Overview of Definitions, Qualifying Expenses, and Implementation Regulations
What is the Difference? Credits vs. Deductions?
Tax “incentives or benefits” in the form of credits and deductions are available for higher educational qualifying expenses. These tax breaks actually become a “quasi educational tax scholarships”. There are two types of tax breaks;
- Tax Credits reduce your amount of tax liability, example American Opportunity Tax Credit (“AOTC”).
- Tax Deductions lower the amount of income that is included in your tax liability calculation, example Tuition and Fees Deduction.
We will explain how the two tax credits and the two tax deductions below work. Prior to that a review of qualifying educational expenses is necessary so you can understand the regulations that verify your use of these credits and deductions.
- Lifetime Learning Credit (“LLC”)
- American Opportunity Tax Credit (“AOTC”)
- Tuition and Fees Deduction
- Student Loan Interest Deduction
Qualifying Educational Expenses – What You Need to Know
Who is the Payee of Expenses?
Qualified education expenses must be paid by:
• You or your spouse if you file a joint return
• A student you claim as a dependent on your return
• A third party including relatives or friends.
What are Approved Sources of Funds
You can claim an education credit for qualified education expenses paid by cash, check, credit or debit card or paid with money from a loan.
If you pay the expenses with money from a loan, you take the credit for the year you pay the expenses, not the year you get the loan or the year you repay the loan.
What Expenses Qualify?
Tuition, fees, and other related expenses that are required for enrollment or attendance at an eligible educational institute. The student must be eligible and the expenses must be paid for an academic period that starts during the tax year or the first three months of the next tax year.
Qualified expenses are amounts paid for tuition, fees and other related expense for an eligible student that are required for enrollment or attendance at an eligible educational institution. You must pay the expenses for an academic period* that starts during the tax year or the first three months of the next tax year.
Eligible expenses also include student activity fees you are required to pay to enroll or attend the school. For example, an activity fee that all students are required to pay to fund all on-campus student organizations and activities.
For AOTC only, expenses for books, supplies and equipment the student needs for a course of study are included in qualified education expenses even if it is not paid to the school. For example, the cost of a required course book bought from an off-campus bookstore is a qualified education expense.
Expenses that Do Not Qualify
Even if you pay the following expenses to enroll or attend the school, the following are not qualified education expenses for AOTC, LTC, and tuition/fees deduction;
• Room and board
• Medical expenses (including student health fees)
• Similar personal, living or family expenses
Exceptions to Non-Qualifying Expenses
Expenses for sports, games, hobbies or non-credit courses do not qualify for the education credits or tuition and fees deduction, except when the course or activity is part of the student’s degree program.
For the Lifetime Learning Credit only, these expenses qualify if the course helps the student acquire or improve job skills.
Tax-Free Funds Exclusion
You cannot claim credit for education expenses paid with tax-free funds. You must reduce the amount of expenses paid with tax-free grants, scholarships and fellowships and other tax-free education help.
What Happens if the Student Withdraws from Classes?
Any expenses paid and not refunded qualify for the credit/deduction.
You Must Choose One Tax Incentives Each Tax Year Per Student
The three educational expense tax breaks Lifetime Learning Credit, American Opportunity Tax Credit, and Tuition | Fees Deduction are limited to one tax strategy per dependent student per tax year. However, you can use multiple tax strategies on the same tax return with multiple qualifying students.
Lifetime Learning Credit
20% of the first $10,000 spent on qualified educational expenses up to a maximum of $2,000. To claim the full credit, your modified adjusted gross income (“MAGI”) must be $52,000 or less ($104,000 or less for married filing jointly). If your MAGI is over $52,000 but less than $62,000 (over $104,000 but less than $124,000 for married filing jointly), you receive a reduced amount of the credit. If your MAGI is over $62,000 ($124,000 for joint filers), you cannot claim the credit.
The credit is non-refundable which mean you cannot receive the credit as a refund (like AOTC) but it can lower you tax liability. Unlike the AOTC limit of four years the LLC has no limit to the number of tax years it can be used.
American Opportunity Tax Credit
For qualified tuition, fees and course materials paid toward the first four years of secondary education it matches up to 100% of the amount paid for these costs to a maximum of $2,000 plus 25% of the next $2,000. The maximum credit is $2,500, 40% which is refundable regardless of your tax liability (you can have zero liability and receive up to $1,000).
You receive the full credit if single filer with modified adjusted gross income (“MAGI”) of less the $80,000 and married filing jointly less than $160,000. You receive a reduced amount of the credit if your MAGI is over $80,000 but less than $90,000 (over $160,000 but less than $180,000 for married filing jointly).
Tuition and Fees Deduction
This deduction allows a taxpayer to reduce his/her taxable income by up to $4,000 based upon amounts paid for tuition and certain related expenses required for enrollment.
For 2015, the tuition and fees deduction is phased out for single filers starting at $65,001 to $80,000 and $130,000 to $160,000 for joint return filers. If your AGI is above $80,000/$160,000, the deduction will not be available to you
If you select the AOTC or the LLC, you cannot select the tuition and fees deduction. The deduction is currently set to expire on December 31, 2016.
Which Credit/Deduction Should You Take?
You are eligible to claim all three benefits above on one tax return. However, you can only use one for each student each tax year and in most situations qualifying expenses (for each student if multiple students) can only be used once. The regulation against non-recurring use of expenses for different strategies are referred to as “Double Benefit Limitation” and/or “Double Dipp’in”.
Double Benefit Limitation / Double Dipp’in
There are certain sources of money that might pay for qualifying expenses that you need to adjust (subtract) from qualifying educational expenses so you don’t violate the double benefit limitation.
Strategy Alert: The best practice approach would be to do this calculation for each tax benefit you are considering so you eliminate having to go back and check once you are calculating the best option (steps outlined below).
Start: Total Qualifying Educational Expenses Amount
Less: Adjusted qualified education expenses (AQEE) [Any tax-free educational assistance and any qualified education expense deducted on your tax return used for credit/benefit or used for tax-free distribution.]
- Expenses used to Calculate Tax-Free Coverdell Withdrawals
- Expenses paid with Pell Grants
- Expenses paid with FSEOG Grants
- Tax-free Scholarships & Fellowships
- Expenses Used to Calculate Tax-free 529 Plan Distributions
- Employer provided Assistance (Example, Section 127 Plans)
- Veterans’ Educational Assistance
- Other Tax-free Payments Received as Educational Assistance except for inheritances and gifts.
Equals: Qualified Higher Education Expenses (QHEE) Available for Allocation Toward Tax Strategy Benefit.
Five Steps to Determine the Most Valuable Benefit
- Check eligibility by reviewing the chart directly below.
- Match your income (in most cases your MAGI will be your AGI) to see if you fall within any of the phase-out income ranges, make the appropriate note or disqualification if that applies.
- Review the remaining credit/deduction options, check the chart below for qualifying expenses and cross reference with your QHEE information.
- Calculate the value of each option, remember any possible phase-out situations.
- Choose the best option
2015 Tax Year Regulatory Comparison
Education Credits and Tuition/Fees Deduction
|Criteria||AOTC||LLC||Tuition and Fees Deduction|
|Maximum credit or benefit||Up to $2,500 credit per eligible student||Up to $2,000 credit per return||Up to $4,000 taxable income reduction per return|
|Refundable or nonrefundable||40% of credit||Not refundable||Does not apply|
|Limit on MAGI* for married filing jointly||$180,000||$128,000||$160,000|
|Limit on MAGI* for single, head of household, or qualifying widow(er)||$90,000||$64,000||$80,000|
|Can you file married filing separately?||No|
|Dependent status||Cannot claim credit if you are claimed as a dependent on someone else’s return|
|Must you or your spouse be a U.S. Citizen or Resident Alien?||Yes, unless nonresident alien is treated as resident alien for tax purposes (see Publication 519 for information on nonresident alien status)|
|Number of years of post-secondary education available||Only if student hasn’t completed 4 years of post secondary education before 2014||All years of post secondary education and for courses to acquire or improve job skills||All years of post secondary education|
|Number of tax years credit available||4 tax years per eligible student including any years former Hope credit claimed||Unlimited||Unlimited|
|Type of program required||Student must be pursuing a degree or other recognized education credential||Student does not need to be pursuing a degree or other recognized education credential||Student must be enrolled at eligible educational institution for one or more courses|
|Number of courses||Student must be enrolled at least half time for at least one academic period beginning in 2014||Available for one or more courses||Available for one or more courses at eligible educational institution|
|Felony drug conviction||No felony drug convictions as of the end of 2014||Does not apply||Does not apply|
|Qualified expenses||Tuition, required enrollment fees and course materials needed for course of study||Tuition and fees required for enrollment or attendance||Tuition and fees required for enrollment or attendance|
|Whom can you claim the benefit for?||
|Who must pay the qualified expenses?||
|Payments for academic periods||Made in 2014 for academic periods beginning in 2014 or the first 3 months of 2015|
|Do I need to claim the credit or deduction on a schedule or form?||Yes, Form 8863, Education CreditsForm 8863 Instructions||Yes, Form 8863, Education Credits|
* For most taxpayers your MAGI is your Adjusted Gross Income (AGI), check with your tax professional if you have any “add backs”. Chart Source: Internal Revenue Service
Student Loan Interest Deduction
As a general rule personal interest on loans is not deductible. However, student loan interest in most cases is deductible up to $2,500 per tax year for eligible educational loans.
For 2015, the amount of your student loan interest deduction is gradually reduced (phased out) if your MAGI is between $65,000 and $80,000 ($130,000 and $160,000 if you file a joint return). You can’t claim the deduction if your MAGI is $80,000 or more ($160,000 if you file a joint return).
The deduction is an “above the line deduction” which means you do not have to itemize your deductions to receive the benefit.The student loan interest deduction can be claimed at the same time as other education tax benefits AOTC, LLC, and the Tuition/Fees.
Loan proceeds must be used to pay for qualified education expenses, the double limitation (expenses can only be used for one education tax relief method) applies.
Qualification Factors for Eligible Interest Deduction
Eligible Student – The student must have been enrolled at least half time when the loan was issued.Eligible Institution – Expenses must be paid to an institution participating in the Department of Education’s student loan program.
Eligible Expense – The loan must have been used to pay tuition, fees, room & board, books, supplies, equipment, or other necessary expenses (such as transportation).
Eligible Borrower – Funds must be borrowed to pay eligible education expenses of you, your spouse, and your dependent.
Eligible Interest – Deductible interest includes loan origination fees, capitalized interest, voluntary interest prepayments, and current period interest charges. The loan does not have to be a Federal or state loan to be eligible for the interest deduction. For example, you can deduct interest charged by your credit card company if you only use the card for eligible expenses.
Beware: Tax Return Choices Can Conflict With Financial Aid
The IRS Code and Financial Aid Regulations do not always sync, tax minimization efforts can have adverse affects on need-based financial aid.
Here are two examples that occur. Remember, the question becomes how much is the tax liability reduced and then what is the impact on financial aid eligibility?
- A tax preparer my elect to file the IRS Form 1040 rather than IRS Form 1040A or 1040EZ in the pursuit of certain income exclusions. When this occurs (claiming AOTC when eligible to file 1040A or 1040EZ can be an exception) usually makes you ineligible to qualify for the auto-zero EFC and/or the Simplified Needs Test (assets are not required to be reported. Certain income thresholds are required in each instance.
- On the surface the American Opportunity Tax Credit provides the greatest financial benefit compared to the LLC and the tuition/fees deduction. However, the tuition/fees deduction reduces your adjusted gross income. Such a reduction may increase your financial aid eligibility. As an example, if your Expected Family Contribution (EFC) number falls below $50,000 as a result of using the tuition/fees deduction, you would not be required to report assets for the FAFSA. Many families have sizable assets but low incomes as they phase-out/retire from work related income activity for varied reasons.
Tax Planning Part of College Planning
As you can see, understanding education related tax planning can provide another source of cash flow for helping with your out-0f-pocket costs.