for Computer Technology or Equipment and internet access, as well as room and board costs expenses generally not qualifying for the education credits.

So what benefits should you claim?

When it comes to the benefits and limits inherent in higher education benefits, it is important to consider carefully how to best take advantage of these options. Income levels of the parent and student should be considered.  Also taken into account is whether the student is working and has a tax liability.

In some situations, allowing your child to claim a credit is more advantageous.  Starting in 2013, married couples with income over $300,000 will see a phase out of personal exemptions and be totally phased out of all Federal educational tax credits and deductions listed above.  So the ability to claim your child’s personal exemption may not be as valuable of a tax deduction as it has in the past.

If this is the case, it may be beneficial to allow the child to claim himself on his own return and claim an education credit.  This choice is all or nothing choice, that is to say the credit will follow the personal exemption or allowing a student to claim themselves also allows them to also take the tax credit.  Similarly, a parent can’t claim a credit without claiming the student on their return.  If a student is working and claiming the credit they have the opportunity to obtain a refundable portion of the education credit with the American Opportunity credit, whereas the other credits will only reduce a tax liability.

There is also a scenario in which a working student claims a credit for the first $4,000 of qualified expenses to fully utilize education credits.  Then parents can cover other qualified expenditures by utilizing a Section 529 plan.  Since this account can be set up at any time, a parent can contribute money one day and take out the next for expenses, allowing a lot of flexibility.  With no income limitations, parents can obtain the Colorado state deduction for the Section 529 account contributions while allowing the child to claim the credit they would otherwise be phased out of.  When utilizing this strategy, ensure that the $4,000 of funds used for the credit are separate from the Section 529 funds, those two benefits can be doubled dipped.

If you have more than one student in college these considerations should be made on a per student basis.  For each student, you can elect for any year only one of the credits. For example, if you elect to take the lifetime learning credit for a child on your 2013 tax return, you cannot, for that same child, also claim the American opportunity credit for 2013. If you are eligible to claim the lifetime learning credit and you are also eligible to claim the American opportunity credit for the same student in the same year, you can choose to claim either credit, but not both.

Optimization of your situation should be consider carefully and discussed with your tax advisor to ensure you have all the details worked out properly.

 

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