Tax Credits for Education

The day your child has been waiting for since kindergarten has finally arrived – GRADUATION DAY!!

Woot!  Woot!

The day you have been dreading since kindergarten is now on the horizon – FOUR YEARS OF COLLEGE TUITION!!

Woot?

I hope that you started planning for your child’s college education before now, but if you’re a little late to the game, there are still some tax-related options available.  If your child is still a few years away, keep this stuff in mind – and do start planning today for the future.

Let’s start with the best-case scenario in which your child has received scholarships and other forms of financial assistance.  The most common question I get in that regard is whether scholarships are considered taxable income.  And the answer is that most of the time, they are not taxable.

If you’re attending an accredited school for the purpose of obtaining a degree, then scholarships that pay for tuition, fees, books, supplies and equipment are not taxable.  Only amounts that go for room and board, optional equipment and incidental expenses are considered taxable.  Any amount that your child receives for services rendered (that would be a student job on campus) is also considered taxable income.

Regarding any taxable portion of your child’s scholarship, remember that as of last year, the first $5,700 of your child’s income will be eliminated by the standard deduction, so even with $3,000 in income from a job and $5,000 in taxable scholarship money, your child’s taxable income is going to be $2,300 with a tax of only about $230.

A full year of tuition, room and board paid for, and it cost $230 out of pocket.  Complaints?  Anyone? 

Bueller?

Now let’s assume that scholarships didn’t cover the whole cost and you’re paying out-of-pocket for your child’s college education.  When that’s the case, you have several options available to you.

The best is the American Opportunities Credit, which can provide up to $2,500 per year (per student, if you happen to be the parent of twins) who are attending college.  The American Opportunities Credit covers “Qualified Education Expenses.”  What’s a Qualified Education Expense?  For nearly all tax credits and deductions a Qualified Education Expense includes tuition, fees, and supplies but doesn’t include room and board.

Bear in mind that the American Opportunities Credit was part of the Obama Administration’s stimulus package, and there’s no telling how long it will last.  It’s scheduled to expire on December 31, 2012 and if it does, it will like revert back to its previous incarnation, the Hope Credit.

The Hope Credit is similar to the American Opportunities Credit, with the biggest difference being income eligibility.  The Hope Credit phases out at $80,000 whereas the American Opportunities Credit doesn’t phase out until income reaches $160,000.   In addition, the American Opportunities Credit is good for all four years of undergraduate education, where the Hope Credit is only good for two years. 

When you’ve maxed out the Hope Credit, the next option is the Lifetime Learning Credit.  This credit is often overlooked, but can be quite beneficial.  For a fulltime student, you can receive a credit of up to $2,000 per year – but it’s also available to graduate students and people taking only a single class and not pursuing a degree.

The final option available is the Tuition and Fees Deduction.  This deduction (not a credit) reduces your taxable income – potentially both your federal AND state taxable income, by up to $4,000.  Remember that this is a reduction in taxable income, so the amount that you actually save will be a percentage of that amount based on your tax bracket.

The last resort, of course, is taking out a student loan.  There are two quick things to remember here.  The first is that people often exclude Qualified Education Expenses paid by using student loans because they feel that it’s somehow “not their money.”  You’re paying that loan back with interest, so it’s your money, all right.  And the second thing is that once you’re out of school and paying back that loan, the interest is tax deductible – don’t pass up that deduction!

Congratulations to the graduating class of 2011 and to those parents who made all this possible.

Have a great summer, and if you have any tax questions, drop me a line at jeffrey.ritchie@yahoo.com and don’t forget to follow me on Twitter at http://twitter.com/#!/MilwaukeeTaxPro