Education Tax Deductions and Credits

August 28th, 2009 | cashrunner | Posted in Finance, Jobs

Regardless of whether you are already in school or you are planning to go to school, it’s important that you are aware of the various tax deductions and credits that are available to lower your cost of attendance.

1. WHY EDUCATION TAX DEDUCTIONS AND CREDITS MATTER

It always surprises me that so many people go to college or graduate school without really considering education tax deductions and credits. Sure, you can have a tax specialist or software take care of it for you when you file your tax return the next year, but there are good reasons to know about the tax implications of your enrollment in advance.

When it comes to deciding what school to go to or whether to go to school at all, the cost of education usually plays an important role. Two different types of costs come into play.

The most immediate cost you need to consider is the fact that you actually lose money by not working full-time. That could be tens of thousands dollar a year. In finance jargon, it’s called an opportunity cost. More often than not, however, your education will pay for itself as it will allow you to earn more money in the future, especially if you’re just getting a bachelor’s degree.

Assuming you have decided you want to go to school, your next decision rests on which school you should attend. Many of us try to factor in the cost of attendance as much as the quality of education the school can offer. You need to decide which school is the best value. The single greatest direct expense of a college education is tuition and fees. In addition, if you don’t have the funds to pay for it out-of-pocket, you also need to consider how much it’s going to cost you to take out loans to finance your education. The cost of a loan is the interest you pay on it. That is why it’s important to take into account tax deductions and credits which in effect reduce the cost of tuition and fees as well as loans. The after-tax cost of an education is different from its before-tax cost. When you don’t take taxes into consideration, you may jump to wrong conclusions about the relative costs of different schools as well as the cost of education itself. Unfortunately, many people don’t know enough about tax deductions and credits and therefore don’t even bother taking them into account. Don’t make the same mistake. It’s important that you learn about these things in order to make an informed decision.

2. EDUCATION TAX CREDITS vs. EDUCATION TAX DEDUCTIONS

There are both tax credits and tax deductions available to reduce the cost of education for you. In some instances, you will have to choose or the other because you can’t get different tax credits and deductions for the same educational expenses. You should choose the tax credit or deduction that gives you the most money back.

A tax credit will reduce your tax debt dollar for dollar. For example, a $1000 tax credit means you can pay $1000 less in taxes. To find the value of a tax deduction, on the other hand, you need to multiply it by your marginal tax rate. If your marginal tax rate is 30%, then a $1000 tax deduction means you will pay $300 less in taxes. (Note: Strictly speaking, these calculations work only for refundable tax credits and above-the-line tax deductions, but all education tax credits and deductions fall under these categories. If you want to learn about the difference between tax deductions and tax credits in greater detail, you may want to read our Basic Guide to Income Tax).

Another thing you need to be aware of is that you can get tax credits and deductions for qualified educational expenses only. The definition of ‘qualified educational expenses’ varies a little bit depending on the type of credit or deduction. Generally, though, tuition and books are qualified educational expenses while transportation, room and board, health insurance are not.

All four education tax credits and deductions have income restrictions based on your modified adjusted gross income (MAGI). MAGI is the same as adjusted gross income unless you also claimed the foreign earned income exclusion, the foreign housing exclusion, the foreign housing deduction, the income exclusion for residents of American Samoa, or the income exclusion for residents of Puerto Rico on your tax return, all of which would then have to be added back.

3. EDUCATION TAX CREDITS

Two different education tax credits are available: the Hope Credit and the Lifetime Learning Credit. You can only claim one of the two credits. You will have to determine which one saves you more money. Both credits are non-refundable, meaning they will help you reduce the amount of tax you owe but can’t be used to increase your tax refund.

Hope Credit

Here are some facts about the Hope Credit for tax year 2008:

Amount. The amount of the Hope credit (per eligible student) is the sum of: 100% of the first $1,200 ($2,400 if a student in a Midwestern disaster area) of qualified education expenses you paid for the eligible student, and 50% of the next $1,200 ($2,400 if a student in a Midwestern disaster area) of qualified education expenses you paid for that student.
Maximum benefit. The maximum credit you can claim is $1,800 ($3,600 if a student in a Midwestern disaster area) per eligible student
Time limit. Available ONLY until the first 2 years of post-secondary education are completed and available ONLY for 2 years per eligible student.
Student qualifications. Student must be pursuing an undergraduate degree or other recognized education credential and must be enrolled at least half time for at least one academic period beginning during the year. In addition, there must be no felony drug conviction on student’s record.
Phaseout. The amount of your Hope credit for 2008 is gradually reduced (phased out) if your modified adjusted gross income (MAGI) is between $48,000 and $58,000 ($96,000 and $116,000 if you file a joint return). You cannot claim a credit if your MAGI is $58,000 or more ($116,000 or more if you file a joint return).

You cannot claim the Hope Credit if you claim either the Lifetime Learning Credit or the Tuition and Fees Deduction.

Lifetime Learning Credit

Here are some facts about the Lifetime Learning Credit for tax year 2008:

Amount. The amount of the lifetime learning credit is 20% of the first $10,000 of qualified education expenses you paid for all eligible students.
Maximum benefit. The maximum amount you can claim for the year is $2,000 ($4,000 if a student in a Midwestern disaster area) per return
Time limit. Available for all years of postsecondary education and for courses to acquire or improve job skills. Available for an unlimited number of years
Student qualifications. Student does not need to be pursuing a degree or other recognized education credential. Available for one or more courses. Felony drug conviction rule does not apply
Phaseout. The amount of your lifetime learning credit for 2008 is gradually reduced (phased out) if your modified adjusted gross income (MAGI) is between $48,000 and $58,000 ($96,000 and $116,000 if you file a joint return). You cannot claim a credit if your MAGI is $58,000 or more ($116,000 or more if you file a joint return).

You cannot claim the Lifetime Learning Credit if you claim either the Hope Credit or the Tuition and Fees Deduction.

4. EDUCATION TAX DEDUCTIONS

Tuition and Fees Deduction

Here are some facts about the Tuition and Fees Deduction for tax year 2008:

Type of deduction. The Student Loan Interest Deduction is an adjustment.
Amount. You can deduct tuition and fees up to the maximum allowed and subject to the phaseout restrictions (see below).
Maximum benefit. You can reduce your income subject to tax by up to $4,000.
Qualified expenses. Tuition and fees required for enrollment or attendance at an eligible postsecondary educational institution, but not including personal, living, or family expenses, such as room and board.
Student qualifications. The expenses must be paid for a student enrolled in an eligible educational institution who is either you, your spouse, or your dependent for whom you claim an exemption.
Phaseout. If your modified adjusted gross income (MAGI) is not more than $65,000 ($130,000 if you are married filing jointly), your maximum tuition and fees deduction is $4,000. If your MAGI is larger than $65,000 ($130,000), but is not more than $80,000 ($160,000 if you are married filing jointly), your maximum deduction is $2,000. No tuition and fees deduction is allowed if your MAGI is larger than $80,000 ($160,000).

You cannot claim the Tuition and Fees Deduction if you claim either the Hope Credit or the Lifetime Learning Credit.

Student Loan Interest Deduction

Here are some facts about the Student Loan Interest Deduction for tax year 2008:

Type of deduction. The Student Loan Interest Deduction is an adjustment.
Amount. Your student loan interest deduction for 2008 is generally the smaller of: $2,500 or the interest you paid.
Maximum benefit. You can reduce your income subject to tax by up to $2,500.
Loan qualifications. Your student loan must have been taken out solely to pay qualified education expenses, and cannot be from a related person or made under a qualified employer plan.
Student qualifications. The student must be you, your spouse, or your dependent, and enrolled at least half-time in a degree program.
Time limit on deduction. You can deduct interest paid during the remaining period of your student loan.
Phaseout. The amount of your deduction depends on your income level. If you are married and file a joint return, the amount of your student loan interest deduction for 2008 is gradually reduced (phased out) if your modified adjusted gross income (MAGI) is between $115,000 and $145,000. You cannot take a deduction if your MAGI is $145,000 or more.

Note that you can still claim the Student Loan Interest Deduction even if you also claim the Tuition and Fees Deduction, the Hope Credit or the Lifetime Learning Credit because the Student Loan Interest Deduction is claimed for an expense not covered by the other three.

Photo Credit: VirtualSugar

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