For most people faced with higher education bills, the good news is, federal and state tax breaks can reduce the financial pain.
The bad news is, the rules are complicated. The IRS has an online tool to help people determine eligibility for education tax credits, and the agency estimates it takes 10 minutes just to complete that evaluation process — that’s how complicated.
Maybe that’s why, according to a Sallie Mae study, fewer than half of middle-income families with children in college, and just over a third of those with lower incomes, take advantage of these federal tax breaks. That’s a shame because they can really help.
I’ll lay out some key points.
On the federal level there are three big tax breaks for higher education costs, and a number of smaller ones. Two of the big ones are tax credits, which are dollar-for-dollar reductions in an income tax bill, and the third is a tax deduction, which reduces taxable income.
These tax breaks can’t be combined, so the important thing is to determine the most valuable one for which you will qualify, then make sure to pay college costs in a way that allows that tax break to be claimed. For example, people who saved money for college costs in a tax-advantaged plan, such as South Carolina’s Future Scholar, would need to pay at least a portion of higher ed expenses with other funds in order to claim a federal tax credit.
The most valuable federal incentive is the American Opportunity Tax Credit, worth up to $2,500 per student, yearly, for up to four tax years. The credit can be claimed against up to $4,000 in qualifying expenses including tuition, and required fees and books, but not room and board.
With this credit, a student’s first $4,000 in college costs can be reduced by the tax credit to $1,500. The credit equals 100 percent of the first $2,000 in qualified expenses and 25 percent of the next $2,000. If the tax credit is larger than a person’s federal income tax liability, up to $1,000 of the tax credit is “refundable,” which means they get a check from the government.
The maximum credit is available to married couples earning up to $160,000 and individuals earning up to $80,000, with a reduced credit at incomes up to $180,000 and $90,000. Students must be enrolled at least half-time in a degree program, and must have no felony drug convictions.
For some people, the next most valuable federal tax break is the Lifetime Learning Credit, worth up to $2,000 per tax return. The credit equals 20 percent of qualifying expenses, primarily tuition. There’s no limit on the number of years it can be claimed, and the credit can be claimed for non-degree studies to acquire or improve job skills.
So, the Lifetime Learning Credit could be used for a college student who has exhausted the four-year maximum for the American Opportunity credit. It can also be used by someone taking vocational classes or courses to improve job skills. The income limit for the maximum credit is $55,000 for an individual and $110,000 for a couple filing a joint return, with a reduced credit at incomes up to $130,000 and $65,000.
The credit is non-refundable, so if the credit exceeds tax liability you won’t get a check.
For others, the federal tuition and fees deduction can be more valuable than the Lifetime Learning Credit. A tax deduction reduces the amount of income that’s taxed, so it’s value depends on a taxpayer’s highest tax rate. On the other hand, a deduction could reduce a lower-income taxpayer’s taxable income to a point where they might qualify for additional tax breaks such as the “saver’s credit” or the Earned Income Tax Credit.
Up to $4,000 in qualifying expenses (again, primarily tuition) for undergraduate or graduate education expenses can be deducted from federal returns, even by people who don’t otherwise itemize tax deductions. Importantly, for South Carolina residents, any reduction in federal taxable income also reduces state taxable income, because South Carolina income taxes are based on federal taxable income.
So, a taxpayer with a top federal rate of 25 percent who deducts $4,000 in education expenses would save $1,000 on their federal return, plus another $280 on their South Carolina return (7 percent of $4,000). A taxpayer with a top federal rate of 15 percent would save a combined 22 percent, or $880.
The full tax deduction is available to individuals claiming up to $60,000 in income, and couples claiming up to $130,000. The deduction drops to $2,000 for incomes up to $80,000 and $160,000, respectively, and is unavailable to those with higher incomes.
None of those big three federal tax breaks count the cost of room and board as a qualified expense. South Carolina residents can get a state tax break on room and board costs by putting money in the state’s Future Scholar program, and using those funds to pay room and board. Contributions to Future Scholar are deductible from taxable income on South Carolina returns, but not on federal returns.
Future Scholar is a 529 plan, a federally sanctioned “qualified tuition plan” for college costs. Investment earnings aren’t taxed at the state or federal level when used for qualified expenses. The state’s tax deduction for contributions is an extra perk, and can be claimed even the contributed funds are immediately withdrawn.
Funds from a 529 plan can be used the same year a federal tax credit or deduction is claimed, as long as the 529 funds are used to pay for expenses that were not the basis for claiming the federal tax credit or deduction.