Families planning for college costs typically focus on saving and borrowing.
Preparing for college also involves tax planning. There are several tax-advantaged provisions for higher education in the tax code, including tax credits. In the 2015-2016 academic year, the average family saved nearly $1,300 in education tax credits and deductions, the College Board reported.
Still, many families may miss out on these tax breaks as multiple tax provisions for parents may cause confusion. A 2012 study by the Government Accountability Office found 14% of filers (roughly 1.5 million taxpayers) who were eligible did not take advantage of higher education credits or deductions.
A comprehensive financial plan can address tax issues and implications. Families may want to consider the following tax credits when crafting a plan to pay for college.
American Opportunity Tax Credit (AOTC): This provision allows for a credit of up to $2,500 for each eligible student. There are income limits, and the credit is not available to individual taxpayers with more than $80,000 in income or couples with more than $160,000. The credit is calculated by including 100% of the first $2,000 in qualified expenses and 25% of the next $2,000 in expenses for a maximum of $2,500.
Lifetime Learning Credit: This credit has a maximum limit of $2,000 per tax return. For tax year 2017, the credit is reduced for individual taxpayers with income of more than $56,000 and less than $65,000 (between $112,000 and $131,000 for married couples). The credit is phased out if the modified adjusted gross income (MAGI) is higher than $65,000 ($130,000 for joint filers). The credit is calculated based on 20% of the amount of qualified expenses for all students, aggregated up to $10,000 (for a maximum credit of $2,000).
It is important that taxpayers understand how these tax credits work in conjunction with other college savings programs such as a 529 plan or scholarships. A basic rule to keep in mind is that taxpayers cannot double up on tax benefits for the same college expense. When planning to claim one of the tax credits, the taxpayer must adjust the amount from the qualified expenses total that is expected to come from a 529 plan distribution.
More information on tax credits is available from the Internal Revenue Service Publication 970 “Tax Benefits for Education.”
In addition to tax credits, individuals and families may be able to access a deduction for the interest paid on student loans.
Student loan interest deduction: This deduction can reduce the amount of income subject to tax by up to $2,500. For tax year 2017, this deduction begins to phase out for individual taxpayers with a MAGI in excess of $65,000 and for married couples with a MAGI of more than $130,000. The deduction is completely phased out for individuals with a MAGI of more than $80,000 and joint filers with a MAGI of more than $160,000.
If the parent has a higher income level and is phased out of the deduction, a loan in the child’s name may take advantage of the income tax deduction once he or she graduates.
Tuition and fees deduction: This provision allows for a maximum deduction of $4,000 for individual taxpayers with a MAGI of $80,000 or less ($160,000 or less for joint filers) and completely phased out for individuals with a MAGI of more than $80,000 and joint filers with a MAGI of more than $160,000. The deduction was extended through the 2016 tax year. In recent years, Congress has allowed the provision to expire and then reinstated it.
At all stages of planning for college costs, seeking advice from a financial professional may help maximize the potential of a savings and tax plan. For a broad view of planning for college, read Putnam’s investor education piece, “Strategies to make the most of college savings.”