Ben Franklin once said, "an investment in knowledge always pays the best interest." And if you're going to college to further your education and expand your mind, Uncle Sam offers a few tax breaks that can increase the return on your investment.
Some of the federal education tax credits, deductions, and exemptions are for people who are saving for college, while others help pay for tuition and books while you're a student. There are also tax breaks that help with student loan debt once your days in the classroom are over. However, the rules can be tricky, and sometimes you can't take advantage of one tax break if you already claimed another. So, it's important to be up to date on all the rules all the time. Here's a breakdown of 11 education tax breaks that can help you pay for college. No matter where you are on your quest for knowledge, there's probably a tax break that can help your bottom line.
Perhaps the best way for parents to save for a child's college education is through a 529 savings plan. From the time a child is born to the time he or she goes off to college, parents can be stashing money in a 529 account for the child's education and letting the funds grow tax-free for years. (Grandparents and others can set up 529 accounts for the child, too.) Plus, there's no tax on withdrawals used for qualified college expenses, such as tuition, fees, room and board, books, computers, or internet access fees (withdrawals for room and board are tax-free only for students enrolled at least half-time). Up to $10,000 from a 529 account can also be used to pay down the child's student loan debt. And if your child ends up not going to college, tax-free rollovers to a 529 plan for another family member are allowed.
Money from a 529 plan can be used to cover eligible expenses at a public or private college or university, graduate school, and/or trade school. And if you're trying really hard to get accepted to a top-flight college and you think attending a private elementary or secondary school will help, you can even use up to $10,000 per year in 529 plan funds to cover tuition (only) for a K-12 education. (But try not to blow all your 529 money before you even get to college!)
Many states also offer tax breaks for residents who put money into a 529 plan sponsored by the state. For example, you might get a state tax deduction for contributions to a plan. So, be sure to research your state's rules before selecting a 529 plan.
Although they aren't as popular as 529 savings plans, a few states also offer 529 plans that let you prepay college costs. The benefit of a prepaid 529 plan is that you lock in a set price for future expenses. One disadvantage is that prepaid plans typically only cover tuition and fees.
There are many 529 plan options out there. To find the one that's best for you, check out savingforcollege.com (opens in new tab).
Coverdell Education Savings Accounts (ESAs)
Another way to save for college is through a Coverdell Education Savings Account (ESA). Like 529 plans, money deposited in a Coverdell ESA grows tax free, and there's no tax on distributions used for qualified college expenses. However, unlike 529 plans, the tax code places limits on who can contribute to a Coverdell ESA, how much can be deposited into a Coverdell ESA each year, how long you can contribute to a Coverdell ESA, and how long you can leave money in a Coverdell ESA.
Single people can contribute to a Coverdell ESA only if they have a modified adjusted gross income (AGI) of $110,000 or less. Married couples filing a joint return can't have a modified AGI of more than $220,000. (Modified AGI is equal to your federal AGI, plus any foreign earned income exclusion and/or housing exclusion, foreign housing deduction, and excluded income from Puerto Rico or American Samoa.)
Total contributions for each child in any year can't be more than $2,000, no matter how many separate Coverdell ESAs have been established for him or her. Plus, parents or others might not be allowed to contribute the full $2,000 each year. If a contributor's modified AGI is between $95,000 and $110,000 (between $190,000 and $220,000 for joint filers), the $2,000 limit for each child is gradually reduced to zero for that person.
Contributions to a child's Coverdell ESA aren't allowed after the child turns 18 (except for special needs children). Money in a Coverdell ESA must also be distributed within 30 days after the child turns 30 (again, except for special needs children).
American Opportunity Tax Credit
The American Opportunity tax credit is one of two credits available to people who are taking college courses now. However, it's only available for expenses incurred by students who are in their first four years of undergraduate study. So, if you've already claimed this credit for more than four years, you're no longer eligible. You must also attend college at least half-time for an academic period that began in the tax year for which the credit is claimed. In addition, you must also be pursuing a program leading to a degree or other recognized education credential. If you have a felony drug conviction at the end of the tax year, then you can't claim the credit.
(Warning: If you claim the American Opportunity credit even though you're not eligible, you'll be banned from claiming it again for two years in the case of reckless or intentional disregard of the rules, or 10 years in the case of fraud.)
For purposes of the American Opportunity credit, qualified expenses include tuition and certain related expenses required for enrollment or attendance at the student's college (e.g., necessary fees, books, supplies, and equipment). Expenses that don't count include amounts paid for insurance; medical expenses (including student health fees); room and board; transportation; or similar personal, living or family expenses. This is true even if payment is a condition of enrollment or attendance. You also can't claim the credit for expenses for any class that involves sports, games, or hobbies, or any noncredit course, unless the course is part of the student's degree program.
A parent, spouse or student who isn't claimed as a dependent can claim the credit for 100% of the first $2,000 spent on qualified education expenses — tuition, fees and textbooks — and 25% of the next $2,000, for a total credit of $2,500 for each qualifying student. If the credit amount exceeds the tax you owe for the year, you'll get a refund for 40% of the remaining amount, up to $1,000, for each qualifying student.
Joint filers qualify for the full credit if their modified AGI is $160,000 or less. Single filers get the full amount with a modified AGI of $80,000 or less. The credit is gradually reduced to zero for married couples with a modified AGI between $160,000 and $180,000, and for single taxpayers with a modified AGI between $80,000 and $90,000.
There are a number of rules that prevent duplicate tax benefits. For example, you can't:
- Deduct higher education expenses on your tax return (e.g., as a business expense) and also claim an American Opportunity credit based on the same expenses;
- Claim an American Opportunity credit for any student and use any of that student's expenses in figuring the Lifetime Learning credit (see below);
- Calculate the tax-free portion of a distribution from a 529 plan or Coverdell ESA using the same expenses you use to calculate the American Opportunity credit; or
- Claim an American Opportunity credit based on qualified education expenses paid with tax-free educational assistance, such as a scholarship, grant, or assistance provided by an employer (see below).
Lifetime Learning Tax Credit
The second tax credit for people currently enrolled in college is the Lifetime Learning credit. With this credit, you can claim 20% of the first $10,000 of out-of-pocket costs for college tuition, fees and books for a total maximum credit of $2,000. Unlike the American Opportunity credit, the Lifetime Learning credit is not limited to undergraduate educational expenses, nor does the credit apply only to students attending at least half-time. There's also no limit on the number of years the Lifetime Learning credit can be claimed for each student. That makes this credit perfect for older people going back to school to get a new job, earn a second degree, or just keep their brain in shape. You can claim the credit for yourself, your spouse, or your dependent for up to $2,000 per family each year.
The phase-out rules for the Lifetime Learning credit are the same as those for the American Opportunity credit. So, the full credit is available to married couples filing a joint return if their a modified AGI is $160,000 or less, and single filers with a modified AGI of $80,000 or less. The credit is gradually reduced, and eventually eliminated, for joint filers with a modified AGI between $160,000 and $180,000, and for single taxpayers with a modified AGI between $80,000 and $90,000.
Generally, the same types of education expenses that qualify (or don't qualify) for the American Opportunity credit also qualify for the Lifetime Learning. However, you can also claim the Lifetime Learning expenses for classes taken to acquire or improve job skills.
The same rules that prevent duplicate tax benefits with regard to the American Opportunity credit also apply for purposes of the Lifetime Learning credit. As a result, you can't:
- Deduct higher education expenses on your tax return (e.g., as a business expense) and also claim an Lifetime Learning credit based on the same expenses;
- Claim an Lifetime Learning credit for any student and use any of that student's expenses in figuring the American Opportunity credit;
- Calculate the tax-free portion of a distribution from a 529 plan or Coverdell ESA using the same expenses you use to calculate the Lifetime Learning credit; or
- Claim a Lifetime Learning credit based on qualified education expenses paid with tax-free educational assistance, such as a scholarship, grant, or assistance provided by an employer.
The Lifetime Learning credit is not refundable. As a result, it can reduce your tax to zero, but the excess won't be refunded to you if the credit is more than your tax.
Scholarships, Fellowships, and Other Assistance
Many types of educational assistance are tax free if they meet certain requirements. For example, a scholarship or fellowship grant is excluded from taxable income if you're a degree candidate at an eligible educational institution (including Pell grants and other need-based education grants). The money must also be used for tuition or fees required for enrollment or attendance, or for books, supplies, equipment, or other expenses that are required for a class. It can't exceed your education expenses; be designated or earmarked for non-educational purposes (e.g., travel or room and board); or represent payment for teaching, research, or other services required as a condition for receiving the financial assistance.
Payments to veterans for education, training, or subsistence under any law administered by the Department of Veterans Affairs are also tax free. However, if you qualify for other education tax benefits, you may have to reduce the amount of education expenses qualifying for other tax benefits by any VA payments that are used for education expenses.
(Note: An appointment to a U.S. military academy, such as West Point or the Naval Academy, isn't a tax-free scholarship or fellowship grant. Payments received by a cadet or midshipman at a service academy are not tax-free, either.)
If your tuition is reduced because you or a relative works for a college, you might not have to pay tax on this benefit. (Although any tuition reduction received as payment for your services is taxable). The rules for determining if a tuition reduction is tax free are different if the education provided is at the undergraduate or graduate level. If you receive a tuition reduction for undergraduate courses, it's tax free only if you're:
- An employee of the college;
- A former employee of the college who retired or left on disability;
- A widow(er) of someone who died while an employee of the college or who retired or left on disability; or
- The dependent child or spouse of someone described above.
For graduate courses, a tuition reduction is tax free only for students who perform teaching or research activities for the college or university.
Employer-Provided Educational Assistance
Workers who receive educational assistance benefits from their employer can exclude up to $5,250 of those benefits from their taxable income each year. The benefits must be paid under a written educational assistance program. An employee can't use any of the tax-free education expenses paid by their employer as the basis for any other deduction or credit, including the American Opportunity credit and Lifetime Learning credit.
Tax-free educational assistance benefits include payments for tuition, fees, books, supplies, and equipment. The payments don't have to be for work-related courses or courses that are part of a degree program. Until 2026, employer payments of an employee's student loan debt, whether paid to the worker or directly to a lender, are also tax free. However, employer payments for the following are not tax exempt:
- Meals, lodging, or transportation;
- Tools or supplies (other than textbooks) that you can keep;
- Courses involving sports, games, or hobbies unless they have a reasonable relationship to the employer's business or are required as part of a degree program.
Employees generally have to pay tax on any educational assistance benefits over $5,250. However, benefits over the $5,250 limit are still tax free if they qualify as a working condition fringe benefit. (A working condition fringe benefit is a benefit that, had you paid for it, would be allowable as a business expense deduction.)
Deduction for Self-Employed Person's Work-Related Education
There are a number of self-employment tax deductions. For example, self-employed people generally can deduct the cost of work-related education as a business expense. This reduces the amount of income subject to both the federal income tax and self-employment tax. The education must be required to either:
- Keep your present salary, status, or job; or
- Maintain or improve skills needed in your present work.
However, no deduction is allowed if the education is:
- Needed to meet the minimum educational requirements of your present job; or
- Part of a program that will qualify you for a new job.
If the education meets the requirements above, you can deduct the following expenses:
- Tuition, books, supplies, lab fees, and similar items;
- Certain transportation and travel costs; and
- Other education expenses, such as costs of research and typing when writing a paper as part of an educational program.
Personal or capital expenses aren't deductible, though. For instance, you can't deduct the dollar value of vacation time or annual leave taken to attend classes. You also can't deduct a work-related education expense as a business expense if you paid for them with tax-free scholarship, grant, or employer-provided educational assistance. You also can't deduct them if you also benefit from the expenses under any other provision of the law.
Early Distributions from IRAs
As the name implies, individual retirement accounts (IRAs) are meant to be used in retirement. That's why you generally have to pay a 10% tax if you take money out of an IRA before you reach age 59½ (in addition to income taxes on the amount withdrawn). However, you can withdraw funds from an IRA to pay for qualified higher education expenses without having to pay the 10% additional tax (although you may still owe income tax on all or some of the amount distributed). This penalty exemption applies whether your taking money out of a traditional IRA, Roth IRA, or SIMPLE IRA.
For the 10% penalty tax to be waived, the education expenses must be for:
- Your spouse;
- Your or your spouse's child, foster child, or adopted child; or
- Your or your spouse's grandchild.
Allowable expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. For students attending on at least a half-time basis, room and board are qualified expenses, too. For special needs students, expenses for any special services incurred in connection with the student's enrollment or attendance at an eligible educational institution also count.
To determine the amount of your IRA distribution that isn't subject to the 10% penalty, reduce your total qualified education expenses by any tax-free educational assistance. However, don't reduce the expenses by any amounts paid with funds the student receives as:
- Payments for services (e.g., wages);
- Inherited property given to either the student or the person making the withdrawal; or
- Withdrawals from personal savings (including savings from a qualified tuition program).
Education Savings Bond Program
Do you have any old savings bonds that your grandmother gave you when you were a kid? If so, you might be able to cash them in without paying tax on the interest earned if you use the proceeds to pay qualified education expenses for yourself, your spouse, or a dependent.
The savings bonds must be series EE bonds issued after 1989 or series I bonds. They also have to be issued either in your name (as the sole owner) or in the name of both you and your spouse (as co-owners). In addition, the owner must be at least 24 years old before the bond's issue date, which is printed on the front of the bond.
Tax-free treatment is available if the savings bond money is used for tuition and fees required for college enrollment or attendance, contributions to a 529 plan, or contributions to a Coverdell ESA. It can't be used for room and board, or for courses involving sports, games, or hobbies that aren't part of a degree or certificate-granting program.
If you're married and filing a joint return, the ability to claim this tax break on 2022 returns starts to phase out when adjusted gross income exceeds $128,650 and is completely phased out after $158,650. For singles and heads of households, the 2022 phase-out zone starts at $85,800 and is ends after $100,800.
Student Loan Interest Deduction
When your college days are over and your diploma is in hand, you might have a new financial hardship to worry about – student loan debt. If so, the tax code provides a few ways to lessen this heavy financial burden. The most notable tax break is the deduction for student loan interest.
Most of the time, personal interest you pay isn't deductible on your tax return. However, you may be allowed a special deduction for paying interest on a student loan used for higher education. The student loan interest deduction is an "above-the-line" deduction, so you can claim it on your tax return even if you don't itemize.
You can only deduct up to $2,500 of student loan interest paid each year. However, that amount is gradually reduced to zero if your modified AGI is between $70,000 and $85,000 ($145,000 and $175,000 for joint filers).
The loan must be taken out solely to pay qualified education expenses for you, your spouse, or a person who was your dependent when you took out the loan. Qualified expenses include amounts paid for:
- Tuition and fees;
- Room and board;
- Books, supplies, and equipment; and
- Other necessary expenses (such as transportation).
Married couples filing separate returns can't claim the student loan interest deduction. You're also disqualified if someone else (e.g., a parent or guardian) claims you as a dependent on their tax return.
Here's a tip for lucky recent grads: If your parents pay your student loans, the IRS treats the payment as if the money were given to you, and you then pay the debt. So, as long as you are no longer claimed as a dependent, you can deduct up to $2,500 of student-loan interest paid by Mom and Dad each year.
Student Loan Cancellation and Repayment Assistance
We're all waiting to see if or when President Biden will cancel students loan debt on a wide-scale basis. The most recent reports suggest that he will forgive up to $10,000 of federal student loan debt for single taxpayers with income of $150,000 or less and joint filers with income of $300,000 or less.
So, from a tax perspective, what happens if all or part of your student loan is canceled in 2022? For most loans, any debt that is canceled must be included in your taxable income. With student loans, however, you may be able to avoid tax on debt cancelled through 2025 if the loan is:
- Guaranteed or insured by the government and expressly for post-secondary educational expenses;
- Made by an educational institution expressly for post-secondary educational expenses;
- A private education loan;
- From an educational organization; or
- From a tax-exempt organization to refinance a student loan.
This list includes the vast majority of student loans in the country right now.
And what if, instead of your student loan being forgiven, it's paid by someone else? When it comes to student loan repayment assistance, taxation of the payments depends on who is making them. The payments are tax free for you if they're made by:
- The National Health Service Corps Loan Repayment Program;
- A state education loan repayment program eligible for funds under the Public Health Service Act; or
- Any other state loan repayment or loan forgiveness program that is intended to provide for the increased availability of health services in underserved or health professional shortage areas.
Note, however, that you can't also deduct student loan interest you paid on the loan to the extent payments were made through your participation in one of these programs.
Rocky was a Senior Tax Editor for Kiplinger from October 2018 to January 2023. He has more than 20 years of experience covering federal and state tax developments. Before coming to Kiplinger, he worked for Wolters Kluwer Tax & Accounting and Kleinrock Publishing, where he provided breaking news and guidance for CPAs, tax attorneys, and other tax professionals. He has also been quoted as an expert by USA Today, Forbes, U.S. News & World Report, Reuters, Accounting Today, and other media outlets. Rocky has a law degree from the University of Connecticut and a B.A. in History from Salisbury University.
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