Like most financial matters, navigating the various programs and alternatives for funding and deducting college expense is becoming increasingly complex. Common questions include:
Is it better for the parents or the child to deduct the education expense? Is it better to claim a credit or a deduction? If a relative pays for my child’s tuition, who gets to claim the deduction? The answers to each of these questions can vary based on your individual tax situation.
Available tax credits and deductions are summarized in the table attached (click here to view).
Typically the AOTC will provide the best benefit, but it is only available for the first 4 years of post-secondary education. Please note that each of these benefits is phased out when your income exceeds certain limits. With thoughtful analysis and correct guidance, these limitations can be planned for and result in tax savings opportunities for you and your children.
No Double Benefits
You can’t claim more than one benefit for each eligible student in any one year. If you claim the AOTC, then you can’t take the LLC or tuition and fees deduction. However, if you have more than one student in your household, then each student is eligible to claim either a credit or deduction. Since the determination of whether the credit or deduction will be better for you is dependent on your individual tax situation, we will always review each option to ensure that you receive the maximum tax benefit available.
Who Claims the Credit
If the student can be claimed as a dependent of their parent, then typically the parent would claim the credit or deduction on their return. Due to income limitations the parent may not receive any benefit for these expenditures. As an alternative, the parents could forego claiming the student’s dependency exemption on their return. Unfortunately, this would not enable your child to claim his or her own exemption, but it would allow the student to report the education expenses on his or her own return. The maximum tax cost to the parents would be capped at $1,120 ($4,000 exemption times a 28% tax rate), but the potential benefit to the student could be as high as $2,500 if claiming the AOTC. This strategy only works if the student has sufficient income to generate enough tax liability to utilize the credit. Also, before utilizing this strategy, please check the provisions of your health insurance coverage since some policies require your child to be claimed as a dependent on your tax return.
What if Someone Else Pays
If a relative (i.e. grandparents) want to help the student with college expenses, potentially the student or the parents may also qualify for a credit. If a third party makes a payment directly to the eligible education institution, the student is treated as receiving the payment from the third party, and then paying the tuition. The student can then claim the credit, or if the student is a dependent on the parent’s tax return, then the parents can report the expenditure. Additionally, by paying the college directly, those payments are not subject to the annual gifting limitations of $14,000.
Qualified tuition programs, also known as 529 plans, allow a prepayment of higher education expenses under a tax favored basis. You don’t get a federal tax deduction for the contribution (although a number of states will allow a deduction for state tax filings), but the earnings are not taxed as long as the funds are used for qualified education expenses. These include tuition, books, supplies, and required equipment. Additionally reasonable room and board is also a qualified expense. If distributions are not used for qualified education expenses, then the earnings are subject to income tax and a 10% federal penalty is imposed.
A taxpayer may claim an AOTC or LLC for a tax year and also exclude from gross income the amount distributed from a 529 plan, as long as the credit and exclusion are not claimed for the same expense. In order to maximize your benefit you could pay tuition up to $4,000 (if claiming the AOTC) from other funds and then pay additional expenses, including room and board, by using 529 plan distributions.
There are a number of opportunities that you can use for helping with the cost of college expenses. Each of these benefits can be subject to missteps along the way, but most can be managed by planning ahead with a full understanding of the tax regulations.