12 Tax Deductions and Credits That Help You Pay for College
Whether you're saving for college, currently paying tuition, or dealing with student loan debt, there's probably a tax break that can help your bottom line.
We talk a lot about investing in stocks, bonds, mutual funds, and ETFs here at Kiplinger. But as 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 tax deductions and credits are for people who are saving for college, while others help to 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 12 tax deductions, credits, and exemptions 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 socking away 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.
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.
COVID-19 ALERT: Refunded Tuition. If you withdrew money from a 529 account to pay for college tuition or housing, but the money was refunded because the school closed for coronavirus concerns, the refund is generally tax-free if you redeposit the funds into a 529 account for the student within 60 days.
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).
One of the main advantages Coverdell ESAs used to have over 529 plans was the ability to used Coverdell funds for primary and secondary school expenses. However, the 2017 tax reform law watered down that advantage. Now, up to $10,000 per year can be taken out of a 529 plan to pay for kindergarten through 12th grade tuition without having to pay federal taxes on the amount withdrawn.
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 (or the former Hope credit) for more than four years, you're no longer eligible. The student must also attend college at least half-time for an academic period that began in the tax year for which the credit is claimed. He or she must be also be pursuing a program leading to a degree or other recognized education credential.
(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 is not 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 in the same year that you claim a tuition and fees deduction (see below) for the same student;
- 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 a 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. You can claim the credit for yourself, your spouse or your dependent for up to $2,000 per family each year.
For 2020 tax returns, you qualify for the benefit if your modified adjusted gross income is no higher than $138,000 for married couples filing jointly or $69,000 for single filers ($136,000 and $68,000, respectively, for 2019). Couples get the full 2019 credit at $118,000; singles at $59,000 ($119,000 and $58,000 for 2019).
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.
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.
Tuition and Fees Deduction
The American Opportunity and Lifetime Learning credits are usually the best tax breaks to help pay for current college expenses. However, if you don't qualify for those credits, you still might be able to claim a tax deduction for college tuition and fees for yourself, your spouse, or your dependents.
The deduction is an "above-the-line" deduction, which means that you don't have to itemize to claim it. In addition to tuition, the deduction covers student fees and expenses for course-related books, supplies, and equipment if they are required to enroll or attend a class. Insurance; medical expenses; room and board; transportation; and similar personal, living or family expenses aren't deductible even if they're mandatory for enrollment or attendance. Expenses for any class that involves sports, games, or hobbies, or any noncredit course, aren't deductible either, unless the class is part of the student's degree program.
The tuition and fees deduction is worth up to $4,000. You can get the full amount if your adjusted gross income is under $65,000 on a single return or under $130,000 if you file a joint return. For singles, the maximum write-off drops to $2,000 if your income is more than $65,000, and it disappears when income passes $80,000. For married couples, the max is $2,000 when income passes $130,000, and it's wiped out completely if your AGI exceeds $160,000.
As with the American Opportunity and Lifetime Learning credits, the tax law doesn't let you "double dip" if you're claiming the tuition and fees deduction. So, for example, you can't deduct tuition and fees if:
- You also deduct those expenses for another reason (e.g., as a business expense);
- You or anyone else claims an American Opportunity or Lifetime Learning credit for the same student in the same year;
- The expenses are used to figure the tax-free portion of 529 plan or Coverdell ESA distribution;
- The expenses are paid with tax-free interest on U.S. savings bonds; or
- The expenses are paid with tax-free educational assistance, such as a scholarship, grant, or assistance provided by an employer.
The tuition and fees deduction expires after the 2020 tax year (although it very well could be extended…as it has several times before).
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 veteran 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, its 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. Payment 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.)
COVID-19 ALERT: Student Loan Payments. In response to the coronavirus-induced economic crisis, the CARES Act adds payments of an employee's student loan debt to the list of allowable education assistance benefits. However, this only applies to loan payments made in 2020. The $5,250 cap applies to the combined total of student loan payments and other educational assistance benefits offered by an employer.
Deduction for Self-Employed Person's Work-Related Education
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 trade or business; or
- Part of a program that will qualify you for a new trade or business.
If the education meets the requirements above, the following expenses can be deducted:
- 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.
You can't deduct personal or capital expenses. For example, you can't deduct the dollar value of vacation time or annual leave you take to attend classes. You also can't deduct a work-related education expense as a business expense if 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).
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.
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 2020 returns starts to phase out when adjusted gross income exceeds $123,550 and is completely phased out after $153,550 ($121,600 and $151,600, respectively, for 2019). For singles and heads of households, the 2020 phase-out zone starts at $82,350 and is ends after $97,350 ($81,100 and $96,100 for 2019).
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 claimed as an adjustment to income, 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 ($140,000 and $170,000 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).
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
What if your student loan is canceled or repaid by someone else? For most loans, any debt that is canceled or paid on your behalf must be included in your taxable income. With student loans, however, you may be able to avoid tax on the cancelled or repaid debt.
In the case of canceled student loan debt, the cancellation must be (1) due to death or total and permanent disability; or (2) pursuant to a loan provision stating that all or part of the debt will be canceled if you work for a certain period of time, in a certain profession, and for a certain employer. You won't qualify for tax-free treatment if your loan is canceled because of services you performed for the educational institution that made the loan or other organization that provided the funds.
When it comes to student loan repayment assistance, taxation of the payments depends on who is making the payments. 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.