Tax Incentives for Higher Education

Federal tax incentives have focused on higher education since the advent of the education IRA over 15 years ago. We have come a long way in available incentives since the maximum $500 per year deduction for the Coverdell IRA, including the following:

• The available benefits are higher,
  
• there are many more options for credits and deductions,
  
• state incentive plans have come into existence, and
  
• qualifying expenses and eligibility have been expanded.
  

Additionally, recent natural disasters like the floods in the Midwest in May and June 2008 led to additional incentives for those attending school in affected areas.

Like all tax incentives, individual facts and circumstances determine eligibility, but the following provides guidelines to the current landscape of education incentives.

American Opportunity Credit

The American Recovery and Reinvestment Act (passed in early 2009) expanded the Hope Education Credit. Known as the American Opportunity Credit, it is now available to more students than ever before. Whereas the Hope Credit used to only apply during the first two years of college education, the American Opportunity Credit applies to all four years of college. (Students must be enrolled at least half-time and pursuing a degree or certificate). Qualifying expenses include not just tuition, but also books and supplies or equipment required for a class. An expenditure for a computer may even qualify if the school requires a computer for enrollment or attendance.

The American Opportunity Credit provides a credit of 100% of the first $2,000 of tuition and fees and 25% of the next $2,000 for a maximum credit of $2,500 per student per year. Although some phase-outs apply for those with higher incomes, many students and families will qualify for the maximum credit. Furthermore, the new rules allow the credit to create a refund for some situations and not just reduce the tax to zero.

Lifetime Learning Credit

The Lifetime Learning Credit is another way for students to receive a tax credit to offset educational expenses. The Lifetime Learning Credit provides a credit of 20% of up to $10,000 of educational expenses, for a maximum credit of $2,000. Books and other fees are only eligible if they are required for enrollment. Though not as attractive as the American Opportunity Credit, it may be of benefit to those who are taking only one or two classes or who are graduate students. The maximum amount of the credit is less, but even students that are less than half-time and graduate students can take the Lifetime Learning Credit.

Tuition and Fees Deduction

Students (or their parents) who do not take either of the education credits could reduce their taxable income by up to $4,000 by claiming the Tuition and Fees Deduction. Eligible expenses include tuition and any fees required by the college. While the Tuition and Fees Deduction used to be an attractive alternative to the credits for people with higher incomes, the expansion of the credits reduced the number of people who benefit from taking the deduction. Nonetheless, the deduction still fits certain circumstances.

Section 529 Savings Plans

There can be tax advantages to saving for college through a Section 529 Savings Plan. Also called Qualified Tuition Programs (QTPs), 529 Plans allow parents or grandparents to make contributions to a state-run fund that grows tax-free and that has tax-free distributions as long as the money is used for educational purposes. There is no income limit for contributors and a very high limit on the amount that can be contributed (varies by state, but generally more than $200,000). Additionally, some states offer a tax incentive for residents to participate in their plan. For example, there is a deduction of up to $3,000 per child per year for Wisconsin residents who make contributions to the Wisconsin plan (called EdVest). Though each state offers a 529 Plan, people are not limited to the plan of their own state. To find out more about 529 Plans or to compare state plans, click here.

Additional Incentives for the Midwest Disaster Area

Many sections of the Midwest experienced flooding in May and June of 2008 and were part of a federal disaster area, including 30 Wisconsin counties as well as parts of all surrounding states. As an incentive to students, the IRS retained the Hope Credit for 2009 for students whose schools were in the disaster area so that they could claim an increased credit. Though the Hope Credit was replaced by the American Opportunity Credit for most students, disaster area students may still claim the Hope Credit in 2009. With a maximum credit of $3,600 for disaster area students, the Hope Credit may be more attractive for many eligible students than the American Opportunity Credit (with a $2,500 maximum credit). The maximum Lifetime Learning Credit remains increased from $2,000 to $4,000 for any students who attended school in a Midwest Disaster Area in 2009. The additional credits for disaster area students are available for both 2008 and 2009. For more information and county listing visit http://www.irs.gov/pub/irs-pdf/p4492b.pdf

Which is Best for Me?

While the American Opportunity Credit generally offers a greater tax credit, some people are not eligible and may benefit from choosing the Lifetime Learning Credit. Some people may also still benefit most from choosing the Tuition and Fees Deduction. Students in disaster areas may still claim the Hope Credit. You can claim only one of the three education incentives for each student in any given year, although you could conceivably differ between the students or in different years (depending on the credit). The IRS has complicated rules about who can claim which credit for which expenses (and under what circumstances).

The following summarizes key aspects of the American Opportunity and Lifetime Learning Credits:

Choosing the wrong credit could cost you thousands of dollars. The benefits from the credits can be significant, but the rules are complicated. Therefore, Komisar Brady & Co. uses specialized analysis tools to ensure that you take the credit that maximizes your education incentive. Please contact us if you want us to look at your individual situation.

To ensure compliance with Treasury Circular 230, we are required to inform you that any advice concerning U.S. federal tax issues contained on this website is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code and was not written to support the promotion or marketing of any transaction or matter discussed herein. Application of tax regulations is specific to the individual or business and we recommend that you consult a qualified Komisar Brady tax professional for how the above information may apply to you.