Paying for college? You may be able to claim a big tax break, even if you’ve never before qualified.
That’s because the Obama administration replaced an old break with a new and improved one—but only for a limited time. To take advantage of it, you’ll have to negotiate the often wacky world of tuition tax write-offs.
“There is a smorgasbord of education credits available now,” said Bob Meighan, vice president of TurboTax in San Diego. “It’s mind-boggling.”
What are the breaks? Who gets them? And how can you best take advantage of them?
First you have to choose among a trio of tax credits and one tax deduction that offset your cost of tuition. Then you have to look at “income exclusions” for profits pulled out of savings to pay college bills and see if you can write off student loan interest.
Breaks for tuition
The latest and greatest of the college write-offs is the American Opportunity Tax Credit. This can reduce your tax—or increase your refund—by $2,500. To claim the full credit, you must have paid at least $3,000 in eligible college bills and must meet some income restrictions.
Eligible bills include college tuition, fees and books for you, your spouse or a dependent.
In years past, income restrictions locked many people out of claiming education credits because individuals earning more than $50,000 and couples earning more than $100,000 would see their credit phased out.
This year, the break isn’t reduced until single filers earn more than $80,000 and married couples earn more than $160,000. It’s lost completely at $90,000 in single income and $180,000 in joint income.
But that’s based on adjusted gross income, which is the income you declare after subtracting “above-the-line” deductions for contributions to your 401(k) retirement plan, health savings accounts, any alimony and student-loan interest you pay. That means a married couple could be earning in the neighborhood of $200,000 and still get this lucrative break.
Also important for lower-income taxpayers is that this break is partly “refundable.” What does that mean? Most breaks just give you back the tax that you paid through withholding. They typically stop benefiting you once your tax bill is reduced to zero. This one is 40 percent refundable, said Mark Luscombe, principal tax analyst with CCH Inc., a Riverwoods, Ill., publisher of tax information. That means it can provide as much as a $1,000 refund, even if you paid no federal income tax.
The tax code includes two other education credits—the Hope Tax Credit and the Lifetime Learning Credit. But because you can take only one tax credit per college student (if you have more than one student, you can get more than one credit), you have to choose among these and the American Opportunity Credit.
Because the Hope Tax Credit provides a maximum write-off of $1,800 annually and the Lifetime Learning Credit provides a maximum of $2,000 annually, the American Opportunity Credit is going to be the best for most filers.
There is one exception: If you happen to have a student attending college in one of 10 Midwestern states that were affected by floods in 2008, you can double the value of either the Hope or Lifetime Learning credits on your 2009 return.
Why? If you’re looking for logic in the tax code, you’re going to be disappointed. Let’s just say that some legislators thought it was a good idea at the time. For now, it’s a nifty loophole for people going to school in Arkansas, Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Missouri, Nebraska and Wisconsin.
Another education tax break that you’ll probably want to forgo this year is the tuition and fees deduction. The maximum deduction is $4,000, but it’s limited to $2,000 for those who earn more than $65,000 single or $130,000 married, and is eliminated completely once single income exceeds $80,000 and married income exceeds $160,000.
Before you start thinking that sounds better than the American Opportunity Credit for those who meet the lower income restrictions, remember that a credit reduces your tax on a dollar-for-dollar basis. A deduction just reduces the income subject to tax. That means a $4,000 deduction will reduce your tax bill by $1,000 if you’re in the 25 percent federal income tax bracket.
Can you claim both a tuition credit and the deduction? Only if you have more than one student going to college. You have to choose one among these four potential breaks for any individual student.
There are other special breaks for paying education bills that can be used in conjunction with these tuition credits.
For instance, if you take money out of a 529 savings plan, all the investment income (and the principal, of course) is tax free, as long as you use the money to pay for qualified education expenses. If you’ve already used up your tuition write-offs by claiming a credit against those expenses, don’t worry. The 529 money gets tax-free treatment even if it’s used to pay for room and board for a full-time student.
Likewise, money taken out of a Coverdell Education Savings Account is tax-free as long as it’s used for qualified education expenses, which can include room and board as well as classroom supplies and computers. Coverdell money can also pay the cost of a private elementary or secondary school.
As much as $2,500 in student loan interest also is deductible for taxpayers earning less than $60,000 when single or $120,000 when married. Lesser amounts are deductible for those earning up to $75,000 single and $150,000 married.
And, in some instances, the interest earned on savings bonds that are cashed in to pay for education bills can be exempt from tax.
If your employer provides tuition assistance, that’s tax-free, too, as long as it amounts to less than $5,250 a year.
Not enough for you? Wait until next year. At the rate that Congress is passing tuition tax breaks, there’s a 50-50 chance that there will be another one to talk about in 2011.