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The Best Tax Breaks Uncle Sam Can Cut Your Costs
From a Wall Street Journal article 10/29/11 by Laura Saunders
Here's a rundown of the most useful education tax benefits. Note that with the exception of the student-loan interest deduction, taxpayers are prohibited from "double-dipping," or taking more than one tax break for the same expenses.
American Opportunity Tax Credit.
This is one of the best benefits for those who qualify. It's a dollar-for-dollar tax offset of up to $2,500 per student per year, for up to four years of undergraduate (but not graduate) education for students enrolled at least half-time in a degree program. Up to $1,000 of the credit is "refundable," meaning the family can get a check for that amount from Uncle Sam if no tax is due. If the taxpayer writes a tuition check in December for the spring semester, the credit may be claimed for that year's taxes. The credit can be used for books, supplies and equipment as well as tuition, but it can't be claimed by anyone with a felony drug conviction.
For 2011, the benefit fully phases out at $90,000 of adjusted gross income (AGI) for most single returns and $180,000 for most joint returns. If the family can't claim the credit and the student has earned income, some advisers suggest running the numbers to see if the student qualifies for the credit on his own. Lifetime Learning Credit. While less generous than the American Opportunity Tax Credit, this is a useful tax offset of up to $2,000 for tuition and fees per year per family. It applies to graduate as well as undergraduate education, plus continuing-education courses taken to acquire or improve job skills.The credit fully phases out at $122,000 of AGI for most joint returns and $61,000 for most single returns.
Qualified Tuition Programs ("529 plans").
529 plans are often the best education benefit for taxpayers who don't qualify for other breaks, in part because there are no income phaseouts. Individual donors (often parents and grandparents) may put up to $65,000 per beneficiary into a 529 plan once every five years, without gift tax consequences. In 2008, President Obama and his wife used this provision to put $120,000 each into 529 plans for their two daughters. 529 plans are run by the states, which set terms and limits within federal guidelines; some give a tax deduction to in-state residents. There's no federal deduction on money as it goes into an account, but the earnings are tax-free if used for either undergraduate or graduate tuition, fees, room, board, books and supplies. (For more, please see "529 Plans Roll Out New Perks," Page B8.)
Grandparents often like 529 plans, because they control the account and can withdraw funds if circumstances change. (The earnings portion of a withdrawal are subject to a 10% penalty and are taxable.) So if a grandparent stocks a 529 account with $50,000 but later needs the money for medical bills, he or she can reclaim the money. What's more, 529 funds aren't considered part of an estate. While federal taxes don't matter for many while the estate tax exemption remains $5 million per individual, many states still have significant estate taxes.
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It's often possible to change a 529 account's beneficiary, so if Mom or Dad wants to go back to school, the plan could be shifted; check your state's rules. Because of the double-dipping rules, taxpayers with 529 plans who also qualify for another credit will want to use the credit first and then withdraw remaining funds from the 529 plan.
For example, if qualified college costs come to $12,000 after merit scholarships and there's a sizable 529 plan, pay the first $4,000 out of pocket in order to preserve the American Opportunity Tax Credit, and then withdraw the rest from the 529 plan. Many 529 plans are currently "underwater" because of high fees or poor market performance over the last decade. In that case, the taxpayer may close the account without penalty or tax. A net loss can be taken as a miscellaneous deduction.
Business Deduction for Work-Related Education.
This deduction allows a full write-off for tuition, fees, transportation and other expenses. There is no dollar limit on the size of the deduction, nor is there any income phase-out. There's a big catch, however: The education can't qualify the taxpayer for a new trade or business, such as a law, medical, or nursing degree. An advanced law degree or an M.B.A. can work, if the taxpayer isn't switching fields. Mr. Baker, the small-business adviser in Washington, is writing off the costs of his Masters degree at American University, plus transportation. "Many of my students have claimed this deduction with success, even when it has been challenged by the IRS," says Robert Willens, an adjunct professor at Columbia University's Business School.
Student-Loan Interest Deduction.
Interest paid on student loans for tuition, room and board, transportation and other expenses may be deductible up to $2,500 per year, depending on the type of loan, if the student was enrolled at least half-time in a degree program. It applies to debt from graduate and undergraduate programs. The benefit fully phases out by $150,000 of AGI for most joint returns and $75,000 for most single returns.
Employer-Provided Educational Assistance.
Both an employer and an employee may exclude up to $5,250 from tax per year for payments for education. The exclusion applies to undergraduate and graduate tuition, and there's no income phaseout. No payroll tax is due on the payment, either, and the aid may be used for books and supplies as well as tuition.
Philip Vogt, a 28-year-old M.B.A candidate at Monmouth University in New Jersey, is using this benefit. He works at a division of Parexel International, a clinical research firm, and wants to add accounting skills to his degree in management. "It's a great benefit for an employer to offer," he says. To offer it, the employer must have a "127 plan" in place, and it must be publicized to all employees. A family business might be able to provide this assistance to a relative who works in the business, if he or she doesn't own 5% or more of the business. "Check with an expert about age requirements and other issues," says Monmouth's Mr. Stives.
Tuition and Fees Deduction.
Experts suggest thinking twice before taking this $4,000 deduction for tuition and fees. In most cases, the offset of a tax credit is more valuable.
"A bigger number doesn't mean a bigger benefit," says Melissa Labant of the American Institute of CPAs.
This deduction available for graduate as well as undergraduate education, and it fully phases out at $160,000 for most joint filers and $80,000 for most single filers.
Early IRA Distribution.
Early withdrawals from a traditional IRA (usually before age 59½) that are used for education aren't subject to a 10% penalty. The payout can be used for books, supplies, and room and board (if at least a half-time student) as well as tuition. The problem: Full income tax is due. And "once assets are out of an IRA, they can't be put back," says Mr. Carpenter. "I advise against this."
Write to Laura Saunders at email@example.com