Tax Breaks (And Pitfalls To Avoid) For Students In 2016
Earning a degree is expensive — as in $19,548 per year expensive if you go to a public university and live on campus. If you plan to head to a private college, prepare to shell out $43,921, according to The College Board which calculated both figures for the 2015-2016 school year.
Fortunately, the government wants to help you save a little money. Students and their families have access to several deductions and credits that can be claimed either while a student is school or once the student loan bills begin to arrive.
Unfortunately, many people make common mistakes when claiming them and end up leaving money on the table each year. Don't worry; we've got you covered. Keep reading for the basics of five, unranked college tax breaks and how to avoid the common pitfall associated with each one.
1. American Opportunity Tax Credit
The tax break:
- $2,500 tax credit to offset the first four years of college tuition and other eligible expenses for students enrolled at least half-time.
- $1,000 is refundable if the credit exceeds your tax liability.
- Parents get the credit if the student is a dependent. Otherwise, a student can claim the credit.
- Income limit for the full credit is $90,000 for individuals and $180,000 for couples.
Failing to keep documentation for non-tuition purchases.
Previously known as the Hope Credit, the American Opportunity Tax Credit may well be the most lucrative tax break for college students and their parents.
It's a dollar for dollar credit, up to $2,500. That means for every dollar you pay in tuition, you can wipe out one dollar in taxes. In the event the credit is more than what you owe, the government will cut you a check for up to $1,000 of the excess.
Nicole Odeh, founder and president of The Small Business Accounting Solution in Thorndale, Pennsylvania, says the credit can't be used for room and board, but it can be applied toward books and even computers, if required by a school.
However, here's the pitfall. Odeh says the government is cracking down on people who claim the credit for non-tuition purchases but don't have supporting documentation. Schools will send students a 1098-T form at the end of each year with the amount of tuition paid and when the 1098-T has a different amount than the credit being claimed, the IRS is asking for more information.
The fix is simple. "We're really recommending our clients keep their receipts in some sort of file management system [such as a cloud application]," Odeh says.
2. Lifetime Learning Credit
The tax break:
- Nonrefundable credit of 20 percent of eligible higher education expenses, capped at $2,000 per year.
- Cannot be claimed at the same time as the American Opportunity Tax Credit.
- No limit on the number of years it may be claimed.
- Income limit for the credit is $65,000 for individual filers and $130,000 for couples.
Forgetting it can be used for professional development and continuing education.
After four years of school, the American Opportunity Tax Credit disappears as an option. However, many students are still hitting the books at that point. They may be on a 5-year track for a bachelor's degree or maybe they are pursing graduate studies. Either way, the Lifetime Learning Credit gives them a way to use their expenses to offset taxes.
Unlike the American Opportunity Tax Credit, this isn't a dollar for dollar credit. Instead, you get 20 cents on the dollar, up to $2,000 per year. It's also not refundable. Finally, don't think you can get away with claiming both the Lifetime Learning Credit and the American Opportunity Tax Credit for the same expenses. The IRS forbids double-dipping.
Where people go wrong with this credit is failing to realize it's an option even if you're not earning a degree. "The Lifetime Learning Credit is for whenever you go back to school," Odeh says, "even if you've only have one college class to learn QuickBooks."
The only requirement is you have to take the class through an eligible school. In other words, don't think you can sign up for an independent class online or pay a friend to teach you and get a tax credit. As with the American Opportunity Tax Credit, Odeh says keeping documentation of expenses is crucial.
There is no limit to how many years you can claim the Lifetime Learning Credit. If you take an eligible class every year, you can take a tax credit every year.
3. Unreimbursed Employee Expenses Deduction
The tax break:
- Allows workers to deduct tuition and fees for work-related education, so long as an employer does not reimburse those costs.
- Only expenses in excess of 2 percent of a person's adjusted gross income can be deducted.
- Individuals must itemize deductions to claim unreimbursed employee expenses.
- Only the cost of educational programs related to a person's current line of work are eligible. Education programs to train for a new career or to maintain a license or certification are exempt.
Assuming the deduction is not as good as the Lifetime Learning Credit.
When it comes to tax incentives, credits are just about as good as it gets. Each credit dollar reduces a tax bill by a dollar. Deductions are nice, but they reduce a person's adjusted gross income instead. As a result, they can reduce taxes but typically not by as much as a credit.
So it's not surprising many people default to the Lifetime Learning Credit when claiming work-related education expenses. That could be a mistake, Odeh says.
Since the Lifetime Learning Credit is only 20 cents on the dollar and capped at $2,000, some people might find bigger tax savings if they itemize their deductions and claim their education costs as unreimbursed employee expenses. This is particularly true for those in a higher tax bracket.
"If they have $10,000 or more in education costs, it might be better to take it as a non-reimbursed employee expense and get a 33 percent deduction," Odeh says as an example. The deduction may also be appropriate for those who find they don't meet the income or eligibility criteria for the credit programs.
The catch is the expenses must be related to an individual's current job and can't be professional development classes required by law to keep a license or certification. In addition, only those expenses greater than 2 percent of a person's adjusted gross income can be deducted. However, for those who qualify, mileage from school to work may be included as well which, at 54 cents per mile, can add up quickly.
4. 529 College Savings Plans
The tax break:
- Plans are state-run, and rules can vary by state.
- Many states allow some or all of contributions to be deducted from state income tax.
- Withdrawals for qualified education expenses are exempt from federal income tax and may be exempt from state income tax.
- A gift tax may apply to contributions of more than $14,000 in certain situations.
Thinking these plans are only for parents saving for their younger children.
529 savings plans are a popular way for parents to put aside money for their children's college expenses. Often, they are opened when children are young so that invested money can grow into a substantial pot of cash by the time Junior or Jane graduates from high school. However, there is no reason why college-age students and their parents can't leverage these plans for some tax savings as well.
Currently, 34 states plus the District of Columbia offer a partial or full state income tax deduction on money deposited into a 529 plan. While contributions are subject to federal income tax, withdrawals for qualified educational expenses are exempt. In addition, most states exempt withdraws from their income tax.
Every 529 plan operates under its own set of rules, and states may have a minimum period of time money needs to be invested in order to claim a deduction. Depending on state law, it may be possible for a current college student to contribute to a 529 plan this year, claim a state income tax deduction and then withdraw the money for qualified expenses next year.
If you are planning to apply for the American Opportunity Tax Credit or the Lifetime Learning Credit, be aware you can't use money from a 529 plan to pay for expenses used to claim these credits. For example, if you paid $10,000 in tuition and plan to claim a $2,500 American Opportunity Tax Credit, you can only pay $7,500 in tuition out of your 529 plan.
Another caveat of the plans is that if you withdraw money for a purpose other than education, it becomes subject to income tax plus a 10 percent federal penalty. Be sure you're only depositing as much as you expect to use.
5. Student Loan Interest Deduction
The tax break:
- Deduction of up to $2,500 in student loan interest.
- Loan must have been taken out to pay for qualified education expenses and cannot have come from a relative or employer.
- Deduction not available to those filing as married, filing separately.
- Income limits are $80,000 for an individual and $160,000 for a couple.
Taking your time to pay off a loan to keep the deduction.
While other tax credits and deductions are only available to those in school, the student loan interest deduction provides tax relief long after the mortarboard has been tossed in the air.
Students, as well as their parents, can deduct up to $2,500 in interest each year from qualified student loans. It's an "above-the-line" deduction which means anyone can claim it, even if they don't otherwise itemize their deductions. "It's a dollar for dollar deduction off income," Odeh says.
While deducting interest can be a perk, don't let it lull you into a sense of complacency about your loan. As an unsecured debt that is difficult to shed even in bankruptcy, student loans should be paid off as quickly as possible.
A higher education can be costly, but many argue it's worth every penny. Thanks to these sweet tax breaks, you may find you pay fewer pennies in 2016.
1. Nicole Odeh, president and founder of The Small Business Accounting Solution, Interview with the author
2. Average Published Undergraduate Charges by Sector, 2015-2016, The College Board, http://trends.collegeboard.org/college-pricing/figures-tables/average-published-undergraduate-charges-sector-2015-16
3. American Opportunity Tax Credit, IRS, https://www.irs.gov/uac/American-Opportunity-Tax-Credit
4. Lifetime Learning Credit, IRS, https://www.irs.gov/publications/p970/ch03.html
5. Unreimbursed Employee Expenses, IRS, https://www.irs.gov/publications/p529/ar02.html
6. Publication 970, IRS, https://www.irs.gov/pub/irs-pdf/p970.pdf
7. How to Spend from a 529 College Plan, Fidelity, https://www.fidelity.com/viewpoints/personal-finance/college-529-spending
8. How Much is Your State's 529 Deduction Really Worth? Saving for College, http://www.savingforcollege.com/articles/how-much-is-your-states-529-plan-tax-deduction-really-worth-733
9. Student Loan Interest Deduction, IRS, https://www.irs.gov/publications/p970/ch04.html