The MainStreet Guide to College & Taxes

 

NEW YORK (MainStreet) – In recent weeks a new class of freshmen has lined up to register at America’s colleges and universities, with tuition bills coming due as a result.

Each year the cost of a college education gets more expensive. When I was an undergraduate I paid only $40 per credit, with more prestigious schools like New York University charging $100 per credit. But that was 40 years ago.

Today the College Board estimates that the average annual cost of tuition and books for a full-time student enrolled in a four-year undergraduate degree program, after taking into consideration grants and financial aid, is $7,605 for in-state students and $11,990 for out-of-state students at a public college and $27,293 for a private nonprofit institution. The average cost of a public graduate school is about $39,000.

And that does not include room and board.

The current U.S. tax code provides several ways to help American students pay for a “post-secondary” education.  Let’s take a look at the “education menu” of tax breaks.

(The following slides represent only an introduction to each item. Note that each has its own set of unique rules and regulations, especially when combining them on your tax return. For more information you should consult your tax professional.)

American Opportunity Credit

This benefit provides a maximum credit of $2,500 per student -- 100% of the first $2,000 of qualified expenses and 25% of the next $2,000. To get the maximum credit you must spend at least $4,000 on tuition or educational expenses. The student must be pursuing an undergraduate degree or other recognized education credential.

The credit is available for the first four years of post-secondary education. Qualified expenses include tuition, fees, and required “course materials” such as books and supplies.

The credit is phased out for single taxpayers with “modified” Adjusted Gross Income (MAGI) of between $80,000 and $90,000 and joint filers with MAGI of $160,000 to $180,000. No credit is allowed for married couples who file separately. These amounts are not indexed for inflation.  “Modified” AGI begins with regular AGI and adds back any exclusion or deduction for foreign income, foreign housing costs, income for residents of certain U.S. possessions, and income from Puerto Rico.

Up to 40% of the total credit, to a maximum of $1,000, may be refundable. A taxpayer can get back more money then he paid in!

Generally you cannot claim this credit if you are a dependent. But if the MAGI of a dependent student’s parents exceeds the phase-out, the parents can elect not to claim the student as a dependent. The student cannot claim himself, but can claim a credit of up to the amount of his income tax liability. None of the credit is refundable.

 

 

Tuition and Fees Deduction

While the American Opportunity Credit is only available for the first four years of undergraduate costs, taxpayers can claim an “above the line” deduction for qualified undergraduate and graduate school tuition, fees, and required course materials. You do not have to itemize to claim the deduction.

The deduction is available for up to $4,000 in expenses for joint filers with Modified Adjusted Gross Income of $130,000 or less, and up to $2,000 for couples with an MAGI of between $130,001 and $160,000. For single filers the MAGI cutoffs are $65,000 or $80.000.

You cannot claim this deduction if you are married filing separately, if you qualify as a dependent of another taxpayer whether or not you are actually claimed as one, or if you claim the American Opportunity or Lifetime Learning Credit. And you cannot deduct expenses paid with a tax-free education benefit like a scholarship or employer-provided assistance.

Lifetime Learning Credit

This credit is available for all years of post-secondary education, including graduate school, as well as education to acquire or improve one’s job skills. Unlike the American Opportunity Credit, the student does not have to be a degree or certificate candidate; it is available for students taking even a single class. The cost of course materials, though, is not included in calculating the Lifetime Learning Credit.

The amount of the credit is 10% of up to $20,000 in expenses, for a maximum of $2,000. While the American Opportunity Credit maximum is per student, the Lifetime Learning Credit maximum is per tax return. You can have two dependents in college during the year and each can generate up to $2,500 as an American Opportunity Credit, for a total of $5,000. But if you have two dependents in graduate school in the same year the maximum Lifetime Learning Credit you can claim for both combined is $2,000.

The MAGI phase-out ranges for the Lifetime Learning Credit in 2011 is from $102,000 - $122,000 for joint filers and $51,000 - $61,000 for single filers. No credit is allowed for married couples filing separately.

Employer Educational Assistance

You can receive up to $5,250 per year for college expenses from an employer-sponsored educational assistance program tax-free. These benefits are not included in the taxable wages reported in Box 1 on your Form W-2.

To qualify as an educational assistance program the plan must be written and it must meet certain other requirements. Your employer can tell you whether there is a qualified program where you work. What’s more, the payments do not have to be for work-related courses. Tax-free benefits include payments for tuition and fees and course materials. The payments may be for either undergraduate or graduate-level courses.

Tax-free benefits do not include payments for courses involving sports, games, or hobbies unless they have a reasonable relationship to the business of your employer, or they are required as part of a degree program.

 

Savings Bond Interest Exclusion

You may be able to exclude from taxable income the interest accrued on U.S. Series EE or I Savings Bonds issued after Dec. 31, 1989 that are cashed in to pay for qualified college expenses.

The owner of the bonds that are cashed in must have been at least 24 years old before the bonds’ issue date. The bond proceeds must be used to pay for tuition and fees at a college, university, or vocational education institution for the bond owner or the spouse or dependent of the owner. The age requirement eliminates bonds that children received when they were born or at birthdays, graduations, or other milestone events. Parents must be the owners of bonds used to pay for their children's education.

The cost of course materials and room and board do not qualify for the exclusion, but contributions to a Qualified Tuition Program or an Education Savings Account do.

A full 100% of the interest is tax-free if the total proceeds (principal and interest) of the bond redemption are less than the total qualified education expenses incurred in the year of redemption. If the amount redeemed is more than the allowable expenses then the excludible interest must be pro-rated.

Needless to say there is a MAGI phase out. For 2011 the exclusion phases out for MAGI between $106,650 and $136,650 for married taxpayers filing jointly and $71,100 and $86,100 for singles. No exclusion is allowed if the married taxpayers file separately. In this situation MAGI is regular AGI after adding back the exclusions for foreign income and housing, income from certain U.S. possessions and Puerto Rico, and employer adoption expenses, and the deductions for foreign housing, student loan interest, tuition and fees, and domestic production activities.

Education as an Employee Business Expense

You can deduct on Schedule A as an “employee business expense”, or on Schedule C if self-employed, the cost of education that is expressly required by an employer, by law or by government regulation, or if it maintains or improves skills required in your current trade or business.

Education is not deductible if it is the minimum requirement for a trade or business or if it prepares one for a new trade or business, even if the taxpayer does not intend to enter the new trade or business.

Deductible expenses include:

  • Tuition, fees, textbooks and supplies
  • Round-trip transportation to the educational institution
  • Meals (at 50%) and lodging while away from home
  • Lab fees, student cards, insurance and degree costs
  • Writing expenses for term papers and dissertations (i.e. research and typing)

Generally, expenses for education that lead to a degree are not deductible. It is assumed that an undergraduate degree is the “minimum requirement” for a trade or business and a graduate degree usually prepares one for a new trade or business. A graduate degree may be deductible in certain circumstances, and more lenient rules apply for the graduate education of teachers.

 

 

Qualified Tuition Plan

Perhaps the best way to save for college is with a Qualified Tuition Program (QTP), also known as a “Section 529 Plan”.  Contributions to a QTP are not deductible, but the earnings that accrue over the years are tax-free if used for qualified education expenses.

There are two types of Qualified Tuition Programs :

  1. Prepaid Tuition Plan: You purchase future tuition credits at a specified institution, often at current tuition prices, for a designated student.
  2. Savings Plan: You contribute to an investment account that will be used to pay for the qualified higher education costs of a designated student.

You can use money accrued in a Section 529 plan to pay for tuition, required fees, books, supplies and equipment, computer equipment and services, special needs services, and room and board for someone who is at least a half-time student. If the designated beneficiary does not use all of the monies that have accrued in the plan for qualified expenses, or does not go to college, the cash can be transferred to another beneficiary in the same family.

There are no statutory limitations to the amount that can be contributed to a Section 529 Plan, though there are Gift Tax considerations. Basically you can contribute whatever is necessary to provide for the qualified education expenses of the beneficiary. There are no MAGI income phase-outs. Anyone can contribute to a Section 529 Plan regardless of income.

Coverdell Education Savings Account

This is like a ROTH IRA for education. Contributions are not deductible, but they grow tax-free until distributed, and distributions are tax-free if they are used for the beneficiary’s qualified education expenses at an eligible institution.

Individuals can contribute up to a maximum of $2,000 per student beneficiary per year to a Coverdell ESA. The beneficiary of the account must be under the age of 18 at the time the contribution is made, but there is no requirement that the beneficiary be your child or have any other particular relationship to the taxpayer.

Of course there is a MAGI phase-out range: $95,000-$110,000 for singles (including married people filing separately) and $190,000-$220,000 for married couples filing jointly.

The beneficiary can also make contributions to the ESA. There is no requirement that the person making the contribution have earned income. If the parents’ AGI is more than the phase-out amount they can gift the money to the child and have the child make the contribution to the Coverdell ESA. Monies remaining in the account must be distributed as taxable income to the beneficiary within 30 days after he reaches age 30. As with the QTP, monies can be rolled over to an ESA for a family member.

What is good about a Coverdell ESA is that distributions can be used for qualified education expenses for kindergarten through 12th grade as well as college and graduate school. Qualified expenses include tuition, fees, books, supplies and equipment (not computers), and room and board for students enrolled at least half-time.

 

 

Student Loan Interest

You can deduct “above the line” up to $2,500 in interest paid on qualified student loans (used to pay for post-secondary education – college or vocational school) for yourself, your spouse, or your dependent. You do not have to itemize to benefit from this deduction.

In order to claim the deduction you must have the “primary obligation” to repay the loan and you must actually make the payments. If the student has the primary obligation to pay the loan, but the payments are made by the parents, neither the parents nor the student can claim the Student Loan Interest deduction.

Student loan interest paid is reported on Form 1098-E. As a general rule, the Social Security number and name of the person with the “primary obligation” appears on this form. If you are claimed as a dependent on your parents’ (or anyone else’s) tax return you cannot deduct student loan interest on your return, even if you have the primary obligation and make the payments.

The amount you can deduct is phased out as your Adjusted Gross Income (AGI) goes from $60,000 to $75,000 if you are single, or from $120,000 to $150,000 on a joint return. You cannot claim the deduction if you are married and filing separately.

Sometimes the best preparation you can do for tax season is to make sure your paperwork is in order. Check out MainStreet's look at What Forms to Take to Your Tax Preparer! And be sure to check out MainStreet's Tax Center for all the latest tax tips!

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