As the calendar turns to August, many students begin to lament the end of summer and the upcoming first day of school. Similarly, many parents of college-aged children are dreading the fall tuition bills arriving from universities. Paying for college is one of the largest financial investments many families make, and the costs continue to increase.
For several decades the federal government has sought to alleviate some of the financial burden by offering education-related tax breaks to students and their families. During the tax reform process last year, there were several proposals that called for modifying or eliminating certain education tax breaks.
Fortunately, most of the major tuition tax breaks are still in place for the 2018 tax year. This post aims to provides a refresher on the three major individual income tax breaks for paying higher education expenses, along with some planning ideas to consider in order to maximize your potential tax savings.
This is the most lucrative of the education tax breaks, allowing families to claim a tax credit of up to $2,500 per student, per year. The credit is calculated by taking 100% of the first $2,000 spent on qualified education expenses plus 25% of the next $2,000 spent. For eligible families, this means a $2,500 tax credit can be claimed on $4,000 of qualified higher education expenses paid in the year.
Qualified expenses include fees mandatory for enrollment at the school: tuition & fees, books, supplies, and required equipment.
Qualified education expenses do not include optional fees that are not required for enrollment: health insurance, student activities, or athletics. Room & board are also not eligible for the credit.
If a student is not eligible for the American Opportunity Credit, they can look instead to the Lifetime Learning Credit. This credit typically provides a smaller tax benefit but is available to a wider range of students.
The Lifetime Learning Credit offers a tax credit equal to 20% of the first $10,000 of education expenses (maximum $2,000 annual credit per year). The credit is available for an unlimited number of years, for both degree and non-degree programs, making this a viable option for graduate students or others who do not meet the degree/enrollment requirements of the American Opportunity Credit.
Qualified education expenses for the Lifetime Learning Credit are similar to those for the American Opportunity Credit, but the expenses for the Lifetime Learning Credit must be paid to the educational institution.
This provision expired at the end of 2017, but it’s possible Congress may extend it to 2018 as has been done the past several years. If this deduction is retained for 2018:
Taxpayers who are not claiming the American Opportunity Credit or Lifetime Learning Credit may claim an above-the-line deduction of up to $4,000 for qualified higher education expenses paid in the year.
This deduction is most frequently used when a taxpayer is ineligible for the American Opportunity Credit and their income phases out the Lifetime Learning Credit. It is also possible in certain circumstances for this deduction to yield a greater tax savings than one of the education tax credits.
The deduction is available for an unlimited number of years, for both degree and non-degree programs, similar to the Lifetime Learning Credit. Qualified education expenses for the Tuition & Fees deduction are also the same as those for the Lifetime Learning Credit.
In order to qualify for these tax benefits, eligible expenses must be paid to ‘eligible institutions.’ Eligible institutions are any accredited post-secondary educational institutions eligible to participate in a student aid program administered by the US Department of Education (which includes certain institutions outside the US). An institution should be able to confirm whether it is eligible for you, or there is a ‘school code search’ at https://fafsa.ed.gov
When claiming any of these tax benefits, it is critical to keep for your records the necessary documentation supporting the education expenses paid in the year. The IRS requires you retain a copy of the Form 1098-T from the university, along with any other receipts, cancelled checks, or transcripts from the university’s bursar office. Note that the Form 1098-T, while required, is not sufficient on its own. The Form 1098-T typically just reports amounts billed during the year; you must retain additional documentation of amounts paid during the year.
Remember that the tax benefits are claimed in the year the expenses are actually paid, not the year they are billed or semester they relate to. These tax credits (particularly the refundable American Opportunity Credit) are often misused and as such, are often questioned by the IRS.
The tax breaks are generally easy to verify under IRS scrutiny as long as you have retained the necessary documentation.
While we appreciate the government’s efforts to alleviate some of the financial burden of paying for college, their work has left us with a complex and uneven landscape that requires annual planning.
If you have a family member paying for higher education, there are at least three tax planning questions to ask annually:
1) Which funds should be used?
We will devote a separate post in the future to the various provisions available for tax-efficient education savings and education funding sources (529 Plans, Coverdell accounts, etc). For purposes of this post, it is important to remember that expenses paid from such tax favored accounts are generally not eligible for the tax credits discussed above.
For example, consider a family that expects it will be eligible for the American Opportunity Credit but also has money set aside in a 529 Savings Plan. This family may choose to pay the first $4,000 of annual education expenses out of pocket, thereby qualifying them for the maximum $2,500 tax credit. And then for any annual education expenses beyond the first $4,000, the family would look to use their 529 Savings Plan.
2) Which tax break to claim?
Given the various requirements for each credit/deduction, it is possible for a family member to qualify for multiple tax breaks each year, but they can only use one per year.
This analysis must factor in all household members who are paying education expenses during the year. Your tax advisor should be running an optimization calculation each year to provide you with the answer to both of those questions when preparing your tax return.
3) Who claims the tax break?
The American Opportunity Credit and Lifetime Learning Credit may be claimed by either the student or the parents of the student (if the student qualifies as their dependent). The credits are often claimed on the parents’ tax return since this is typically where the greatest tax savings can be achieved.
For example, consider a student that qualifies for the American Opportunity Credit but their parents’ income is $200,000, and thus any eligible credit is phased out for the parents. If the child has taxable income to report on their tax return, the education expenses can be moved to the child’s tax return and the child can claim a tax credit.
By doing so, the parents may lose a federal dependency tax credit and a state tax exemption for the child. But the benefit of the federal education tax credit for the child may outweigh the forfeited tax benefits of the parents.
As a result of the ability to claim the tax credit on either the parents’ tax returns or the child’s tax return, we recommend having the family’s tax returns prepared at the same time each year, and having the education optimization factor in this question as well. Again, your tax advisor should be optimizing not only which tax break is best each year, but which taxpayer should claim the best tax break available.
*Modified Adjusted Gross Income for these purposes: Adjusted Gross Income increased by the exclusions for foreign earned income, foreign housing, and income from certain US possessions and Puerto Rico
Dan Larson is the Director of Tax Planning at Wealthquest, a Cincinnati-based financial planning and wealth management firm that offers a full range of financial services under one roof, for one simple fee. Wealthquest’s team approach is built to provide holistic solutions to interrelated financial decisions, including education planning. Our team of investment advisors, financial planners, and tax advisors work together to provide families with a personalized strategy to help them save and pay for college.