Planning for future education expenses can be a daunting task. Education planning is a part of SFG’s integrative planning process. We consider our clients’ adjusted gross income, cash flow needs, as well as tax incentives. This blog post focuses on tax credits and tax break opportunities that may help you pay educational expenses while maximizing your tax savings. Getting the most from the education tax incentives requires careful planning, particularly because of the interrelationship between many of the rules. Some of the education tax incentives are listed and described below:
American Opportunity Tax Credit
The American Opportunity Tax Credit (AOTC) provides a maximum credit amount of $2,500 per year for four years of post-secondary education. The AOTC is computed as 100% of up to $2,000 qualified higher education expenses plus 25% of the next $2,000 of eligible expenses. The AOTC begins to phase out for married couples filing jointly with adjusted gross income (AGI) between $160,000 and $180,000. The AOTC begins to phase out for single individuals with AGI between $80,000 and $90,000. Forty percent of the AOTC is refundable for those lower-income taxpayers with a tax liability smaller than the credit amount.
To qualify for the AOTC, the tuition must be paid on behalf of the taxpayer, the taxpayer’s spouse or the taxpayer’s dependent. An eligible student for purposes of the credit is an individual who is enrolled in a degree, certificate or other program leading to a recognized educational credential at an eligible educational institution. The student must be enrolled at least half-time and must not have been convicted of a federal or state felony for possession or distribution of a controlled substance. Study at many types of post-secondary institutions qualifies for the credit, such as programs for a bachelor’s degree, associate’s degree, or another recognized post-secondary credential.
Lifetime Learning Credit
The Lifetime Learning credit can be claimed for an unlimited number of tax years. The Lifetime Learning credit equals 20% of up to $10,000 in eligible education costs during the tax year. The Lifetime Learning credit is subject to phase-out rules based on adjusted gross income.
The Lifetime Learning credit may be applied to a non-degree program. For example, an individual who is enrolled in a non-degree program to improve job skills may be eligible for the credit. Moreover, the Lifetime Learning credit may be claimed even if the student is not enrolled at least half-time. An individual who is taking just one class at a community college, for example, may be eligible for the credit.
Section 529 Plans
The Tax Code allows states and some educational institutions to offer “529” plans (known for the section of the Tax Code that governs them). They are sometimes called qualified tuition programs (QTPs). 529 plans allow you to either prepay or contribute to an account for paying a student’s post-secondary education expenses. An eligible educational institution generally includes colleges, universities, vocational schools, or other post-secondary educational institutions. In addition, distributions from state programs, even to the extent of earnings, are now entirely tax-free to the extent that they are used for qualified higher education expenses.
Qualified higher education expenses include tuition, fees, books, supplies, and equipment required for the beneficiary’s enrollment at an eligible educational institution, which includes most institutions that participate in federal student aid programs. The cost of computers or peripheral equipment, computer software, and internet access and related services also qualify as higher education expenses. If the student is attending an institution at least half-time, room and board is treated as a qualified expense.
Beginning in 2018, Code Sec. 529 qualified tuition plans are modified to allow the plans to distribute up to $10,000 in tuition expenses incurred during the tax year for designated beneficiaries enrolled at a public, private, or religious elementary or secondary school.
Coverdell Education Savings Accounts
Coverdell education savings accounts (also sometimes called education IRAs) are similar to IRAs. You can save today for future educational expenses and not just higher educational expenses. Funds in a Coverdell ESA can be used for K-12 and related expenses. The American Taxpayer Relief Act made permanent some temporary enhancements to Coverdell ESAs. The maximum annual Coverdell ESA contribution is $2,000 per beneficiary. Contributions are not deductible by the donor and are not included in the beneficiary’s income as long as they are used to pay for qualified education expenses.
Contributions generally must stop when the beneficiary turns age 18 except for individuals with special needs. Parents can maximize benefits by transferring older siblings’ accounts for use by a younger brother, sister, or first cousin, thereby maximizing the tax-free growth period. Excess contributions are subject to an excise tax. The annual contribution starts to phase out for married couples filing jointly with modified AGI at or above $190,000 and less than $220,000 and at or above $95,000 and less than $110,000 for single individuals.
Many individuals may find Coverdell education savings accounts attractive because distributions can be used for room and board (if the designated beneficiary is enrolled at least half-time) as well as for qualified tuition and the costs of books and supplies required for enrollment. Beneficiaries who have special needs may also find these expenses qualify.
Education Savings Bond Interest Exclusion
When you use U.S. savings bonds to pay qualified higher education expenses, the interest may be excluded from income if your income is below a certain range. Qualified education expenses include the cost of tuition and fees at an eligible educational institution for the taxpayer, the taxpayer’s spouse, or the taxpayer’s dependent at an eligible educational institution. Colleges, universities and vocational schools that participate in federal student aid programs generally qualify for the incentive.
For bond interest to be excluded, the taxpayer must have attained the age of 24 before the issue date of the bonds. Qualified bonds must also be issued in the name of the taxpayer as sole owner or in the name of the taxpayer and the taxpayer’s spouse as co-owners. Married taxpayers must file a joint return to exclude bond interest.
Employer-provided Educational Assistance Exclusion
When an employer pays an employee’s education expenses, the tax consequences depend on the reason for the education. Your employer may have a plan under which it pays for qualified education expenses for college or graduate studies. If it has such a plan, up to $5,250 of education benefits can be excluded from the recipient’s gross income each year. Employer-provided educational assistance can include tuition, fees, books, supplies, and equipment.
Deduction for Interest on Education Loans
Student loan interest of up to $2,500 a year is deductible whether or not you itemize your deductions. The deduction is completely phased out when a taxpayer’s modified AGI exceeds certain thresholds. Only those legally obligated to make the loan payments may deduct them. Individuals who are claimed as dependents on another person’s return cannot take this deduction. Qualified educational institutions for the student loan interest deduction are generally ones that participate in federal student aid programs.
The Tax Code also allows individuals under age 59½ to take distributions from an IRA for qualified higher education expenses without having to pay the 10% early withdrawal penalty. The qualified education expenses generally must be for the IRA holder, his or her spouse, or a child (including a foster child). Qualified education expenses include tuition, books, and supplies. Room and board is also a qualified expense if the individual is at least a half-time student. An eligible education institution is generally one that participates in federal student aid programs.
As you have read, there are many federal education tax incentives. All of the incentives must be coordinated. You generally cannot use education expenses to claim a double benefit. If you are considering claiming any of the education incentives, please contact your CPA.
For more information on the Tax Cuts and Jobs Act, read our other blogs about it: