This section provides information on the tax benefits available to students and families saving for college. It explains the tax treatment for the most common incentives, such as the American Opportunity Tax Credit and the Lifetime Learning Credit. plus additional tax benefits, including student loan interest deduction, tuition deduction, and college savings accounts.

American Opportunity Credit

The American Opportunity Credit is a non-refundable credit against an individual’s federal income tax liability.

Calculation of Credit

The American Opportunity Credit is calculated by taking 100% of the first $2,000 of “qualified tuition and related expenses” plus 25% of the excess of these expenses up to a $2,000 limit.

Example: If the qualified expenses of an individual student were $2,500, the American Opportunity Credit would be $2,125 (100% x $2,000 plus 25% x $500). If the expenses were only $1,600, the American Opportunity Credit would be $1,600 (100% x $1,600).

Maximum Credit Allowed

The maximum American Opportunity Credit allowed per student is $2,500 per year for four years. The credit can be claimed for each student claimed on the tax return. For example, if there are two “eligible students” who have qualified expenses, a maximum American Opportunity Credit of $5,000 (2 students x $2,500) can be claimed.

Note: The American Opportunity Credit can be claimed on an amended return filed within the limitation period for claiming refunds if the taxpayer neglected to claim it on their original return.

Credit Phase Out

The American Opportunity Credit is phased out when the taxpayer reaches certain levels of “Modified Adjusted Gross Income.” The credit is ratably phased out for Modified AGI of between $80,000 to $90,000 for single or head of household taxpayers and between $160,000 to $180,000 for married taxpayers.

Modified AGI is AGI plus foreign income, or certain types of income from Puerto Rico, Guam, American Samoa, or the Northern Mariana Islands. The prior types of excluded income are defined in IRC Sec.s 911, 931, and 933.

Example: A married taxpayer with $170,000 in modified AGI would have a maximum American Opportunity Credit of $1,250 per eligible student.

Qualified Expenses

The American Opportunity Credit is only available for certain qualified expenses for undergraduate courses at “eligible educational institutions.” Qualified expenses are tuition and related fees at these eligible educational institutions, and do not include books, room and board, personal transportation or living expenses, activity fees, or insurance. The qualified expenses have to actually be paid during the academic period or, if paid in a prior tax year the academic period must begin within the first three months of the next year.

The qualified expenses are reduced by tax-free grants or scholarships, employer provided educational assistance, veterans education benefits, and qualified expenses deducted elsewhere on the tax return (e.g., Schedule A, C, or F).

Only out-of-pocket qualified expenses are used to calculate the American Opportunity Credit. The expenses may be paid by the student, the parents of the student or by a third party (such as a grandparent) for the student. The expenses can be paid, with no reduction in qualified expenses, by loans (loan repayments for qualified expenses do not count as qualified expenses), savings (including savings from a qualified state tuition program), gifts, bequests, devises, or inheritances.

Eligible Students

An eligible student as one who, as of the beginning of the tax year, has not completed the first four years of post secondary education.

Example: Karla has been attending college for several years, but on a part-time basis. In 2016 and again in 2017 Karla is still completing her sophomore year. Under the proposed regulations, Karla will be eligible for the American Opportunity Credit for 2017 because she has not completed the first four years of post secondary education as of the beginning of the 2017 tax year.

If a third party (someone other than the taxpayer, taxpayer’s spouse, or a claimed dependent) makes a payment directly to the educational institution to pay tuition, the tuition is treated as paid by the student for purposes of the credits.

Also, the student must be enrolled in a degree, certificate, or other program leading to a recognized educational credential at an eligible educational institution; this includes an approved program of study abroad. The student must be enrolled on at least a half-time basis. Half-time enrollment is defined as at least one academic period, which begins during the taxable year during which the student must carry at least one-half the normal full-time workload for the course of study the student is pursuing. This is usually six credits. This is the same definition that is used (under the Higher Education Act regulations) to determine the “number in the household who will be attending college.”

Married taxpayers must file a joint tax return to be eligible for the American Opportunity Credit.

The student must not have been convicted of a federal or state drug felony offense consisting of the possession or distribution of a controlled substance to be eligible for the American Opportunity Credit.

A nonresident alien may not claim the American Opportunity Credit. There is an exception for certain nonresident aliens who are married to U.S. citizens or resident aliens.

The student must have a high school diploma or its equivalent.

Eligible Educational Institutions

To qualify for the American Opportunity Credit, the student must be attending an eligible educational institution. The institution must be a post-secondary institution, not a high school institution. The institution must meet the criteria defined in Section 481 of the 1965 Higher Education Act and therefore qualify to participate in the student aid programs administered by the Department of Education. This would include virtually all accredited public, nonprofit, and proprietary postsecondary institutions.

Interaction With Other Education Tax Benefits

A taxpayer may claim either the American Opportunity Credit or Lifetime Learning credit in the same year in which an exclusion from gross income occurs for amounts distributed from a Coverdell Education Savings Account on behalf of the same student. The distribution, however, cannot be used for the same educational expenses for which a American Opportunity Credit or Lifetime Learning credit is claimed. Qualifying education expenses used to exclude distributions from a Coverdell Education Savings Account are first reduced by amounts used for the American Opportunity Credit or Lifetime Learning credit, before calculating the CESA exclusion.

Observation: This rule parallels the ability to claim a American Opportunity Credit or Lifetime Learning credit in the same year as a tax-free Qualified Tuition Plan exclusion.

The American Opportunity Credit cannot be claimed for the same qualified expenses for which the Lifetime Learning credit is claimed.

The American Opportunity Credit can be claimed in the same year as the student receives a distribution from a “Qualified Tuition program.”

Financial Aid Consequences

The American Opportunity Credit amount claimed on the tax return will not reduce the student’s financial aid eligibility under the FM. However, the IM will consider the American Opportunity Credit to be untaxed income.

Observation: Some private colleges have indicated that they will consider the American Opportunity Credit or Lifetime Learning Credit as a “resource” of the student and will reduce financial eligibility on a dollar-for-dollar basis.

 

Lifetime Learning Credit (Lifetime Learning Credit)

The Lifetime Learning Credit is a non-refundable credit against the individual’s federal income tax liability.

Calculation of Credit

The Lifetime Learning Credit is calculated by taking 20% of up to a maximum of $10,000 in “qualified tuition and related expenses.” The limit for the Lifetime Learning Credit is $2,000 per taxpayer tax return.

Example: If a family has a combined total of $12,000 in qualified tuition expenses for all the exemptions claimed on the tax return, the Lifetime Learning Credit for the tax return would be $2,000, 20% x $10,000 maximum qualified expenses. If the same family only had combined expenses of $8,000, the Lifetime Learning Credit would be $1,600, 20% x $8,000.

Maximum Credit Allowed

The maximum Lifetime Learning Credit allowed is $2,000 per taxpayer return, not per eligible student. The qualified expenses for all eligible students can be combined to reach the maximum credit of $2,000.

Example: If there are two eligible students that each have qualified expenses of $10,000, the maximum Lifetime Learning Credit that could be claimed is $2,000 per that taxpayer return.

Credit Phase Out

The Lifetime Learning Credit is phased out when the taxpayer reaches certain levels ($55,000 – $65,000 for Single or Head-of-Household and $111,000 – $131,000 for Married) of Modified AGI. Modified AGI is the same as it is for purposes of the American Opportunity Credit.

Example: A married taxpayer, with $121,000 Modified AGI, would have a maximum Lifetime Learning Credit of $1,000 per taxpayer return.

Qualified Expenses

The Lifetime Learning Credit is available for certain qualified expenses for undergraduate, graduate, or professional degree courses at “eligible educational institutions.” Qualified expenses for the Lifetime Learning Credit have the same definition as the “qualified tuition and related expenses” for the American Opportunity Credit.

Eligible Students

There is no limit to the number of years in which an eligible student may claim the Lifetime Learning Credit. The student must be the taxpayer, the taxpayer’s spouse, or a dependent of the taxpayer.

The definition of an eligible student is the same as in the American Opportunity Credit, with three exceptions:

  1. the student may be enrolled less than half time and still qualify for the Lifetime Learning Credit,
  2. the courses, at eligible educational institutions, taken by the student are allowed to be taken to acquire or improve job skills, and
  3. the student convicted of a federal or state drug felony can qualify for the Lifetime Learning Credit.

Eligible Educational Institutions

The requirements to be considered an “eligible educational institution” for the Lifetime Learning Credit are the same as those for the American Opportunity Credit.

Interaction With Other Education Tax Benefits

A taxpayer may claim either a American Opportunity Credit or Lifetime Learning Credit in the same year in which an exclusion from gross income occurs for amounts distributed from a Coverdell Education Savings Account on behalf of the same student. The distribution, however, cannot be used for the same educational expenses for which a American Opportunity Credit or Lifetime Learning credit is claimed. Qualifying education expenses used to exclude distributions from a Coverdell Education Savings Account are first reduced by amounts used for the American Opportunity Credit or Lifetime Learning Credit, before calculating the CESA exclusion.

Observation: This rule parallels the ability to claim a American Opportunity Credit or Lifetime Learning credit in the same year as a tax-free Qualified Tuition Plan exclusion.

The Lifetime Learning Credit cannot be claimed for the same qualified expenses for which the American Opportunity Credit is claimed.

Example: If a family has a student in the first year of college and a student in the third year in college, the American Opportunity Credit may be claimed for the expenses of the student in the first year of college and the Lifetime Learning Credit may be claimed for expenses of the student in the third year of college

The Lifetime Learning Credit can be claimed in the same year as the student receives a distribution from a “Qualified Tuition Plan.”

The Lifetime Learning Credit can be claimed for some students at the same time that the American Opportunity Credit is claimed for other students in the family.

 

Student Loan Interest Deduction

This tax benefit is a deduction to adjusted gross income is allowed for interest paid on qualified student loans. The loans do not have to be federal interest subsidized loans.

Calculation of the Interest Deduction

The interest deduction is calculated by taking 100% of any interest due and paid on a qualified student loan.

Maximum Interest Deduction Allowed

The maximum interest deduction allowed is $2,500. Payments made before the required repayment dates are now deductible. Voluntary payments of interest during periods in which the education loan is in deferral or forbearance are also deductible.

Note: Parents are able to deduct education interest expense on PLUS loans during college years. Repayment begins immediately after the loan proceeds are disbursed to the parents. Students who claim themselves on their tax returns are able to deduct education interest expense on Federal Stafford and Perkins loans . Repayment of these loans does not begin until after the student leaves college.

Interest Deduction Phase-Out

The deduction for student loan interest is phased-out when the taxpayer reaches certain levels of Modified AGI as described at the end of this paragraph.

Modified AGI includes:

  • amounts excluded under IRC Sec. 911, 931, and 933 (income earned abroad or from Puerto Rico or U.S. possessions),
  • amounts excluded from gross income under IRC Sec. 135, Series EE bonds used to pay higher education tuition and fees, and
  • amounts excluded under IRC Sec. 137, qualified adoption expenses. In addition, Modified AGI is calculated after application of IRC Sec. 86, income exclusion of certain Social Security benefits, IRC Sec. 219, deductible IRA provisions, and IRC Sec. 469, limitations on passive activity losses and credits.

The AGI phase-out range is doubled for married taxpayers filing jointly, and the income limits are increased as follows:

Filing Status AGI Phase-out Range
Joint $130,000 – $180,000
Single $65,000 – $80,000

Example: A married taxpayer, with $155,000 in Modified AGI, would have a maximum interest deduction of $1,250 in the year 2013.

Qualified Expenses

The student loan interest deduction is only available for qualified expenses for undergraduate or graduate courses. The loan must have been used to pay the cost of attendance at an eligible educational institution for a student enrolled at least half-time in a program leading to a degree, certificate, or other recognized educational credential. These qualified educational expenses are defined in Section 472 of the Higher Education Act of 1965. These expenses include tuition, fees, room and board, supplies, equipment, transportation and related personal expenses. Qualified expenses for the interest deduction include more items than are allowed for the American Opportunity Credit or Lifetime Learning Credit.

Qualified expenses do not include expenses paid by a loan from a person related to the student. Also, qualified expenses do not include expenses paid with a loan from a qualified employer retirement plan.

The qualified expenses are reduced by:

  • IRC Sec. 135 exclusions (U.S. EE Savings Bonds used to pay education expenses),
  • distributions from CESAs which are excluded from gross income,
  • IRC Sec. 117 exclusions, scholarship or fellowship grants, and
  • other tax-free educational assistance, such as IRC Sec. 127, employer provided education assistance.

Eligible Students

To be eligible for the interest deduction, the student must be enrolled on at least a half-time basis in a program leading to a degree, certificate, or other recognized educational credential. The student must be the taxpayer, the taxpayer’s spouse, or a dependent of the taxpayer at the time the loans were received. No deduction is allowed for an individual who is claimed as a dependent on another taxpayer’s tax return.

Eligible Educational Institutions

To qualify for the interest deduction, the student must attend an eligible educational institution. The institution must be a postsecondary institution as defined in Section 481 of the Higher Education Act of 1965 and, therefore, eligible to participate in the federal student aid programs administered by the Department of Education. This category includes virtually all accredited public, nonprofit, and proprietary post-secondary institutions. For purposes of the student loan interest deduction, eligible educational institutions also include institutions that conduct an internship or residency program leading to a degree or certificate awarded by an institution of higher education, a hospital, or a healthcare facility that offers postgraduate training.

In early 1999, the IRS issued proposed regulations regarding student loan interest, and indicated that the regulations may be relied upon now in preparing tax returns (Prop. Reg. 1.221-1, REG-116826-97, 1/21/99).

Qualified Education Loan

The loan must have been incurred solely to pay qualified higher education expenses at an eligible institution (any college, university, vocational school or other post-secondary institution described in the Higher Ed Act of 1965 and certified by the U.S. Dept. of Higher Education as eligible to participate in student aid programs). In addition, an eligible institution includes one conducting an internship or residency program leading to a degree or certificate awarded by an institution, hospital, or healthcare facility that offers post-graduate training [Prop. Reg. 1.221-1(f)].

The higher education expenses must be paid or incurred within a reasonable period of time before or after the debt originates. The regulations provide two safe harbors in meeting the reasonable period test:

  1. Any education loan that is issued as part of a federal post-secondary education loan program is deemed to meet the requirement.
  2. Loan proceeds disbursed within a period that begins 60 days prior to the start of an academic period and ends 60 days after the end of that academic period are deemed to be within the reasonable period of time of the indebtedness [Prop. Reg. 1.221=1(f)(3)].

The proposed regulations do not require actual tracing of loan proceeds to the payment of qualified higher education expenses.

Example: In August, Ron borrows $9,000 from a local bank for the purpose of paying his tuition and board for the fall semester at Minnesota University. Ron, an avid traveler, deposits the loan proceeds in his personal checking account, and immediately expends the funds on a world vacation. In September, Ron starts school, and arranges a monthly payment plan for his tuition and board with the university. Ron covers these monthly payments to the school through part-time work. Because the loan proceeds were disbursed with the time frame described in the regulations, and because the regulations do not require actual tracing of the loan proceeds to the payment of the higher education expenses, Ron will be able to deduct the interest expense on the student loan, assuming the other requirements are met.

Loan Fees and Capitalized Interest

Loan origination fees (other than any fees for service) and capitalized interest are deductible. These are deemed to be paid by the taxpayer when the principal is repaid on the qualified education loan.

The regulations provide a priority to the allocation of payments:

  1. payments (regardless of its label) are treated first as a payment of interest, to the extent interest has accrued and remains unpaid.
  2. payments are allocated to any loan origination fees or capitalized interest, until such amounts are reduced to zero.
  3. payments are allocated to principal.

Planning tip: Students who have Unsubsidized Stafford Loans or other educational loans with accruing interest on the principal balance when the student completes school should consider the following:

The accrued interest that is added to the original loan amount will be nondeductible as student loan interest to the taxpayer, and will become part of the principal balance of the loan if the student does not pay that interest before they finish school. If the student does pay the accrued interest on the educational loan before they finish school, the interest is then deductible to the taxpayer as student loan interest.

Interaction With Other Education Tax Benefits

The qualified education expenses for the interest deduction are reduced by distributions from CESAs which are excluded from taxable income.

Financial Aid Consequences

Since the interest deduction is “above-the-line,” this will increase the financial aid eligibility of any student who is currently enrolled in college. Since the interest deduction lowers the financial aid income of the parents or student, it could increase the financial aid eligibility by the amount of the interest deduction times the parents’ (47%) or student’s (50%) financial aid income assessment rate.

 

Penalty-free IRA Withdrawals

Penalty-free withdrawals from regular IRAs can be made to pay for undergraduate or graduate qualified higher education expenses for the taxpayer, the taxpayer’s spouse, or the child or grandchild of the taxpayer or taxpayer’s spouse at an eligible educational institution. The taxpayer will owe federal income tax on the amount withdrawn, but will not be subject to the 10% early withdrawal penalty (imposed when amounts are withdrawn from an IRA before the taxpayer reaches age 59½).

Qualified Expenses

The penalty-free IRA withdrawal is only available if the withdrawal is used to pay for qualified education expenses. Qualified education expenses include tuition, fees, books, supplies, and equipment. Room and board are also included if the student is enrolled on at least a half-time basis. These education expenses must be reduced by any IRC Sec. 117 tax-free scholarships or grants, IRC Sec. 135 qualified U.S. Series EE bonds, veteran’s education benefits, and other tax-free educational benefits.

Eligible Students

To be eligible for the penalty-free IRA distribution, the student must be the taxpayer, the taxpayer’s spouse, or any child or grandchild of the taxpayer or the taxpayer’s spouse at an eligible educational institution.

Eligible Educational Institutions

To qualify for the penalty-free IRA distribution, the student must be attending an eligible educational institution. For purposes of the penalty-free IRA distribution, the definition of an eligible educational institution is the same as the definition used for the American Opportunity Credit, Lifetime Learning Credit, and CESA.

Interaction With Other Education Tax Benefits

Tax-free distributions from a CESA, qualified U.S. EE Savings bond, or employer-provided educational assistance reduce the amount of qualified education expenses for the penalty-free IRA distribution.

Financial Aid Consequences

The withdrawals from IRAs used for qualified higher education expenses may be penalty-free. However, the withdrawals do have some adverse financial aid ramifications. These IRA withdrawals are considered taxable income and reduce the financial aid eligibility of the student by 47% (the parents’ assessment rate for income) of the increase in AGI caused by the taxable IRA withdrawal.

Example: A parent wishes to fund a child’s college education with regular IRAs. The parent withdraws $10,000 from the IRA. Since this is a fully taxable distribution, the parents’ AGI increases by $10,000. Because of the increase in AGI, the family’s EFC increases by $4,700 ($10,000 x 47%).

If grandparents withdraw penalty-free funds from their IRA accounts and use the money to pay for their grandchild’s qualified education expenses, they must be aware of the financial aid consequences to the grandchild. Remember, payments made directly to the college for tuition and fees reduce a student’s financial aid eligibility on a dollar-for-dollar basis.

 

Employer-Provided Educational Assistance

IRC Sec. 127 extends tax-free treatment to employer-provided educational assistance for undergraduate courses, regardless of whether the course is job-related. They are also permitted to cover graduate education.

Employers can provide job-related educational assistance for graduate and professional courses as a tax-free fringe benefit under certain circumstances. Educational assistance would generally qualify as job-related if it maintains or improves skills required for the employee’s current job or satisfies certain express employer-imposed conditions for continued employment.

Maximum Deduction Allowed

Employers may provide up to $5,250 per year in educational assistance to each employee on a tax-free basis.

Qualified Expenses

Qualified expenses are those incurred for the student’s tuition, fees, books, supplies, and equipment. Expenses related to sports, games, or hobbies do not qualify for this exclusion.

Eligible Students

The employer-provided educational assistance fringe benefit is limited to no more than 5% of the total amount spent on the employer-paid educational assistance program for employees, their spouses, or their dependents that have more than 5% ownership in the business.

An Owner’s Child May Be Eligible For This Fringe Benefit

To qualify the child must:

  • Be at least age 21
  • Be a legitimate employee of the business
  • Not own more than 5% of the business
  • Not be a tax dependent of the parent/owner

Note: Section 127 educational assistance programs that are funded are welfare benefit plans. Accordingly, such plans must file Form 5500.

Interaction With Other Education Tax Benefits

The amount of the tax-free employer-provided educational assistance reduces the taxpayer’s qualified expenses for calculating the American Opportunity Credit or Lifetime Learning Credit. It also reduces the qualified expenses for calculating the student loan interest deduction.

Financial Aid Consequences

These tax-free benefits are considered a “resource” of the student (employee) and thereby reduce financial aid eligibility on a dollar-for-dollar basis.

Note: Any reimbursement in excess of the annual exclusion of $5,250 is taxable as income to the recipient. Nonetheless, if the recipient is the owner’s child the income will be taxed at the child’s lower tax rates. This can create a family tax savings that can be used for college costs.

 

U.S. Series EE Bond Tax-free Interest

The interest from EE Bond redemptions, used to pay for qualified education expenses, is tax-free.

Maximum Tax-free Interest Allowed

If a taxpayer’s redemption proceeds (interest and principal) exceed the qualified education expenses for that year, a ratable portion of the interest proceeds is taxable.

Example: If a taxpayer redeems $10,000 ($5,000 interest and $5,000 principal) and pays only $6,000 in qualified expenses, $3,000 of interest would be taxable ($6,000 / $10,000 = 60% x $5,000 =$3,000 taxable interest).

Tax-free Interest Phase-out

The tax-free interest is phased out when the taxpayer reaches certain levels of Modified AGI. It is phased out when the Modified AGI (2011 amounts) is between $77,550 to $92,550 for single or head of household taxpayers and between $116,300 to $146,300 for married taxpayers. These phase-out levels are adjusted yearly for inflation.

Qualified Expenses

Qualified education expenses for the purpose of this tax benefit are defined as tuition and related fees at an eligible educational institution. For tax years beginning after December 31, 1997, the transfer of U.S. EE Savings Bonds or I Bonds redemption proceeds to a QTP or to a CESA for the taxpayer, the taxpayer’s spouse, or taxpayer’s dependent is considered a qualified education expense. However, a condition for a tax-free transfer is that the Modified AGI of the taxpayer must be under the threshold for tax-free status. Therefore, the rollover should be made before the client’s Modified AGI moves above the phase-out amount. These expenses must be reduced by expenses used in the calculation of the American Opportunity Credit and Lifetime Learning Credit.

Parents who have acquired series EE bonds intending to use them tax-free for qualified education expenses, and find that their income is increasing to the AGI limit, can rollover the bonds to a QTP. These parents may also benefit from a state tax deduction for QTP contributions for the rollover.

Eligible Students

To be eligible for the tax-free interest benefit, the student must be the taxpayer, the taxpayer’s spouse, or the taxpayer’s dependent and the student must have been enrolled at an eligible institution. Married taxpayers must file a joint return to be eligible for the tax-free redemption.

If a parent without custody redeems these bonds to pay college tuition for a child, accrued interest is taxed to the parent.

Two exceptions:

  1. if a custodial parent agrees that the other can claim the exemption for a child, or
  2. if the divorce decree awards dependency exemption to a non-custodial parent.

Eligible Educational Institutions

An eligible educational institution is the same definition for this tax benefit as the definition for the American Opportunity Credit or the Lifetime Learning Credit.

Interaction With Other Education Tax Benefits

The amount of tax-free interest claimed by the taxpayer reduces the qualified expenses used in the calculation of the American Opportunity Credit and the Lifetime Learning Credit..

Financial Aid Consequences

Some taxpayers may feel that investing for future college costs (tuition and fees only) with U.S. EE Savings Bonds may be preferable to the new CESAs.

Since the bonds are in the parent’s name, the value of the U.S. EE Savings Bonds, at the date of signing the financial aid application, will be assessed at the parents’ asset assessment rate of 5.6%. A loss in financial aid eligibility, the value of the savings bonds times the rate of 5.6%, will result.

Example: If a parent has $10,000 in U.S. EE Savings Bonds at the time of filing the financial aid application form, the student will lose $560, $10,000 asset times 5.6% assessment rate, in financial aid eligibility.

If the U.S. EE Savings Bonds are redeemed during college years, only the interest portion of the withdrawal will be considered financial aid income; this financial aid income will be assessed at the parents’ income assessment rate of 47%.

Example: If the parents redeem $10,000 in U.S. EE Savings Bonds, including $4,000 in interest, to help pay for college, the student will lose $1,880 ($4,000 x 47%) in financial aid eligibility. The bond principal will not be assessed upon redemption.

 

Higher Education Tax Deduction

IRC Section 222 has been added to the Tax Code allowing an individual to claim an above-the-line deduction for qualified tuition and related expenses paid during the year.

Eligible expenses for the deduction are qualified tuition and fees, using the same definition as for the American Opportunity Credit and Lifetime Learning credits. Accordingly, tuition and fees for the taxpayer, the taxpayer’s spouse, and a dependent qualify, including books, supplies and equipment if paid to the educational institution as a condition of enrollment or attendance. However, costs associated with room and board, student activities, transportation, and other expenses are not permitted.

As with tuition and fees for the college credits, the eligible expenses must be reduced by scholarships that are excludable from income, tax-free employer-provided educational assistance under Section 127, and similar nontaxable benefits (other than gifts or bequests).

To claim the deduction, the name and taxpayer identification number of the student must be identified on the tax return, again similar to the requirements of the American Opportunity Credit.

  • The deduction must relate to tuition and expenses in connection with enrollment at an institution of higher education during the tax year, except prepayments are allowed for academic terms beginning during the tax year or during the first three months of the next tax year.
  • No deduction is allowed for married individuals filing separate returns or for non-resident aliens.
  • A deduction is not allowed to an individual who is eligible to be claimed as a dependent of another taxpayer.

Deduction and Income Limits

Modified AGI
Year       Single                                       Joint                                             Maximum Deduction
2017     $0 – $65,000                       $0 – $130,000                         $4,000
2017     $65,001 – $80,000          $130,001 – $160,000         $2,000

  • No deduction is permitted in 2018 and after unless this deduction is renewed.
  • Modified AGI is defined as adjusted gross income without the foreign earned income exclusion and the possessions income exclusion (but after application of the taxable social security calculation, the exclusion from income for U.S. Savings Bonds for higher education, the adoption assistance exclusion, IRA and student loan interest deductions, and application of the passive loss rules.)

Observation: There is no phase-out range for this deduction. Accordingly, joint filers whose modified AGI is only slightly in excess of $130,000 may forfeit a $2,000 pre-AGI deduction for higher education tuition.

Coordination With Other Education Incentives

No deduction is allowed under this provision for any expense for which a deduction is allowed to the taxpayer under any other provision, such as an employee business expense deduction.

No tuition deduction is permitted under IRC Sec. 222 with respect to a student if the taxpayer or any other person elects to have the American Opportunity Credit or Lifetime Learning Credit apply with respect to such student for the tax year.

Deductible tuition and fees must be reduced by amounts distributed during the year from a Coverdell Education Savings Account, by any income excluded from education savings bonds, and by the excluded income portion of a Section 529 Qualified Tuition program disbursement. A taxpayer may, however, claim a deduction for the amount of a distribution from a Section 529 Qualified Tuition plan that is not attributable to earnings.

Example: Janice is taking online classes, as well as having a daughter in college. She can take the expenses she incurs for the tuition deduction, and using the expenses from her daughter’s tuition and fees for the American Opportunity Credit or Lifetime Learning Credit.

Summary of Education Tax Incentives

The education tax incentives create opportunities for the financial advisor to reduce the cost of college for every client, regardless of income. If the parents are not eligible for these tax incentives (because of the income phase out rules), alternatively the financial advisor can implement strategies to make the child eligible for the tax incentives. However, the child must have sufficient income in order to take full advantage of these tax incentives. Since tax planning and financial aid planning are interrelated, the financial advisor must understand the effect that qualifying for the education tax incentives has on the financial aid eligibility of the student.