Tax Deductions for College Expenses

As a parent of a college-age child, your goal is to pay for current or imminent college bills. We would like to address this concern by suggesting several approaches that seek to take maximum advantage of tax benefits to minimize your expenses. (Please note that the following suggestions are strictly related to tax benefits. You may have non-tax-related concerns that make the suggestions inappropriate.)

Tuition tax credits. You can take an American Opportunity tax credit (AOTC) of up to $2,500 per student for the first four years of college-a 100% credit for the first $2,000 in tuition, fees, and books, and a 25% credit for the second $2,000. You can take a Lifetime Learning credit of up to $2,000 per family for every additional year of college or graduate school-a 20% credit for up to $10,000 in tuition and fees.

Both credits are phased out for higher-income taxpayers. The American Opportunity tax credit is phased out for couples with income between $160,000 and $180,000, and for singles with income between $80,000 and $90,000. The Lifetime Learning credit is phased out (for 2017) for couples with income between $112,000 and $132,000, and for singles with income between $56,000 and $66,000. The phase-out range for the Lifetime Learning credit is adjusted annually for inflation.

Only one credit can be claimed for the same student in any given year.

Statement from institution required before tuition credits or qualified tuition deduction can be claimed. To claim the tuition tax credits, a taxpayer must receive a Form 1098-T payee statement from the educational institution. For purposes of this requirement, if a person the taxpayer claims as a dependent receives the Form 1098-T, the statement is treated as received by the taxpayer.

Scholarships. Scholarships are exempt from income tax, if certain conditions are satisfied. The most important are that the scholarship must not be compensation for services, and it must be used for tuition, fees, books, supplies, and similar items (and not for room and board).  Scholarships used for room and board would be taxable to the student.

Although a scholarship is tax-free, it will reduce the amount of expenses that may be taken into account in computing the American Opportunity and Lifetime Learning credits, above, and may therefore reduce or eliminate those credits.

Employer educational assistance programs. If your employer pays your child's college expenses, the payment is a fringe benefit to you, and is taxable to you as compensation, unless the payment is part of a scholarship program that's "outside of the pattern of employment." Then the payment will be treated as a scholarship (if the other requirements for scholarships are satisfied).

Tuition reduction plans for employees of educational institutions. Tax-exempt educational institutions sometimes provide tuition reductions for their employees' children who attend that educational institution, or cash tuition payments for children who attend other educational institutions. If certain requirements are satisfied, these tuition reductions are exempt from income tax.

College expense payments by grandparents and others. If someone other than you pays your child's college expenses, the person making the payments is generally subject to the gift tax, to the extent the payments and other gifts to the child by that person exceed the regular annual (per donee) gift tax exclusion of $14,000 for 2017. Married donors who consent to split gifts may exclude gifts of up to $28,000 for 2017.

However, if the other person pays your child's school tuition directly to an educational institution, there's an unlimited exclusion from the gift tax for the payment. The relationship between the person paying the tuition and the person on whose behalf the payments are made is irrelevant.

The unlimited gift tax exclusion applies only to direct tuition costs. There's no exclusion (beyond the normal annual exclusion) for dormitory fees, board, books, supplies, etc. Prepaid tuition payments may qualify for the unlimited gift tax exclusion under certain circumstances.

Student loans. You can deduct interest on qualifying loans used to pay for college education expenses. The maximum deduction is $2,500. However, the deduction phases out for taxpayers who are married filing jointly with AGI between $135,000 and $165,000 (between $65,000 and $80,000 for single filers).

Bank loans. In order to take the student loan interest deduction, the loan must be a “qualifying” student loan.  Therefore, interest on non-qualifying bank student loans will be nondeductible. However, if you use a home equity loan, the interest is deductible for regular income tax purposes (although not for alternative minimum tax purposes). Interest on home equity debt would be reported on Schedule A.

Borrowing against retirement plan accounts. Many company retirement plans permit participants to borrow cash. This option may be an attractive alternative to a bank loan, especially if your other debt burden is high. However, the loan must carry an interest rate equal to the prevailing commercial rate for similar loans, and, unless you qualify for the deduction for education loan interest (described above), there's no deduction for the personal interest paid. Moreover, unless strict requirements are satisfied, a loan against a retirement account is treated as a premature distribution (withdrawal) that's subject to regular income tax and an additional penalty tax.

Withdrawals from retirement plan accounts. IRAs and qualified retirement plans represent the largest cash resource of many taxpayers. You can pull money out of your IRA (including a Roth IRA) at any time to pay college costs without incurring the 10% early withdrawal penalty that usually applies to withdrawals from an IRA before age 59½. However, the distributions are subject to tax under the usual rules for IRA distributions.

Not all of the above breaks may be used in the same year, and use of some of them reduces the amounts that qualify for other breaks. So it takes planning to determine which should be used in any given situation. If you would like to discuss one or more of the above payment possibilities, or any other alternatives, in more detail, please contact us.