Education Credits and Deductions
The education of your children, or even of yourself and your spouse, can be a major investment. Knowing if your college-age child is still a dependent, what scholarships are taxable, and which tax credits are available can be confusing. You need to consider your situation to determine which options are best for you. Tax planning is essential to make the most of these benefits. You need to know which one of the options are best for you based on your income the varying definition of allowable expenses. You should also consider issues such as the student's eligibility for financial aid and who has control over the money used for college. In certain circumstances, it might be better to have the child pay the education expenses rather than the parent.
Keep the following in mind when determining the best way to claim a tax break for education:
- Is the student a dependent?
- Does the student have any Scholarships or Grants?
- Did you pay any student loan interest?
- Does the student have a Coverdell Education Savings Account?
- Does the student have a Qualified Tuition Program?
- What are the Education Credits?
- Does the student have eligible savings bonds?
Whether a student is claimed as a dependent on your tax return may affect yours, or the student's eligibility, for the different tax benefits available for education expenses.
A student is someone enrolled in school full-time for at least five months out of the calendar year. A full-time student under age 24 who has a job may still be claimed as a dependent on their parents' return.
Scholarships and Grants
If a student is a candidate for a degree, they can exclude from income the amount of scholarship or grant used for tuition, books, and fees. The amount of the scholarship or grant that is used for room and board or for teaching or research is considered taxable income even if the teaching or research is a condition for receiving the scholarship or grant.
Students who win a scholarship prize in a contest must include the amount as prize winnings on their tax return unless the prize is designated to be used for educational purposes only.
Payments, or scholarships received from the Department of Veterans Affairs, National Health Services Corps Scholarship Programs or by the Armed Forces Health Professions Scholarship and Financial Assistance Program are not included in income.
Student Loan Interest Deduction
You may be able to deduct up to $2,500 of interest you paid on a qualified student loan to attend an accredited, higher educational institution. The loan must have been for you, your spouse, or someone you claimed as your dependent when you took out the loan. This deduction is an adjustment to income so you can claim it even if you do not itemize deductions on Schedule A, Itemized Deductions. Your modified adjusted gross income must be less than $75,000 ($150,000 if Married Filing Jointly). If you are filing Married Filing Separately, you cannot take this deduction.
Qualified expenses used to claim the tuition and fees deduction must be reduced by any tax-free benefits received, such as distribution of earnings from a Qualified Tuition Program (QTP) or tax-free savings bond interest. Qualified expenses must also be reduced by the full amount of a Coverdell Education Savings Account (Coverdell ESA) distribution.
Coverdell Education Savings Account (ESA)
The Coverdell Education Savings Account (Coverdell ESA) is an account for the sole purpose of paying for the qualified education expenses of the designated beneficiary of the account.
the beneficiary can use the funds in the Coverdell ESA to pay for their qualified expenses of attending a public, private, or religious school at the elementary, secondary or higher education levels. Qualified expenses include books, tutoring, computer equipment, software and services, room and board, uniforms, extended-day program costs, and the expenses of an individual with special needs that are necessary for that person's enrollment or attendance at an eligible educational institution.
Anyone, including the beneficiary, can establish and contribute to this account but contributions can not exceed $2,000 per year, per beneficiary. You can make a contribution to a Coverdell ESA if your modified adjusted gross income for the year is less than $110,000 ($220,000 if Married Filing Jointly). If your modified adjusted gross income is above the limit, it is possible for you to provide the beneficiary with the money as a gift and have the beneficiary make the contribution on their own behalf, as long as the beneficiary's income is not over the limit. No contributions can be made to the account once the beneficiary turns age 18, unless the beneficiary is an individual with special needs.
The contributions are not tax deductible but earnings are tax free to the beneficiary if they are used to pay for qualified education expenses. A 10% penalty may apply to a distribution that is not applied to qualified education expenses. Money remaining in the account after a beneficiary is no longer in school can be rolled into another family member's Coverdell ESA account tax free if certain conditions are met.
Contributions to a Coverdell ESA are considered a gift from the contributor to the beneficiary and are eligible for the annual gift tax exclusion.
Qualified Tuition Program (QTP)
A Qualified Tuition Program (QTP or Section 529 plan) is a program that allows you to prepay a student's college tuition or contribute to a higher education savings account for payment of qualified higher education expenses. Qualified expenses include books, supplies, equipment, and room and board if the student is attending at least half-time. Half-time attendance is defined by the institution. Plans can be established by a state agency or by a qualified educational institution. You are not restricted to investing in your state's plan, but contributions to your own state's plan may qualify you for certain additional tax benefits on your state tax return.
Contributions to a QTP are not tax deductible. If not used for qualified educational expenses, distributions may be subject to a 10% additional tax. Money remaining in the account after paying for a beneficiary's qualified expenses can be rolled into another family member's QTP account tax free if certain conditions are met.
Contributions to a QTP are also considered a gift from the contributor to the beneficiary and are eligible for the annual gift tax exclusion.
You can contribute to both a QTP and a Coverdell education savings account in the same year for the same beneficiary.
Higher Education Credits
The following two tax credits are available to taxpayers who pay higher education costs:
- The American Opportunity Credit
- The Lifetime Learning Credit
The American Opportunity Credit is a credit of up to $2,500 for the qualified tuition and related expenses paid for each eligible student. The credit is 100% of the first $2,000 of qualified expenses plus 25% of the next $2,000 of qualified expenses paid per student. It can be claimed for the first four years of postsecondary education for each student. The student must be enrolled at least half time in a qualified program and must not have been convicted of a felony drug offense. Eligible expenses include tuition, required fees, and the cost of required books and software for courses.
You do not qualify for the credit if your modified adjusted gross income is greater than $90,000 or $180,000 if married filing jointly.
The American Opportunity Credit is unique in the fact that it combines both a nonrefundable and a refundable credit in one. The first 40% of the credit up to $1,000 is refundable with the balance of the credit treated as a nonrefundable credit. This unique feature allows you to receive the refundable portion of the credit as a refund if you have no remaining taxes.
You may be able to claim a Lifetime Learning Credit of up to $2,000 each year for the total qualified tuition and related expenses paid during the tax year for all eligible students who are enrolled in eligible educational institutions. This credit is 20% of the first $10,000 of qualified expenses paid per tax return. Unlike the American Opportunity Credit, the Lifetime Learning Credit is not based on the student's workload and is not limited to the first two years of postsecondary education. Expenses for graduate-level degree work are eligible. You do not qualify for the credit if your income is greater than $66,000 ($132,000 if Married Filing Jointly). The Lifetime Learning Credit is a nonrefundable credit. This means that if your taxes are less than your credit, then you will lose any remaining credit amount left after you reduce your income taxes to zero.
You do not qualify for either credit if your filing status is Married Filing Separately. In addition, you cannot claim both the American Opportunity Credit or the Lifetime Learning Credit for a student in the same year. You must claim the student as a dependent to receive either education credit. If you do not claim the student as a dependent, or if someone else is eligible to claim the student as a dependent but elects not to, only the student may claim the credit. A student claimed as a dependent on another person's tax return cannot claim the credit. Claiming the American Opportunity Credit may be more beneficial than claiming the Lifetime Learning Credit, if you are eligible for both.
For example, Brad's filing status is Single, and he has wages of $31,000. After allowing for the standard deduction and personal exemption amount, his tax is just over $2,500. He is a sophomore in college and paid $10,000 in qualified tuition expenses during the year as part of a degree program. He has no other income or deductions. Brad has the choice of taking the American Opportunity Credit or the Lifetime Learning Credit. He should choose whichever option gives him the biggest tax savings:
- If Brad takes the Lifetime Learning Credit instead, he would save $2,000 in taxes (the maximum credit amount) because his income is below the limits.
- If Brad takes the American Opportunity Credit instead, he would save $2,500 in taxes (the maximum credit allowed) because his income is below the limits.
The American Opportunity credit gives him $500 more in tax savings than the Lifetime Learning credit would.
Brad should claim the American Opportunity Credit for the best bottom line on his tax return.
Education Savings Bond Program
You may exclude interest on qualified U. S. savings bonds from your gross income if you have paid qualified higher educational expenses during the redemption year. When calculating the amount of higher education expenses paid during the year, you may include any contribution of the bond proceeds to a QTP and any contribution to a Coverdell ESA as a qualified expense. You do not qualify for the exclusion if your filing status is Married Filing Separately or if your modified adjusted gross income is $93,150 or more ($147,250 if Married Filing Jointly) in the year the bond is redeemed.
Contact your neighborhood Jackson Hewitt office for more information or assistance. Use the Office Locator available on this Web site or call 1-800-234-1040 to find the Jackson Hewitt location most convenient to you.