College tuition tax savings

Were you able to maximize your education tax breaks this year?

Sure …. Uh, actually I don’t know. All these terms like “deductions” and “non-refundable credit” kinda scare me.

That’s OK – the tax code can be pretty intimidating – just like finding financial aid for college.  However, the basic principle is fairly simple.  As a society, we try to encourage people to do useful things by giving them a nudge in the tax code. In theory, if someone does something we think is good[1], like give to charity or invest in new business equipment, we let them pay a bit less in taxes. Since investing in your own or your children’s education is something that is good for society, we subsidize that through the tax code – if you’re smart enough of take advantage of it.

How?

There are three general tax savings for college tuition. First, you can deduct qualified educational expenses. Or you might be able to claim either the American Opportunity Tax Credit or the Lifelong Learning Tax Credit.

There you go again with “deduction” and “tax credit.” What do those terms mean?

A credit is a direct reduction on the amount that you owe for taxes, while a deduction is a reduction in the amount of income subject to taxation.

That sounds clearer, but could you give me a concrete example?

No problem. Let’s say I make $1,000 a year at my job as an armadillo trainer, and the government charges a 10 percent tax rate.  In a normal year, I’d owe $100 in taxes.

But this year I paid $100 so I could go to college and get my degree in Gila-monster training so I can get a better job.  If government tax policy recognizes the critical shortage of Gila-Monster trainers and allows me to take a deduction for my tuition, I deduct $100 from my $1,000 income and only owe taxes on $900 of my earnings, which would be $90. As a result, I save $10 on my taxes.

If the government decides to offer a tax credit for my entire tuition, then I directly reduce my tax bill by the amount of my tuition — in this case I reduce my tax bill by $100, wiping out my tax liability entirely.  Some credits are refundable, meaning that the government will reimburse you all of the credit even if it is more than you owe in taxes, and some are non-refundable, meaning that the credit only removes your tax liability and nothing more.

So you’re saying that credits usually save more than deductions. What education credits are available to me?

There are two: The American Opportunity Tax Credit and the Lifelong Learning Credit. You can only claim one in any year for a given student. Most tax preparation software will ask you a few simply questions and automatically claim the one that gives you the most dollars back.

I like “American Opportunity,” it sounds so patriotic. Tell me more.

This is an expanded version of the “Hope Credit” that was signed into law as part of the 2009 stimulus package.  Filers with a modified gross adjusted income of under $80,000 (or $160,000 for a married couple) can claim the full credit of $2,500 for qualified educational expenses. The value phases out for higher incomes. Additionally, up to $1,000 can be a refundable credit – so even if you don’t owe any taxes, the government will essentially give you a $1,000 tuition discount.

The credit is especially valuable because of its structure – you get to claim the first $2,000 of your qualified academic expenses as a credit (and 25 percent of your next $2,000).

You can only claim the credit four years for any given student.

Wait – what are qualified educational expenses?

Tuition paid that tax year at an accredited institution of post-secondary education is the largest example, but for other ones see Question 5 of this IRS FAQ or for a detailed discussion see IRS publication 970.

Hmm, so how is the Lifelong Learning Credit different?

Five ways. First, its income limits are stricter – a Modified Adjusted Gross Income of $63,000 for singles and $127,000 for married couples filing jointly. (For some reason married couples filing separately cannot claim the Lifelong learning Credit.  Don’t ask us why.)

Second, the maximum size of the credit is smaller, only $2,000.  Third, the credit is structured differently – you can only claim a 20 percent of tuition paid up to $10,000 in qualified educational expenses. So if you paid $2,000 in tuition for tax year 2013, you can claim a $2,000 American Opportunity Credit but only a $400 Lifelong Learning Credit.

Fourth, the credit is non-refundable. Finally you can claim the credit for an unlimited number of years.

What about deductions?

If you don’t qualify for either of the credits, you can claim qualified education expenses as a deduction.  Single filers with a Modified Gross Adjusted Income of under $65,000 can deduct up to $4,000 from their taxable income, while those with incomes greater than $65,000 up to $130,000 can claim up to $2,000 in deductions.

In some cases, you can also deduct student loan interest.

Wow, this sounds a bit complicated, where can I get more information?

Detailed information about these tax credits and deductions as well as specific questions about what qualifies as an “educational expense” are available in IRS publication 970[4].  Or consult your friendly local tax professional.