10 Education Tax Breaks and Rules You Should Know About

The U.S. tax laws are unnecessarily complicated and extensive. But it’s worth taking the time to understand how to make them work for you, because paying for a college education is an expensive undertaking. The tax rules and regulations include numerous breaks for parents of college students and some for young adults as well who have previously incurred college costs and taken out some college loans.

Those who are knowledgeable about the tax laws and associated strategies can save themselves a lot of tax dollars. This article highlights ten things you should know related to educational expenses that can legally and permanently reduce the income taxes that you pay.

Contributing to Retirement Accounts

As a parent working and earning money, one of the financially smartest things you can generally do (unless you pay low federal income taxes), is to contribute to a retirement savings plan. Besides reducing your current and future federal (and state) income taxes, funding retirement plans helps you build up a nest egg, so you don’t have to work for the rest of your life. Also, for purposes of the financial aid system, your retirement accounts are generally the best places your assets to reside.

As you’re earning it, you can exclude money from your taxable income by tucking it away in employer-based retirement plans, such as 401(k) or 403(b) accounts, or self-employed retirement plans, such as SEP-IRAs. If your combined federal and state marginal tax rate is, say, 30 percent and you contribute $1,000 to one of these plans, you reduce your federal and state taxes by $300. Also, some employer plans provide free matching money. And when your money is inside a retirement account, it can compound and grow without taxation.

Many people miss this great opportunity to reduce their income taxes because they spend all (or too much) of their current employment income and, therefore, have nothing (or little) left to put into a retirement account. If you’re in this predicament, you first need to reduce your spending before you can contribute money to a retirement plan.

If your employer doesn’t offer the option of saving money through a retirement plan, lobby the benefits and human resources departments. If they resist, you may want to add this to your list of reasons for considering another employer. Many employers offer this valuable benefit, but some don’t. Some company decision-makers either don’t understand the value of these accounts or feel that they’re too costly to set up and administer.

If your employer doesn’t offer a retirement savings plan, individual retirement account (IRA) contributions may or may not be tax-deductible, depending on your circumstances.

Do you qualify for the saver’s tax credit?

Married couples filing jointly with adjusted gross incomes (AGIs) of less than $65,000 and single taxpayers with an adjusted gross income of less than $32,500 can earn a federal income tax credit (claimed on Form 8880) for retirement account contributions. Unlike a deduction, a tax credit directly reduces your income tax bill by the amount of the credit.

This saver’s income tax credit, which is detailed in this table, is a percentage of the first $2,000 contributed (or $4,000 on a joint return). The credit is not available to those under the age of 18, full-time students, or people who are claimed as dependents on someone else’s tax return.

The tax benefits of 529 plans

Money invested in section 529 plans is sheltered from taxation and is not taxed upon withdrawal as long as the money is used to pay for eligible education expenses. Some states also provide small tax incentives to fund these accounts.

Subject to eligibility requirements, 529 plans allow you to sock away upwards of $200,000. Please be aware, however, that funding such accounts may reduce your potential financial aid.

Coverdell Education Savings Accounts (ESAs)

Coverdell Education Savings Accounts (ESAs) are similar to 529 plan accounts. The contribution limits, however, are dramatically lower — up to just $2,000 per year per child. Money in ESAs grows without taxation and isn’t taxed when withdrawn if used for qualified educational expenses, which includes college as well as K–12 education.

Higher income earners lose the ability to fund these accounts. The single taxpayers’ phase-out range is from $95,000 to $110,000 of income. The range is $190,000 to $220,000 for all other taxpayers.

The American Opportunity tax credit

The American Opportunity (AO) tax credit provides up to $2,500 per student per year of college that families incur at least $4,000 of educational expenses. Up to $1,000 of this credit is refundable. Use of this credit is limited for each child for up to four years of undergraduate expenses.

There are income limitations for using this credit. Single taxpayers’ phase out of being able to take this credit at modified adjusted gross incomes (MAGIs) of $80,000 to $90,000. Other taxpayers’ phase-out is from $160,000 to $180,000.

When parents claim this credit for one of their children for a particular tax year, they may not claim the next credit — the Lifetime Learning credit. Each tax year, for a particular child, you may only take one or the other of these credits.

The Lifetime Learning credit

Like the American Opportunity tax credit, the Lifetime Learning (LL) credit also was designed to provide tax relief to low- and moderate-income earners facing higher education costs. The LL credit may be up to 20 percent of the first $10,000 of qualified educational expenses — up to $2,000 per taxpayer.

For parents filing tax returns, only one of these credits may be claimed for each child per tax year, and parents are subject to the same income limitations. Single taxpayers’ phase-out being able to take this credit at modified adjusted gross incomes (MAGIs) of $59,000 to $69,000. Other taxpayers’ phase-out is from $118,000 to $138,000.

The retirement account withdrawal penalty waiver

Normally, when you withdraw money from a retirement account early (the year in which you turn 59-1/2), you pay a 10 percent federal income tax penalty and whatever penalty your state assesses. You also owe current federal and state income tax on the taxable amount withdrawn.

If withdrawn retirement account money is used to pay for higher education expenses, the penalty is waived. That’s a good thing and perhaps worth considering.

However, taking money from retirement accounts to pay for college costs is generally not advised. For starters, you’re tapping money you’ve earmarked for your nonworking future years. Second, despite the penalty for early withdrawal being waived, the taxable amount withdrawn will show up on your federal and state income tax returns and you will owe federal and state income tax. Your higher reported income will harm your financial aid chances.

Finish on time without high income earning years

When students continually take breaks from college, especially due to the financial stress of full-time attendance and the associated costs, the likelihood of not finishing rises. Also, when a student is working enough to be making $10,000, $15,000, $20,000 or more in a tax year, that really begins to affect the financial aid/pricing that the school assesses the family.

If a student’s interest in college courses has noticeably dropped in the first or second year, it’s worth examining why and doing so with an open mind. Given the high cost of attendance and the fact that increasing numbers of lower cost and potentially more effective alternatives exist, consider the alternatives to high-cost colleges.

The student loan interest deduction

You may take up to a $2,500 deduction for student loan interest that you pay on IRS Form 1040 for college costs as long as your modified adjusted gross income (AGI) is less than or equal to $70,000 for single taxpayers and $140,000 for married couples filing jointly. Your deduction is phased out if your AGI is between $70,000 and $85,000 for single taxpayers and between $140,000 and $170,000 for married couples filing jointly.

This deduction is not an itemized deduction, so anyone can take it on Form 1040 as a so-called “adjustment to income.” Each of your lenders should be able to provide you with a yearly summary that shows how much you paid in interest for the tax year. If you paid $600 or more in interest to a single lender, that lender is required to provide you with Form 1098-E, which documents the interest you paid for the year.