Thursday, February 16, 2012

Education tax breaks - which one is best?

There are a lot of great tax breaks for folks in college.  But they can be confusing.  How do you know which one is best for you?  I'll try to run through the basics.

A few generalities with education credits.  All tuition must be for an accredited college.  The student can't have been convicted of a felony for possession or distribution of a controlled substance (I guess first degree murder felony would be okay, though).  There are some income limitations, as noted below. Lastly, if you are married, you must file jointly to claim any education credits or deductions.

You only can claim one tax break for dollars spent - that means you can't get both a credit and a deduction for the same tuition or the student.  Similarly, you can't get a credit or deduction for tuition that was covered by a grant or scholarship, or that was paid from a 529 or other college savings plan. However, you can claim a credit for tuition paid for with student loans. You can also claim a credit for tuition paid for by a friend or relative - the tax break goes to the taxpayer who is the student, spouse or who claims the student as a dependent.

American Opportunity Credit - this is the best credit by far.  It's up to a $2,500 credit, which means it goes directly in your pocket (or reduces what you owe dollar for dollar). The student must be in their first four years of college (i.e., not grad school) and they have to be a full-time student.  It's 100% of the first $2,000 of qualified tuition and 25% of the next $2,000.  That means you only have to spend $4,000 to get the maximum credit.  It's the only education credit that is partially refundable.  That means if your tax liability is reduced to zero, you can still receive a refund of up to $1,000 from this credit. And it's the only credit that allows you to use your book expenses as part of your qualified expenses. Most college tuition is more than $4,000, so the book expenses don't always help you.  But if you have some grants or scholarships that are covering your tuition, you may benefit by including those book expenses. This credit phases out if your income is above $90K single and $180K married.  It's just a fantastic credit.

Once you have four years of college under your belt, or if you are no longer a full-time student, the following education tax breaks may suit you.

Lifetime Learning Credit.  This credit is generally for the part-time college student or grad student in the 15% or lower tax bracket.  The credit is 20% of qualified tuition (not books) up to $2,000 maximum credit. If you or your dependent are just taking a class or two at a time, this is the credit for you. This credit phases out earlier than the other two breaks:  at income above $60K single and $120K married.

Tuition and Fees Deduction.  This is an above-the-line deduction, meaning it lowers your taxable income.   The maximum deduction is $4,000, but the dollar amount of the benefit to you depends on your tax bracket.  The above-the-line piece means you don't have to itemized to take it and it also lowers your Ohio income, thus saving some tax dollars there.  This deduction can be used by virtually any college student, full or part-time, undergraduate or graduate school.  This credit phases out if your income is above $80K single and $160K married.

The above should be considered a summary of the rules for each education tax break and is not meant to be all-inclusive.  That would be a really boring blog. Please consult the IRS Publication 970 or other sources for all the rules regarding the various education tax breaks.

Many tax software programs will optimize the education credit that's right for you, factoring in what you qualify for and your income level.  Most are not sophisticated enough to include the Ohio savings on the tuition deduction, so you might have to factor that in by hand.  The bottom line is that education tax breaks are generous and plentiful.  Did you take the right one this year?