Education has become increasingly expensive, especially college education. The cost of college has nearly tripled over the past 20 years with an annual growth rate of 6.8%. Depending on whether you or your child attends an in-state, out-of-state, or private 4-year university plays a significant role in determining the final cost. Average yearly costs can range from nearly $10,000 to $37,000 on tuition and fees alone. This does not include all of the additional costs associated with attending college.
There has been some form of education expense deduction or education-related tax credit for some time. The fundamental goal of these tax laws is to save taxpayers money by providing an avenue for reimbursement when the annual tax return is completed. There are several types of self-employed deductions and credits available but there have been some changes to the tax laws you need to be aware of. When claiming these tax benefits it is also important to understand the differences between tax deductions, tax credits, and tax exclusions as they impact your tax return differently.
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Defining a Qualified Education Expense
Every tax deduction, credit, and savings opportunity is based on whether or not the monies are used for qualified expenses. To complicate matters, "qualified" can vary from one opportunity to another. While you should always confirm what is considered qualified expenses for your benefit, there are some general rules to follow.
What are Qualified Expenses?
There are certain education expenses which are always considered qualified, regardless of what benefit you are trying to benefit from.
Expenses that are always considered qualified education expenses
Related expenses required for enrollment or attendance at eligible institutions
Student activity fees that are required to enroll or attend school
Education expenses that are qualified only for the AOTC
The AOTC is more generous than most other options. As a result, there are some additional expenses that are considered qualified for tax purposes
Supplies required to pay to enroll or attend school
Equipment required to pay to enroll or attend school
Expenses Never Considered "Qualified"
There are some expenses that are never considered qualified regardless of whether they are actually required or not.
Special Note for Sports, Games, Hobbies, and Non-Credit Courses
Expenses for sports, games, hobbies, or non-credit courses never qualify for education credits or deductions unless the course or activity is part of the student's degree program.
If you are looking at the Lifetime Learning Credit then the expenses may qualify if the course helps the student acquire or improve job skills.
Education Expense Tax Deductions
Let's quickly review tax deductions and how to claim educational ones.
What is a Tax Deduction?
On top of saving money to pay taxes, you'll want to claim tax write-offs. A tax deduction reduces your taxable income for the year. Tax deductions are "above the line" tax benefits because they are used to reduce your overall taxable income. By taking your gross income and reducing it by your deductions, you are left with your modified adjusted gross income. This is the amount which actually gets taxed. The other benefit of above the line deductions is you do not need to itemize your tax deductions in order to claim it. You only need to itemize to claim below the line deductions.
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The Tuition and Fees Deduction Has Been Eliminated
One of the most well known education expense deductions was the Tuition and Fees Deduction. The tuition and fees deduction was fairly straightforward. Taxpayers who paid qualified tuition and fees from 2018-2020 could claim a maximum deduction of $4,000. To qualify for this deduction, you would need to have a modified adjusted gross income of $80,000 or less for single filers and $160,000 for married filing jointly filers. This deduction was claimed on the Schedule 1 and Form 8917.
As of December 31, 2020 the $4,000 tuition and fees deduction is no longer available. The temporary tuition and fees deduction was removed as part of the Consolidate Appropriations Act of 2021. As a result, this deduction only matters if you are behind and filing prior year taxes.
Student Loan Interest Deduction
Along with the now defunct tuition and fees deduction, the other most popular deduction is the student loan interest deduction. Anyone paying back student loans can reduce their taxable income by $2,500. The student loan interest deduction applies to all of the interest you paid back during the tax year, with a ceiling of $2,500. As with all tax deductions, this is an above-the-line deduction.
To qualify for the student loan interest deduction, your student loan must be a commercial loan taken out solely to cover education expenses. The loan must also be applied to covering a student enrolled at least half-time in a degree program. The student loan interest deduction starts to phase out once your modified adjusted income is higher than $85,000 for a single filer and $140,000 for married filing jointly filers.
Education Expense Tax Credits
The second group of tax benefits related to education expenses are tax credits. Tax credits reduce the amount of income tax you owe on a dollar-to-dollar basis. For example, if you receive a $100 tax credit, the amount of taxes you owe the federal government is reduced by $100. Since tax credits are below the line deductions, it does not impact your modified adjusted gross income - only the total amount of taxes owed.
There are two types of tax credits - refundable and non-refundable. Refundable tax credits are always applied to your tax return - even if you do not owe any taxes. Essentially, you always receive a refundable tax credit - even if it is in the form of refund. Non-refundable tax credits are only applied when you owe federal income taxes to reduce the amount you owe. For example, if you are in a position where you owe $100 in taxes but receive a $200 non-refundable tax credit you will not get a $100 refund but it will cover the $100 you owe.
American Opportunity Tax Credit
The first time you claim an education related tax credit, it will likely be the American Opportunity Tax Credit (AOTC). This tax credit allows you to lower your income tax amount due by up to $2,500 per student, per year. There are some restrictions on when and who can claim it.
When can this credit be claimed?
This tax credit can only be claimed for four (4) years.
This tax credit is only for undergraduate tuition, fees, and books.
Undergraduate college students who file their own tax returns OR
Parents who pay the college tuition costs for children they list as dependents on their tax return.
Modified Adjusted Gross Income Limits
For single filers - $80,000
For joint filers - $160,000
Note: This credit begins phasing out at the above limits, so if your MAGI exceeds these limits you may still qualify for a partial credit.
Lifetime Learning Credit
The Lifetime Learning Credit is similar to the AOTC is many ways but is structured differently. In most cases, you will claim the AOTC as long as possible and then transition to the Lifetime Learning Credit.
With the Lifetime Learning Credit you can claim 20% of the first $10,000 you pay for tuition and fees. While this means you have a credit cap of $2,000, it is not just for undergraduate tuition and fees. As an eligible educational institution, this credit can be claimed for both graduate and vocational schooling.
What is an eligible educational institution for the Lifetime Learning Credit?
It is also important to note there is no limit on how long you can claim this credit. The AOTC credit can only be claimed for four years, which is one reason the Lifetime Learning Credit is often the credit claimed after the first four years of undergraduate schooling.
NOTE: The same MAGI limits apply to the Lifetime Learning Credit as the AOTC.
Key Points to Consider About the American Opportunity Tax Credit and Lifetime Learning Credit
The AOTC and Lifetime Learning Credit cannot be claimed at the same time, for the same person.
In net credit value, the AOTC is "worth" $500 more which is why it is typically claimed for the first four years and then the Lifetime Learning Credit is claimed for all following years.
The Lifetime Learning Credit is the only option for graduate students and vocational education students.
Education Expense-Related Tax Exclusions
Along with tax deductions and tax credits, you should also consider tax exclusions (income that is tax free). Tax exclusions are funding sources which are not considered taxable income. While this is most beneficial to undergraduate students, there are situations it will apply to graduate and vocational students as well.
The most common financial aid related tax exclusion is scholarship income. Any amounts received from a scholarship to pay for tuition, fees, and required course materials are excluded from income by college students. There are also no income phase-outs for the exclusion. The only factor to keep in mind is the scholarship must not represent a payment for services - essentially, the scholarship can be provided to a student in exchange for services. Grants are also a form of financial aid that may be excluded from taxable income.
Employer-Provided Educational Assistance
If a student is employed by a company that provides educational assistance, the amount is not considered income although there are limits to this benefit. A student can receive up to $5,250 per year from their employer without the amount being considered taxable income. Any amount above this limit is considered taxable income - just like a regular paycheck.
While the amounts exceeding $5,250 are considered taxable income, there is still a net benefit to maximize employer-provided educational assistance. For example, if your employer provides up to $10,000 in assistance and you take advantage of the entire $10,000 then $4,750 will be considered taxable income. Since you taxable income is still a percentage of the total - depending on your tax bracket - you are still only paying a small percentage of the total amount of schooling.
If your employer reimburses you for student loan payments, it will fall into this category as well. The employer reimbursement amount includes both the principal and interest payments. Based on current tax laws, this will only be valid until 12/31/2025, although this will likely be extended at some point in the next 3 years.
Student Loan Debt Forgiveness
Every taxpayer can exclude from their income, any student loan debt forgiven between tax year 2021 and 2025.
Education Savings Bonds
The final category of tax exclusions is the interest earned on education savings bonds. Any interest on qualified education savings bonds is excluded from income when the proceeds are used to be eligible education expenses.
Tax-Beneficial Savings Incentives
There are currently two (2) programs which offer tax benefits geared towards education expenses. These program do not offer tax credits but do offer financial benefits.
Qualified Tuition Programs (529 Plans)
The most common tax beneficial plan is the 529 plan. All earnings on investments in a 529 plan are excluded from income if used to pay for qualifying education expenses. Additionally, $10,000 per beneficiary, per year may be used to pay for K-12 expenses which makes this tax vehicle ideal for parents. Up to $10,000 per borrower can also be used to repay student loan principal and interest.
Coverdell Education Savings Account
This type of education savings account has a maximum contribution of $2,000 per year. Earnings on investments are not taxed if used for eligible expenses.
Don't Forget to Look at State-Specific Benefits
If you are looking to maximize your education expense-related deductions then it is also important to consider state-specific tax benefits. Every state is a little bit different. Some states offer a variety of benefits and some states offer no additional tax benefits.
Louisiana a great example of State that falls right in the middle. They offer State income tax deductions for school tuition, home school educational expenses, and public school educational expenses. The tax deduction has been in effect since 2009.
From 2011 forward, the deduction is 50% of the costs paid per dependent, limited to $5,000. The key is to consult your tax professional to learn more about any deductions available in your State.
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