Plain Talk: Tax Savings for Higher Eduction

There are several ways to receive a tax benefit if you are incurring higher education costs. It can be confusing to understand all of the options, so I'm breaking it down for you in plain talk.

Credit vs. Deduction. The difference between a credit and a deduction is significant. Deductions pertain to reducing the amount of income that you are taxed upon. Common deductions are mortgage interest, taxes, and charitable contributions. They will decrease your tax bill indirectly by reducing your taxable income. Think of a deduction as a 25% off coupon. You will still owe tax, just not as much. A credit however, is like an angel paid part of your tax bill for you. It is a dollar-for-dollar reduction of your tax liability. Remember, tax liability equals taxable income multiplied by your tax rate. This begs the question: Wouldn't you always want to claim a credit? Who wants a silly deduction when there are credits available? Let's talk about the differences.

Who gets to claim the credit or deduction? If you are paying for undergraduate or graduate education for yourself or your dependent, (and you're not a dependent on anyone else's return) you are eligible for savings under one (only one!) of three avenues: American Opportunity Credit, Lifetime Learning Credit, or Tuition and Fees Deduction. Please note, if the student qualifies as a dependent on their parents (or someone else's) return, the student is not eligible to take the credit or deduction.

American Opportunity Credit: A $2,500 credit per student is available for $4,000 of qualifying education expenses (100% of the first $2,000; 25% of the next $2,000) if your student is enrolled at least half-time in a degree program. Forty percent of the credit is refundable. This means that if this credit is enough to generate a refund for you on your return, the refund is limited to 40% of the credit, or a max of $1,000. There are exceptions to the refundable portion, and you should contact your tax professional for guidance if your filing status is not Married Filing Jointly. I mentioned qualifyingeducation expenses, which connotes that there are nonqualified expenses. Amounts spent for room and board, insurance, transportation or other personal living expenses do not qualify for the credit. This credit is also limited to four years, and although it is the highest credit available, its many restrictions disqualify some taxpayers. Case in point: if your AGI is $160k or more, you are ineligible for the credit.

Lifetime Learning Credit: A $2,000 max non-refundable credit per return is available if you have spent $10,000 in qualifying expenses (there's that word again!), but the amounts must be paid directly to the institution. Unlike the AOTC, the student need not be enrolled in a degree program to claim the credit. Here's the caveat: once your Married Filing Jointly AGI hits $111k, the credit starts to phase out. The most exciting part of this credit is that it can be used if you incur expenses related to courses taken to acquire or improve existing job skills! So all of you high-achieving working peeps who take evening classes are now eligible to claim a credit! Pretty cool!

Tuition and Fees Deduction: By now, you should know that the deduction is not as powerful as the credit. This deduction is available to you, your spouse or your dependent for qualified expenses paid directly to the institution, and is worth a max deduction of $4,000 if you file Married Jointly and your AGI is $130k or less; $2,000 if filing Married Jointly and your AGI is $160k or less; and a big fat zero if your AGI is over $160k.

Other Avenues to Save:

Student Loan Interest Deduction: If you incur debt in the form of a student loan, you get an above-the-line deduction of $2,500 for interest paid on the loan. I know, I threw a new term at you. An above-the-line deduction is an amount that you get to subtract from gross income to arrive at adjusted gross income. The best part about these types of deductions is that you do not necessarily have to itemize your deductions to claim one.

Penalty-Free (but not Tax-Free!) IRA Distributions: This is a tough one, because I rarely recommend withdrawing retirement savings before age 59 1/2. However, people do, and the IRS waives that automatic 10% penalty for early withdrawal. But guys, the amount you withdraw is still taxable! And, the tuition has to be paid in the same year as the distribution. Be careful with this one, and be sure to consult your tax professional before deciding on this option.

Bottom Line: you can only take advantage of one of these options. The IRS calls this a double benefit restriction, meaning that you cannot claim more than one education benefit for the same qualifying expense. Check with your tax pro to see which one fits you best!