Many people think of back-to-school season as a costly affair (new school supplies, clothing, etc.) without considering the opportunities it provides for tax savings and investments. Here are some federal and state income tax advantages related to education expenses that we believe all taxpayers should understand.
Lifetime Learning Credit (LLC)
Expenses that qualify for this tax credit include tuition and fees, along with books, supplies, and equipment required for enrollment, paid directly to an educational institution. Expenditures such as transportation, medical expenses, room and board are not allowable expenses under this credit.
This credit is calculated by taking 20% of the first $10,000 in qualified education expenses. Thus making the maximum tax credit potential $2,000 for all eligible students per tax return. The allowable amount of this credit could be reduced based upon taxpayers modified adjusted gross income and filing status. This tax credit cannot be claimed if another individual claims you as a dependent on his or her tax return.
One interesting element the LLC allows is the capability of taking classes, without the requirement of pursuing a degree or other form of credential. This tax credit is beneficial if an individual is a graduate student or even merely taking one class. Classes can be non-credit courses and would still qualify if it helps you to acquire or improve your job skills.
American Opportunity Credit (AOC)
The applicable expenses for this tax credit are similar to the LLC, although with a few caveats. Like the LLC, tuition and fees required for enrollment are allowed, however, under the AOC, expenses for books, supplies, and equipment required for courses of study, can be expenses not paid directly to the school.
The calculation for this tax credit takes 100% of the first $2,000 of qualified expenses and adds 25% of the following $2,000 of applicable expenses. This means the maximum potential tax credit is $2,500 for each qualifying student, which is a different parameter than what the LLC offers. Similar to the LLC, phaseouts apply based upon modified adjusted gross income and filing status. In addition, the AOC has the potential to allow 40% (or $1,000) of the AOC to be refundable, meaning you could have no tax liability and still receive a refund.
The AOC has more requirements and restrictions than the LLC. These include:
- The student must be enrolled at least half time in a college program, toward earning a degree or other education credential.
- The student must not have completed the first four years of post-secondary education at the beginning of the tax year.
- Not permitted if the student has been convicted of a federal or state felony drug offense.
Tuition and Fees Deduction
In most circumstances, the aforementioned tax credits are more beneficial than the tuition and fees deduction, however, if your filing status is married filing separately, you are not eligible to claim the credit for either the LLC or AOC. In this case, the Tuition and Fees Deduction can be a good option.
This deduction has the potential to reduce your income by $4,000 and does not require an individual to have itemized deductions. Again, phaseouts of the deduction do apply based upon income and filing status.
College Savings Plans (§529 plans) and Coverdell Education Savings Accounts (ESA)
Planning, rather than immediately spending for college, can provide tax benefits as well. A Coverdell ESA allows for a tax deduction of up to $2,000 contributed each year. When the beneficiary reaches age 30, any remaining balance in this type of account must be distributed within 30 days. Qualified education expenses include those for tuition, fees, books, supplies, equipment and special needs services as required. The Coverdell ESA is not limited to only being utilized for post-secondary purposes; it may also be permitted for elementary and secondary education expenses.
Amounts contributed to a §529 plan are not excluded from federal income tax purposes and are not limited to the annual contribution level of a Coverdell ESA. This allows additional contributions to be made and accumulate for post-secondary education savings. Some states offer tax deductions or credits based upon the level of contributions made to a §529 plan. This varies by state. Indiana, for example, allows a nonrefundable credit amount of 20% of the contributions, not to exceed $1,000 of tax credit. Ohio also offers §529 tax incentive deduction of up to $2,000. Most states require that the §529 contributions must be made to a designated plan as established by their respective state. States that currently allow §529 incentives from any state plans include Arizona, Kansas, Maine, Missouri, Montana, and Pennsylvania.
There are plenty of ways to turn back-to-school expenses into tax savings opportunities! If you have questions about which ones are applicable to you, please contact your local Blue & Co. representative.