Tracy Hess, CPA, spoke about the topic of tax savings when paying for college at Senator Reed’s Financial Aid Workshop for college-bound students this past November at CCRI. Now that high school seniors have made their college selections, first payments will be due before you know it. Tracy wanted to take this opportunity to address questions about ways to save money for many of you who will be paying those upcoming tuition bills.
Q: We all know how expensive college is today. To take advantage of any possible savings, is it better to focus on finding ways to take a tax credit, or to take a tax deduction?
A: If you look at your tax return, it starts with all of your sources of income. From this total income, you are allowed some deductions, or subtractions, which gives you your taxable income. From this taxable income, your tax liability is calculated.
A tax credit would then be subtracted directly from the taxes you owe. Typically, a tax credit, which directly reduces your tax, is much more advantageous than a tax deduction, which only reduces your taxable income.
A: There are a two good options: 1) the American Opportunity Credit, and 2) the Lifetime Learning Credit. Each of these credits is based on eligible higher education expenses paid for an eligible student, at an eligible higher education institution.
The American Opportunity Credit (AOC) is 100% of the first $2,000 of qualifying expenses, and then 25% of the next $2,000 of expenses – for a total maximum credit of $2,500 per student. Remember – this is a direct subtraction from your total income tax. In the case of this credit, qualifying expenses include required tuition, fees and course materials (so books, supplies, and equipment).
This is only available for the first 4 years of higher education. The student must be enrolled at least half-time, in a degree program for at least one academic period. The student is ineligible if they have been convicted of a drug-related felony.
There are income limitations. If you are married and filing jointly and your modified adjusted gross income (AGI) is less than $160,000, you are eligible for the full credit. However, once you hit $180,000 you are no longer eligible for the credit. If you earn between the two amounts, the credit will be reduced. For single filers, head of household, and qualifying widower, the AGI limits are between $80,000 and $90,000.
The Lifetime Learning Credit applies for 20% of up to $10,000 of qualifying expenses – or a maximum of $2,000. This credit is limited per tax return, not per student. In the case of this credit, qualifying expenses include required tuition, fees and course materials (so books, supplies, and equipment) as long as paid directly to the institution.
This credit is much more flexible than the AOC in several ways. There is no limit to the number of years you can claim the credit. You can use it for any qualified course (the half-time enrollment rule does not apply), which includes courses taken to acquire or improve job skills (no degree requirement). There is no restriction for a felony drug conviction.
The income limits for the Lifetime Learning Credit are lower, so for married couples filing jointly the credit will phase-out between $114,000 and $134,000, and for other taxpayers it’s $57,000 to $67,000.
I should point out that the credits apply one per student per year. If you have more than one child in college, you can claim more than one credit. The Lifetime Learning Credit is only one per tax return, but that would not prevent you from claiming an American Opportunity Credit for the other child or the American Opportunity Credit for both children.
In addition, neither of these credits are available if a married couple files separately.
Q: What tax deductions are available?
A: The tuition and fees deduction which allowed for a deduction of either $2,000 or $4,000 depending on your adjusted gross income expired on December 31, 2017. Legislation has been proposed to extend the tuition and fees deduction to December 31, 2018. The fate of the proposed legislation is uncertain as of 5/7/19. We will describe the deduction in the event the proposed legislation ultimately passes.
If you are married filing jointly and your AGI is below $130,000, the deduction is $4,000. If your AGI is above $130,000, but below $160,000 the deduction is $2,000. If your AGI is above $160,000, no deduction is available. For single, head of household, and qualifying widower, the AGI limits are $65,000 and $80,000 respectively. A deduction is not available for married couples filing separately.
The expenses available for the deduction are defined the same as the Lifetime Learning Credit. For example, room and board doesn’t apply. In this case, however, expenses must be paid by the taxpayer, meaning, not by the child or a third party.
Q. Can you take both a tax credit and a tax deduction?
A. No, you cannot take both a credit and a deduction for the same student in the same year. However, if you have two students in school, you could take a credit for one and a deduction for the other.
Q: What considerations should I be aware of when it comes to choosing which credit is most advantageous?
You need to understand your qualifying expenses. Generally, qualifying expense are your out-of-pocket costs (including borrowed amounts) paid for the taxpayer, spouse, or dependent for tuition, fees, and course related books, supplies and equipment paid as a condition of attendance at the educational institution. They usually do not include room and board, insurance or medical expenses, transportation, personal or living expenses, fees for sports, games or hobbies, or any non-credit courses.
When determining your eligible expenses, remember that your qualifying expenses are always reduced by any other tax-free benefits you receive. For example, Molly’s first year tuition at ABC College is $25,000 but she got a $20,000 scholarship. Molly does not have to pay taxes on her scholarship money. Her eligible expenses in this case would be $5,000.
If you withdrew $2,000 from Molly’s 529 plan (see below) to pay towards the $5,000 she owed, and you paid the other $3,000 from your savings, you can claim a credit only on that $3,000 of expenses. The $20,000 scholarship and $2,000 from Molly’s 529 plan were both tax-free.
You claim a credit for expenses paid in that year, as long as the education begins during that year, or during the first 3 months of the following year. Therefore, if you pay tuition in December of 2019 for the school year beginning in January 2020, you would take the credit in 2019.
Q: Who gets to take advantage of these tax credits?
A: Historically, the person claiming the dependency exemption was the one who could take the credit. With tax reform there are no exemptions including dependency exemptions; so now the benefit falls to the custodial parent, regardless of who pays the tuition. With divorced parents, the custodial parent may have released the right to claim the benefits relating to a dependent to the noncustodial parent as part of the divorce or separation agreement. It is a matter of the custodial parent signing a form that will be filed with the noncustodial parent’s tax return.
Back to my example, if Molly, pays her first year tuition out of her own pocket, her custodial parent gets to claim the credit on his/her tax return.
Also note that if a third party pays the tuition directly (for example a grandparent or generous aunt/uncle), the payment is considered to have been made by the student. Therefore, it is considered a nonreportable gift from the third party to the student who then pays the tuition, even if that is not what really happened. In that case, it is still the custodial parent who will get the deduction assuming the form has not been signed.
Having a third party pay the tuition is a great benefit, but it will affect your eligibility for financial aid. The gift is considered support on the FAFSA. If you are in this situation, please speak with your tax advisor.
Do not forget that there are income limitations that may prevent you from qualifying for the credits. If you are in this situation, please talk to your tax advisor. Historically, you were able to waive your dependency exemption that would then allow your child to take the credit on his/her own return assuming they have enough tax liability for it to matter. There is no more exemption, but we are still under the impression that you can still pass the credit on to the child.
Q: Are there any tax-free ways of paying for college?
A: There are some available tax-free ways to pay for college. Scholarships that cover tuition, fees, books, and required supplies at an eligible institution are generally exempt from tax. If the scholarship also covers room and board, that portion is taxable to the student as other income. However, if the student is required to live on-campus to provide services to the school – for example as a Resident Assistant (RA) – you may be able to exclude this portion of the scholarship as well.
If you have an IRA, or a Roth IRA, you can tap into these funds for college education. Funds can always be withdrawn from a Roth IRA up to the contributions you have made without paying tax. If you are over 59 ½ and have held the Roth IRA for more than 5 years, the earnings on the Roth distributions in excess of your contributions are also tax-free.
If it is a traditional IRA, the withdrawal will be subject to income tax, but the 10% early withdrawal penalty will be waived if used for tuition, fees, books, or required supplies and equipment. This will also apply to room and board if the student is enrolled at least half-time. An early withdrawal penalty usually applies when distributions are made from a traditional IRA before age 59 1/2.
I suggest that before you decide to withdrawn from an IRA, please consult with an advisor about the effect it may have on your financial aid and on your retirement.
If you have Series EE or Series I savings bonds, and the bond is cashed in to pay for tuition and fees, you may be able to exclude the interest income on the bonds from your tax return. However, there are many stipulations. The bond owner must be at least 24 years old when the bond is issued and the bond must have been issued after 1989. This means typically the bond must be in the parent’s name. If the child is a joint owner, the bond will not qualify for the exclusion.
If you have a 529 plan, which is an investment vehicle to save for college where you made contributions for future college education, you can take distributions from this plan for qualified education expenses. The 529 plan contributions grow tax-free, and as long as the withdrawals are used for qualified education expenses, the withdrawals are tax-free. Qualified education expenses are tuition, fees, books, supplies and equipment required for attendance at the educational institution, as well as room and board if the student is enrolled at least half-time.
Q: What about loans? Are there any benefits to be found?
A: For most people, education loans are a reality, even after you have taken advantage of what you can to start paying for school. Loan proceeds in and of themselves are not taxable. There is also an available deduction for student loan interest paid of up to $2,500 per tax return as long as the loan is used solely to pay for qualified education expenses.
The student must be, or have been, enrolled at least half-time in a degree program. The deduction is only available to the person or persons obligated on the note. Therefore, if the loan is in Molly’s name, only Molly can take the deduction. Similarly, if Molly’s parents took out the loan – even if Molly starts making the payments after she graduates, she would not be eligible for the deduction.
There are income limits for this deduction. For married taxpayers filing jointly the maximum deduction phases out between $135,000 and $165,000. For all others it is between $65,000 and $80,000. Married taxpayers filing separately do not qualify for the student loan interest deduction.
The lender must send you Form 1098-E for the interest paid if you pay more than $600 of interest during the year. If you have paid less than that amount or if the lender is not aware that the loan was used solely for qualified education expenses, you may either contact the lender or use your records to determine the amount of interest paid, but the deduction is still available. You can use Form W-9S to certify to the lender that the loan was incurred solely to pay qualified higher education expenses. Providing the W-9S to the lender will document for the IRS the amount of interest paid that would be eligible for the deduction.
College tuition is a significant expense, so it is worthwhile to determine if you are eligible for any tax savings. For more information, please contact Tracy Hess or any of our tax professionals at 401-831-0200.