Tax Breaks / Credits Available
Paying for college can be incredibly expensive, but the IRS will help you take a little sting out of bearing the cost. Here is a quick summary of some of the tax breaks available.
American Opportunity Tax Credit
This new tax credit is a component of the American Recovery and Reinvestment Act; it basically replaces the Hope Tax Credit. Qualifying taxpayers can get a $2,500 credit per student enrolled in college; if you have four kids in college, you can claim $10,000 in tax credits. The credit is determined based on the following formula:
- Dollar for dollar on the first $2,000 of education costs, then
- 25% of education costs, up to a total of $2,500. (So, if you spend $4,000 or more, you max out the credit.)
The American Opportunity Tax Credit begins to phase out for single taxpayers with modified adjusted gross incomes between $80,000 and $90,000; the phase out begins between $160,000 and $180,000 for married couples.
This credit is considered a "top line" credit; you do not have to itemize deductions to receive the credit.
Lifetime Learning Tax Credit
The Lifetime Learning credit is available for an unlimited number of years and does not require a student to maintain a specific minimum course load. Graduate students also qualify. The Lifetime Learning Tax Credit is a maximum of $2,000 per year and is based on a 20% credit on tuition and fees. So, if you spend $10,000 on college expenses, you max out the Credit; expenses totaling $5,000 will result in a $1,000 credit.
Qualifying expenses include tuition and fees for you, your spouse, and any other person you can claim as a dependent on your tax return.
Qualification rules change from year to year; currently credits are phased out under guidelines similar to the American Opportunity Tax Credit.
Tuition and Fees Deduction
You could also choose to use the Tuition and Fees deduction instead of taking tax credit, deducting up to $4,000 of higher education costs. You do not, however, qualify if your modified adjusted gross income is higher than $65,000 (single) or $130,000 (married filing jointly). And keep in mind any expenses that were paid from a qualifying Section 529 plan are not considered qualifying expenses.
Also keep in mind the $4,000 maximum is an annual maximum regardless of how many students are in your household. If you only have one child in college, the Tuition and Fees deduction may be your best bet; if you have two or more children in college, taking the American Opportunity Tax Credit makes better sense.
Private College Grant
Some states give grants to students who attend in-state private colleges (not state-funded colleges and universities). In Virginia, for example, a grant of $2,500 per year is given for students who attend private colleges. Called the Virginia Tuition Assistance Grant, the goal of the grant is to help support and promote enrollment at those institutions. While strictly speaking this is not a tax credit, it is money you will not have to pay towards college expenses.
Check with your accountant or other financial professional for similar programs and tax credits in your state.
Student Loan Interest Deduction
Student loans qualify as a tax deduction as long as the student used the proceeds towards qualifying expenses like tuition, fees, room and board, and other directly-related expenses. If you qualify you may be able to deduct up to $2,500 in interest each year.
How will you know? If you paid $600 or more in interest, you will receive a Form 1098-E Student Loan Interest Statement.
You will not be required to itemize deductions in order to claim this deduction on your tax return.
Section 529 Plans
State sponsored college savings plans are a great deal for taxpayers since withdrawals made to pay college expenses for the plan's beneficiary (in other words, the student) are tax-free. The sooner you contribute to a plan, the less money you will need for college expenses.
How much can you contribute? Most college savings plans allow a lump-sum contribution of over $250,000. In many cases that much isn't necessary, especially if you plan for the student to attend a state school instead of a private school. If you want to stay within gift-tax guidelines, you can spread contributions over a five-year period so that each contribution is less than $13,000 (the current limit). That's how "gift tax" normally works; under a 529 Plan you can claim five years of exclusions at one time. So if you are married, you can contribute $26,000 per year (each person is allowed a $13,000 contribution) times 5 years, for a total of $130,000 − without facing gift tax issues.
Plans vary widely; some are state-specific while others let the student attend any qualifying institution in the country. Typically, though, state-specific plans offer state income tax benefits as well.
Keep in mind there are two types of 529 savings plan. A prepaid college tuition plan locks in the cost of tuition and fees; a college savings plan helps you cover other expenses like room and board, books, etc.
You can contribute to both types of plans, and receive tax breaks, regardless of your income level.