Q: There seem to be many options for tax breaks when you have a child in college. Some seem to cancel each other out. We have a son that just started college in the fall and are a bit confused. Please explain which options for tax savings and withdrawals from retirement accounts would be the most advantageous in different situations.
It is rather complex. For some, you can only take one and not the other, some are only available for undergraduate course work and then there are the income limits. The main education tax incentives to take into consideration are: American Opportunity Credit, Lifetime Learning Credit, Tuition and Fees Deduction and Student Loan Interest Deduction.
The American Opportunity Credit is an expansion of the Hope scholarship credit. The tax credit is limited to $2,500 per student, per taxable year. The credit is permitted for 100 percent of the first $2,000 and 25 percent of the next $2,000 of expenses for tuition, fees and course materials. The credit may be claimed for the first four years of undergraduate course work. The credit is also 40 percent refundable, which means you can get it even if you owe no tax. To be eligible, the student must be enrolled at least half-time in a degree program. A taxpayer whose modified adjusted gross income (MAGI) is $80,000 or less ($160,000 for joint filers) can claim the full credit for themselves, a spouse or a dependent. The credit is reduced for those with MAGI above these levels and for those with MAGI greater than $90,000 ($180,000 for joint filers) the credit is not available.
The Lifetime Learning Credit is similar to the one above but it can be used for both undergraduate and graduate course work. The credit is limited to $2,000. This credit is only allowed once per tax return (not per student per year) but there is no limit on the number of years you can claim the credit. You are eligible for this credit if you are enrolled in one or more courses. A taxpayer with MAGI of $52,000 or less ($104,000 for joint filers) can claim the full credit for themselves, a spouse or a dependent. The credit is reduced for those with MAGI above these levels and for those with MAGI greater than $62,000 ($124,000 for joint filers) the credit is not available.
The Tuition and Fees Deduction allows for up to 100 percent of qualified undergraduate or graduate course work to be deducted. The amount of the deduction is limited to $2,000 for single filers with MAGI of $80,000 or less and $4,000 for joint filers with MAGI of $160,000 or less. Taxpayers with MAGI above these levels do not qualify for the deduction.
The three incentives explained above cannot be combined for the same student so you need to determine which is more beneficial in your situation. Since a credit is worth more than a deduction, the first two are probably the best tax break if you qualify.
Student loan interest may also be deducted. A taxpayer with MAGI of $60,000 or less ($120,000 for joint filers) can claim a deduction of up to $2,500 of interest paid on an education loan. The deduction amount is reduced for those with MAGI above these levels and for those with MAGI greater than $75,000 ($150,000 for joint filers) the deduction is not allowed.
IRA withdrawals are penalty free at any age if used to pay for qualified undergraduate and graduate education expenses. Make sure you understand the impact on your retirement plans before you make withdrawals from your IRA, take a loan from your 401(k) or use a home equity line to cover education expenses.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 99466, Raleigh, NC 27624