Q: Tax Playa, what type of tax advantages are there for education?
Chris, Washington DC
A: In general, the many and varied tax benefits for education fall into several categories: savings accounts, deductions and credits, employer help, and exclusions from income.
For more information on these education benefits, consult IRS Publication 970, Tax Benefits for Education.
The first thing to say out front is that these benefits are mutually exclusive of each other. For instance, you can't take $25,000 out of your 529 plan to pay for college one year and then turn around and take the Hope Credit with the same money. One bite at the apple.
The second caveat I have is that the exact definition of "qualified higher education expenses," "tuition and fees," etc. tend to vary from benefit to benefit. If you're interested in getting in the weeds on that, consult Pub. 970 and read the relevant section.
The IRS identifies no less than 12 separate tax advantages for education. I will group them into four major categories to make understanding them easier:
I. Savings Accounts
1. Coverdell Education Savings Account (ESA). These accounts act like Roth IRAs. After-tax money goes in, and the money grows tax-free if used for education. The limit is $2000 per year per student. Contributions are phased out if the contributor's AGI hits $95,000-$110,000 ($190,000-$220,000 for married filing jointly returns). The money can be used for virtually any education cost of a child from nursery school through grad school. The designated beneficiary can be changed at any time to a family member under age 18, but if the beneficiary turns 30, the account must be liquidated.
Non-education distributions are subject to taxes and a 10% penalty on earnings from the contributions.
2. 529 College Savings Plans. These accounts also act like Roth IRAs. After-tax money goes in, and the money grows tax-free if used for higher eduction costs.
They are run by the states, which often have their own rules for annual contribution limits and how big an individual 529 plan can get. Often, states will give at least a partial state income tax deduction for contributing to their state's 529 plan.
The money can only be used for higher education expenses.
Non-education distributions are subject to taxes and a 10% penalty on earnings from the contributions.
II. Deductions and Credits
1. Tuition and Fee Deduction. Actually an adjustment (taken by itemizers and non-itemizers against gross income to compute AGI), this benefit is capped at $4000 of higher education expenses per year (no matter how many students in the household).
The adjustment is disallowed for dependents, married filing separately taxpayers, nonresidents, and those with AGI above $80,000 ($160,000 for married filing jointly).
You do not need to be in a degree program for the higher education expenses to qualify.
2. Hope Scholarship Credit. A credit of $1800 per eligible student is allowed for the first two years of qualified higher education expenses in a degree program in which the student is enrolled at least half time.
The credit is for 100% of the first $1200 in expenses and 50% of the second $1200 in expenses for each qualified student in 2007.
Allowance of the credit phases out between $48,000-$58,000 AGI ($96,000-$116,000 married filing jointly). It is also disallowed for the usual three suspects: dependents, non-residents, and married filing separately taxpayers.
3. Lifetime Learning Credit. A credit of 20% of the first $10,000 in higher education expenses is allowed for this credit. It can be for any year of higher education, does not require at least half-time enrollment, and does not need to be in the context of a degree program. The credit limit is per return, not per qualified student.
Allowance of the credit phases out between $48,000-$58,000 AGI ($96,000-$116,000 married filing jointly). It is also disallowed for the usual three suspects: dependents, non-residents, and married filing separately taxpayers.
4. Student Loan Interest Deduction. Actually an adjustment, this allows up to $2500 per return of student loan interest to be deducted against gross income to calculate AGI. The student loan must have been for higher education tuition and fees in a degree program.
This benefit is phased out for taxpayers with AGI of $55,000-$70,000 ($115,000-$145,000 for married filing jointly taxpayers).
III. Employer Help
1. Employer Provided Educational Assistance. Your employer can provide a fringe benefit to you of up to $5250 per year in a qualified plan for tuition, fees, and expenses for either graduate or undergraduate studies. They do not need to be related to your employment.
2. Business Deduction for Education Expenses. In order for education expenses to be deductible under this provision, the classes must be required by your employer or the law, and be used to maintain or improve skills in your present line of work. Any expenses paid for by your employer are not deductible to you.
If you are an employee, you take the deduction as a miscellaneous itemized deduction. Only those who itemize their deduction (less than a third of taxpayers) can do this. Even if you are one of those third, all of your miscellaneous itemized deductions must be reduced by 2% of AGI, and you can claim what is left. Even if you have something left over after this, the AMT or the Pease deduction phaseout may disallow the deduction. Suffice it to say, this isn't a lucrative deduction.
A more lucrative deduction exists if you are self-employed. Assuming you meet the tests above, you can deduct the expenses against self-employment income. This gives you a double-deduction: one for the income tax, and one for the onerous self-employment tax.
3. Student Loan Cancellations and Repayment Assistance. States and the federal government will often have programs to forgive student loans for graduates who work in specified fields (teachers in at-risk schools, primary health services, etc.) Student loan debt is either canceled or repayed by the sponsoring organization. This does not need to be included in income.
IV. Exclusions from Income
1. Scholarships, Fellowships, Grants, and Tuition Reductions. Degree program students can exclude scholarships and fellowships for tuition, fees, books, supplies, and equipment.
Grants and most qualified tuition reduction programs are also generally tax-free.
Any of this income which does not qualify for tax exemption must be included in income.
2. Education Exception to 10% Penalty on Early IRA Withdrawals. If you take money out of an IRA before age 59 1/2, you generally must pay taxes and a 10% penalty.
One exception to having to pay the penalty (though not the tax) is for qualified education expenses (see IV-1 above). If the student is half-time or better, room and board also qualifies.
3. Education Savings Bond Program. Probably the least-used of any education tax advantage. If you have a Series EE or Series I bond, and cash it in, you have to pay interest that year. However, if you have qualified higher education expenses, you can exclude the interest income to the extent of those expenses.
This break phases out between AGI of $100,650-$130,650 if married filing jointly ($67,100-$82,100 all others). It isn't allowed for married filing separately taxpayers.
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