Life Events & Tax Planning – Part III: Saving for College
Most families understand the necessity of saving funds for higher education. A number of federal and state tax benefits are available to help achieve this goal. To give a better understanding of these tax subsidies, we have divided them into three parts of the student’s life cycle: elementary, college, and post-graduate education.
529 PLANS (OR QUALIFIED TUITION PROGRAMS)
Qualified tuition plans (QTPs), also known as “529 Plans,” are maintained and established by state governments and agencies, or educational institutions, with the goal of encouraging families to save for future college costs. All states offer at least one of the two types of 529 plans: prepaid tuition plans or college savings plans. In addition, private colleges will offer additional prepaid tuition plans within the states. There are state benefits to participating in 529 plans, but they are frequently limited to the resident state and only some states allow residents to deduct the contributions made to 529 plans. For example, New York allows a contributions deduction maximum of $10,000 for married filing jointly taxpayers (or $5,000 for all other filing statuses). Investments in QTPS grow tax free; and distributions of any earnings within 529 Plans are not subject to federal or state taxes if the distributions from the plans are used for qualified expenses such as tuition, books, computer or peripheral equipment, and room and board. There can often be administrative fees associated with 529 plans, so it is wise to review the details of any plan and underlying investments before participation.
AMERICAN OPPORTUNITY CREDIT
The American Opportunity Tax Credit (AOTC) is a maximum annual credit of $2,500 available to eligible higher education students for the first four years of college. The credit is 40% refundable if the taxpayer owes no tax. The credit calculates as 100% of the first $2,000 of qualified expenses, and 25% of the next $2,000 of qualified expenses. Qualified education expenses include tuition and course materials. Eligible students are those who are enrolled at least half-time for at least one academic period within the tax year, in pursuit of a degree or other recognized educational credential. The taxpayer is allowed to claim the credit if the qualified educational expenses are paid by the taxpayer for an eligible student who is the taxpayer, or the spouse or dependent of the taxpayer. The AOTC credit cannot be claimed by the taxpayer if the taxpayer is a dependent of someone else, has a filing status of married filing separately or has a modified adjusted gross income (MAGI) of $90,000 or greater ($180,000 if married filing jointly).
LIFETIME LEARNING CREDIT
The Lifetime Learning Credit (LLC) is available to eligible students who pay for qualified education expenses. The maximum annual amount of the credit is $2,000 and it is nonrefundable; there is no limit to the number of years the credit can be claimed. Eligible students are those enrolled in post-secondary programs including undergraduates, graduates, and those with professional degree courses taken to acquire or improve job skills. Each eligible student is limited to one of the education credits per year, so the student cannot claim both the AOTC and the LLC. Qualified expenses includes tuition, fees and books. The tax credit is available to taxpayers who have incurred qualified tuition or other education costs for themselves, their spouses, or a dependent claimed on their tax returns. The calculation of the Lifetime Learning Credit is 20% of the first $10,000 of qualified expenses. It is not available to taxpayers whose filing status is married filing separately, nonresident aliens, dependents on another taxpayer’s tax returns, or those with a MAGI of $65,000 or greater ($131,000 if married filing jointly).
STUDENT LOAN INTEREST DEDUCTIONS
If a student borrows loans solely to pay for qualified education expenses, the interest on the loans may be deducted on the taxpayer’s income tax return as an “above-the-line” deduction for a maximum of $2,500 per year. To qualify for the deduction, the taxpayer cannot have a filing status of married filing separately, or have an AGI greater than $80,000 ($160,000 if married filing jointly). Additionally, to qualify the taxpayer must be legally obligated to pay the interest on the loan. The interest deduction will be reduced due to phase-out rules based on the AGI, so the taxpayer may not be eligible for the maximum annual limit. Certain loans such as one from a related person or qualified employer plan do not qualify as eligible student loans for this deduction.
TUITION & FEES DEDUCTION
Tuition and fees deductions are also an “above-the-line” deduction for a maximum of $4,000 of qualified expenses such as tuition. The deduction is not available to married taxpayers filing separately, nonresident aliens, those who can be claimed as a dependent by others, or those with an AGI greater than $80,000 ($160,000 if married filing jointly). This is an option for taxpayers who do not qualify for AOTC and LLC. You cannot receive a double benefit, and as such there are certain limitations in place; the taxpayer cannot claim the AOTC or LLC if taking the deduction, and the same education expenses claimed for the deduction cannot be covered by a QTP distribution.
SCHOLARSHIPS AND GRANTS
Scholarships and grants are typically tax free only if you are a degree candidate at an eligible institution and the dollar amounts do not exceed qualified education expenses. They are specifically for expenses other than qualified education expenses; and it is not prepayment for teaching, research, or other services required as a condition of receiving the scholarship.
Regardless of which of the above options seem most beneficial to you, it is always recommended to discuss higher education planning and tax benefit choices with your tax advisor before making a decision.
This blog series is meant to provide an overview of the common implications you might face when you encounter various life events, but there are likely additional considerations dependent on your specific scenario. At FF&F our experienced staff will act as your advisors throughout each step of any event that might affect your tax planning. For more information on this topic, or to discuss tax planning strategies, please contact us at firstname.lastname@example.org or (212) 245-5900.
John Gontijo, CPA, MBA, is a Tax Manager who has been at FF&F for 5 years. He has over 10 years of experience with high net worth individuals, small businesses, and international taxation. John is part of the Expat Services team here at FF&F. Prior to joining the firm, he worked for a niche CPA firm in NYC which specialized in inbound U.S. tax matters for German, Swiss, and Austrian clients, including Offshore Voluntary Disclosure Programs.