"The incentives vary in terms of who may receive benefits, which expenses may be covered, and how large an exclusion, deduction, or credit may be allowed," she told the subcommittee. She also testified that the complexity of the educational tax incentives increases the record-keeping and reporting burden on taxpayers, and makes it difficult for the IRS to monitor compliance.
There is indeed a laundry list of tax deductions, credits and exclusions that related to educational expenses. Most apply to “post-secondary” (after High School) tuition, but some benefits can be used for “primary and secondary” (K-12) education and for books, supplies, room and board.
For example a recent post told you that withdrawals from a Coverdell Education Savings Account can be used for “tuition for any public, private, or religious school that provides elementary or secondary education (kindergarten through grade 12), as determined under state law”
The major tax benefits that relate to the costs of a college (post-secondary) education for yourself, your spouse, or a dependent are the HOPE and Lifetime Learning education tax credits and the “above-the-line” Deduction for Tuition and Fees. As with any item where you are given options you should compare these three tax benefits to see which provides the greatest tax savings.
The availability and amount of all three of these tax benefits is based on AGI. The phase-out range for these credits are available on the WHAT’S NEW FOR 2007 and WHAT’S NEW FOR 2008 pages of my website.
The Deduction for Tuition and Fees is limited to $4,000 for Married Couples with a “modified” AGI of under $130,001 and Single and Head of Household filers with a MAGI under $65,001, and $2,000 with corresponding MAGIs under $160,001 and $80,001. No deduction is allowed for couples with a modified AGI over $160,000 and individuals with a MAGI over $80,000. FYI, this deduction “expired” on December 31, 2007, but legislation has been introduced to extend it for at least tax year 2008.
None of these tuition tax benefits are available if you are married and filing separate returns.
The HOPE credit, named for Hope, Arkansas and not “I hope I graduate”, is limited to the first two fiscal years of postgraduate education. As of the beginning of the tax year the student must not have completed the first two years of college – the freshman and sophomore years. While this fiscal period can occur over three actual calendar years (the calendar year the student starts college as a freshman in the fall, the calendar year the student completes his freshman year and begins his sophomore year, and the calendar year the student finishes his sophomore year) the HOPE credit can only be claimed in two tax years for any individual student.
The maximum HOPE credit is $1,650 – based on $2,200 of qualified tuition and fees. It is determined as follows – 100% of the first $1,100.00 of tuition and 50% of the second $1,100.00. If the total tuition paid is $2,000 the HOPE credit is $1,550 ($1,100 + $900 x 50%). If the total tuition is $1,000 the HOPE credit is $1,000.00.
The Lifetime Learning credit is 20% of the first $10,000.00 of qualified tuition and fees – up to a maximum credit of $2,000. If the tuition and fees paid is $6,000 the Lifetime Learning credit is $1,200.
A student who began college in the fall of 2007 has two options for claiming the credit for 2008. If his total tuition for the year is $5,000 he would by better off with the HOPE credit, which would be $1,650. If his tuition for that year is $9,000 the Lifetime Learning credit would be $1,800 – which is "more better" than $1,650.
Remember that a credit is a dollar-for-dollar reduction of tax liability. So a $1,650 tax credit means $1,650 in your pocket – assuming the tax liability after other credits is at least $1,650 (the education tax credits are not “refundable”).
Also remember that the amount of the credit allowed is phased-out as AGI exceeds a certain amount. You may be entitled to a maximum $2,000 credit based on the amount of tuition paid, but your AGI may limit the amount of credit allowed to $1,000.
The Deduction for Tuition and Fees is an “above-the-line” adjustment to income. It is a tax deduction, not a credit, which reduces your Adjusted Gross Income and ultimately your Taxable Income. So your base tax savings from claiming this deduction is determined by your tax bracket. A taxpayer allowed a $4,000 deduction who is in the 25% tax bracket will save at least $1,000 in federal income tax. A $4,000 deduction for a person in the 28% bracket puts at least an additional $1,120 in his/her pocket.
In the case of both the credits and the deduction the amount of qualified tuition and fees paid must be first reduced by 100% of all tax-free scholarships, fellowships and grants, employer-paid educational assistance, veteran’s education benefits, and any other nontaxable payments (other than gifts or inheritances). These payments are not allocated between qualified (tuition and fees) and non-qualified (room and board, books and supplies) education expenses. So if your son’s total qualifying tuition and fees for the year is $10,000 and he receives a scholarship for $4,000, only $6,000 is eligible for a credit or deduction.
You also cannot “double-dip”. You cannot claim an education credit or tuition and fee deduction for qualifying expenses paid for by a tax-free distribution from an Education Savings Account or a Section 529 qualified tuition program. You cannot claim a Deduction for Tuition and Fees if a Hope or Lifetime Learning education credit is claimed for the same student.
Let us look at a couple whose modified AGI is below the beginning of the phase-out range for the education tax credits - which also means that the MAGI is less than $130,001. The couple paid $10,000 in qualifying tuition and fees for the calendar year. The student, a freshman at the beginning of the calendar year received a $5,000 scholarship and is reimbursed $1,000 from his father’s employer-paid education assistance program. This makes a total of $4,000 in available tuition and fees ($10,000 - $5,000+$1,000).
The amount of Lifetime Learning credit that can be claimed is $800 ($4000 x 20%). However, as the student is in his first fiscal year of college he/she is entitled to a HOPE credit of $1,650. The taxpayers are in the 25% federal tax bracket, so a $4,000 tax deduction would result in $1,000 in federal tax savings. In this situation it is clear that the HOPE education credit puts the most money in the taxpayers’ pocket.
However, if the student starts the year off as a junior, or if the taxpayers had claimed a HOPE credit for the two previous tax years, the Deduction for Tuition and fees would result in $200 more in tax savings than a Lifetime Learning credit. This is because the deduction provides a 25% savings on the $4,000 in qualified tuition while the credit provides only 20%. $4,000 x 5% = $200.
I recently began work on the GD extension for a new client (I know I say “read my lips, no new clients” – but this taxpayer technically qualified as he is the “child”, albeit in his 50’s, of an existing client). As usual with a new client I asked to see the prior two tax returns (in this case 2005 and 2006). I noticed that on the 2005 return he claimed a Lifetime Learning education credit for tuition and fees paid for the final (senior) year of his daughter’s college.
The tuition on which the credit was claimed was slightly less than $2,000. His MAGI was less than the amount required to receive the benefit of 100% of the credit, and he was in the 25% tax bracket by a little over $3,000. He should have claimed a Deduction for Tuition and Fees instead of the Lifetime Learning credit – as it would have reduced his tax liability by an additional $70+ (25% vs 20%). I will be preparing an amended return to do just this (there was also another error that I picket up – so that it is financially worthwhile to amend the return).
I have found that most taxpayers, as well as many tax preparers, will automatically claim an education tax credit if the MAGI is under the threshold amount. They will not check to see if the deduction is “more better”. Don’t make this mistake – calculate your 1040 tax liability claiming an education credit and calculate it again taking a Deduction for Tuition and Fees and see which results in the least tax liability. Also make sure to take into consideration resident and non-resident state and local taxes.
There may be an added benefit to claiming the deduction instead of the credit. A taxpayer in the 25% bracket who claims a deduction for $4,000 in tuition can save more than just $1,000 ($4,000 x 25%). Because the deduction reduces the taxpayer’s Adjusted Gross Income (AGI) it could also increase a multitude of other tax deductions and credits, and therefore reduce the tax liability by additional amounts.
More on claiming a deduction or credit for qualified tuition and fees tomorrow!