As parents plan for their children’s higher education, they may choose from an array of tax-favored savings vehicles and deductions and credits. Options include education savings plans, education credits, deduction of educational expenses, education savings bonds, education loans and other alternatives. No single option works best for everyone, but by reviewing the pros and cons of each alternative, families can choose a strategy that best meets their needs.
Since planning for college education should start when children are young, CPA tax practitioners should offer these services to new parents as well as those with children currently in college. Yearly tax organizers should include questions about tax planning for college. When conducting yearend tax planning for parents of college students, CPAs should discuss related issues, including the dependency exemption on parents’ returns during their children’s college years.
As the need for a college degree has increased, the cost of going to college has also increased. According to The College Board, for the 2011–2012 academic year, the average annual in-state tuition and fees at a public four-year college are $8,244, and the average total out-of-state tuition and fees are $20,770. The average annual tuition and fees at private nonprofit colleges are $28,500 (tinyurl.com/45joe2). These costs do not include room and board, books or supplies. According to The Project on Student Debt, the average college senior graduating in 2010 owed $25,250 in student loans (tinyurl.com/4yv5t7z). Families therefore have good reason to start saving toward these costs while their children are young. Savings vehicles include Sec. 529 plans, education savings bonds and Coverdell education savings accounts (Coverdell ESAs). All of these plans have their merits. (See the SEC’s overview of Sec. 529 plans at tinyurl.com/d8ojwwg.) Families without savings can still take advantage of the following tax incentives once their children are in college.
DEPENDENCY EXEMPTION FOR CHILDREN IN COLLEGE
Most students have little or no tax liability while in school; therefore, it is usually beneficial for their parents or guardians to claim them as dependents. CPAs might start by reviewing with clients the tests that must be met for a qualifying child (Sec. 152). They are:
Relationship. Naturally, a taxpayer’s own children meet this test, but a child’s descendant or a brother or sister or descendant of a brother or sister can also meet the definition of a qualifying child for the purpose of claiming a dependency exemption (Sec. 152(c)(2)).
Residence. A qualifying child must have the same residence as the taxpayer for more than half of the year; however, a student living away from home while in college is considered to be living in the same residence as the parents (Regs. Sec. 1.152-1).
Age. A qualifying child must be under age 19 or be a full-time student under age 24. For purposes of this test, a student must be enrolled in an educational organization, in what the college or university considers full-time attendance, during part or all of each of any five months in a calendar year (Sec. 152(f)(2)). Meeting this requirement can be difficult if the student does not sign up for a full load of classes or withdraws from some classes. Full-time attendance is defined by most universities as at least 12 semester hours. Both fall and spring semesters usually include at least parts of five months.
Support. The student must not provide over half of his or her own support (Sec. 152(c)(1)(D)). The parents do not necessarily have to provide over half the support. College tuition and fees are included in the cost of support. If the parents pay these costs, the child may meet the support test even if the child pays most of his or her own living expenses. However, if a student pays the cost of tuition and fees or receives a student loan to pay them, that amount is counted as support provided by the student and can cause the child to fail the support test and thereby not qualify as a dependent. If a parent takes out a loan for the student, however, amounts paid for support from the borrowed funds count as support provided by the parent.
Income from scholarships is not included in the calculation of support of a taxpayer’s child (Sec. 152(f)(5)) (see “Scholarships and Support,” JofA, May 2011, page 56). The IRS has not given guidance on how distributions from Sec. 529 plans affect the support tests. These distributions can be substantial. If the distribution is counted as support provided by the beneficiary (child), it could prevent the child from qualifying as a dependent. Sec. 529 plans allow the owner (usually a parent or grandparent) to change the beneficiary. This provides some support for the argument that Sec. 529 plan distributions should count as support from the account owner and not count as support provided by the child, but tax practitioners are still waiting for a definitive answer from the IRS.
Joint return. Yet another dependency test requires that the student not be married filing a joint return with his or her spouse unless solely to claim a refund (Sec. 152(c)(1)(E)).
A college student may alternately be the taxpayer’s dependent as a qualifying relative, with tests at Sec. 152(d). For a detailed discussion of the dependency rules, see “Dependency Exemption Issues for College Students,” The Tax Adviser, Aug. 2010, page 546.
EDUCATION DEDUCTIONS AND CREDITS
Deduction of student loan interest. The interest expense on qualified education loans is deductible if the taxpayer meets the income limitations. The loans must be used to pay educational expenses for the taxpayer, spouse or dependents. The loans can be used for tuition, fees and supplies, as well as room and board and other necessary expenses (Sec. 221). Up to $2,500 per year of interest paid on education loans is deductible. This is an above-the-line deduction, so the taxpayer does not have to itemize to take advantage of it. However, the deduction phases out when modified adjusted gross income (MAGI) is between inflation-adjusted limits: $60,000 to $75,000 for single and head-of-household filers (for 2011 and 2012) and between $120,000 and $150,000 for married filers for 2011 (between $125,000 and $155,000 for 2012).
Married taxpayers filing separately cannot take the deduction. If the student can be claimed as a dependent on another taxpayer’s return, he or she cannot take a deduction for student loan interest (Sec. 221(c)). If the loan is in the student’s name, the parents may not take the deduction even if they pay the interest. Parents can deduct the interest only if the loan is in their name and they actually pay the interest.
Deduction for tuition and fees. Taxpayers can claim a deduction (also above the line) of up to $4,000 for qualified tuition and fees they pay if they meet the income guidelines (Sec. 222). Qualified expenses for this deduction include only tuition and fees. For 2011, single taxpayers with MAGI less than $65,000 ($130,000 for married filing jointly) can deduct up to $4,000 (Sec. 222(b)(2)(B)). For single taxpayers with MAGI between $65,000 and $80,000, and married taxpayers with MAGI between $130,000 and $160,000, the deduction is reduced to the lesser of $2,000 or the amount paid. For single taxpayers with income over $80,000 ($160,000 for married taxpayers), no deduction is allowed. Married taxpayers filing separately are not eligible for the deduction.
Note that this provision expired at the end of 2011 and, unless retroactively extended (as occurred in 2010 for that tax year through 2011), is not available for 2012 expenses.
For parents to claim this deduction, they must pay the tuition and fees for their child, and they must claim the child as a dependent. The deduction for tuition and fees cannot be taken for the same student in the same year as the American opportunity tax credit or the lifetime learning tax credit (Sec. 222(c)(2)). Additionally, the same expenses cannot be used as qualified expenses for tax-free treatment of savings plan distributions (such as Sec. 529 distributions) and the deduction for tuition and fees or the education credits.
American opportunity tax credit. This credit is up to $2,500 per student in a degree program for the first four years of college. The first $2,000 is a dollar-for-dollar credit for qualified educational expenses. The other $500 of the credit is 25% of the next $2,000 of qualified expenses (Sec. 25A(i)). Eligible expenses for this credit are tuition and fees and other required course expenses including books and other course materials (Sec. 25A(i)(3)), but they do not include room and board. The American opportunity tax credit phases out for single taxpayers with MAGI between $80,000 and $90,000 and for married taxpayers filing jointly between $160,000 and $180,000 (Sec. 25A(d)).
Forty percent of the American opportunity credit is refundable. Children cannot claim the credit if they are a dependent on a parent’s tax return; however, any allowable expenses paid by the child can be treated as paid by the parents for purposes of calculating the credit (Sec. 25A(g)(3)). The American opportunity credit is currently authorized only through 2012, when, without congressional action, the credit will revert to the pre-2009 Hope scholarship credit, which was available only for the first two years of college attendance, for a maximum annual nonrefundable credit (in 2008) of $1,800.
Lifetime learning credit. The lifetime learning credit is 20% of the first $10,000 of qualified educational expenses (Sec. 25A(c)), for a maximum credit of $2,000 for any taxpayer; therefore, a taxpayer with multiple qualifying children is still limited to $2,000. The credit is allowed for qualified tuition and related expenses even if for only one class that is not part of a degree program. As is the case for the American opportunity credit, eligible expenses do not include room and board, and, unlike with the American opportunity credit, they do not include books and other course materials. The lifetime learning credit is not limited to the first four years of college, so it is available for graduate school. The lifetime learning credit phases out for single taxpayers with MAGI between $52,000 and $62,000 for 2012 ($51,000 and $61,000 for 2011) and for married taxpayers between $104,000 and $124,000 ($102,000 and $122,000 for 2011).
COORDINATING EDUCATION SAVINGS AND CREDITS
A $2,500 credit from the American opportunity credit is more beneficial than a $4,000 tuition and fee deduction at any current tax rate. The income phaseouts are also higher for the American opportunity credit. For the first four years a child attends a regular degree-granting college or university, parents are better off claiming the American opportunity credit if they qualify.
Exhibit 1 shows a comparison for a family of four with two children in college. The parents have a combined salary of $100,000 and pay $4,000 of tuition and $1,000 for course-required books for each of their children, who are 20 and 21 years old and can be claimed as dependents on the parents’ joint tax return. The total qualified educational expenses for the American opportunity credit are $5,000 for each child. This results in a $2,500 credit for each child ($5,000 total credit).
For the lifetime learning credit, only expenses of $8,000 for both children are qualified educational expenses, because the $1,000 per child for books does not qualify. Therefore, if neither child qualifies for the American opportunity credit, the lifetime learning credit is $1,600 ($8,000 × 20%). A taxpayer may not claim two education credits (American opportunity credit and lifetime learning credit) or one education credit and the deduction for tuition and fees for the same child in the same year. However, taxpayers are allowed to claim the American opportunity credit for one child and the lifetime learning credit for another child (or for the parents). Column 3 of Exhibit 1 assumes one child qualifies for the American opportunity credit but that the other child qualifies only for the lifetime learning credit. In this case, the $4,000 for tuition and fees and the $1,000 for books qualify for a $2,500 American opportunity credit for one child, and the $4,000 for tuition for the other child qualifies for a lifetime learning credit of $800 ($4,000 × 20%). The $1,000 for books for the child eligible for the lifetime learning credit does not qualify for a credit.
Tuition and fees of $8,000 are qualified educational expenses for the tuition and fees deduction; however, this deduction is limited to $4,000 total. The $2,000 expense for books does not qualify for the tuition and fees deduction.
Exhibit 2 shows that the credits and the tuition and fees deduction do not apply to room and board. Most full-time universities have tuition and fees of at least $4,000 per year, which will use all the available American opportunity credit. Sec. 529 savings plans and Coverdell ESAs apply to room and board for students attending at least half time, as well as tuition and fees. Therefore, it is beneficial to take tax-advantaged savings plan distributions to pay for room and board and pay tuition and fees with current income or loan proceeds to qualify for one of the credits or the tuition and fees deduction. By careful planning, taxpayers can maximize each benefit.
Example. Sally has $18,000 in a Sec. 529 savings plan. Her total annual educational expenses are $9,000: $4,000 per year for tuition and fees, and $5,000 per year for room and board. Sally could take a $9,000 distribution from her Sec. 529 plan in each of the first two years to pay all of her expenses. The distributions would not be taxable. However, she would not qualify for the education credits in those years. Instead, Sally could take a distribution from her Sec. 529 plan each year to pay only the $5,000 needed for room and board. By paying tuition and fees from non–Sec. 529 funds, Sally (or her parents, if she is a dependent) could claim the American opportunity credit and receive a credit of $2,500 for each of the four years she is in college.
If a student uses loan proceeds to pay qualified educational expenses, the student is eligible to claim an education credit or the deduction for educational expenses based on the amount of loan money used to pay these expenses. Paying these costs with loan proceeds is considered paying them out of the taxpayer’s own funds.
STATE TAX BENEFITS
Some education benefits are available at the state income tax level. Since many states start the calculation of state taxable income based on federal adjusted gross income (AGI), the deduction for tuition and fees could reduce state taxable income and, therefore, state taxes, unless the state requires the amount to be added back for state income tax purposes.
Interest earned on U.S. government savings bonds used for higher educational expenses is exempt from federal taxation. While the interest rates on these investments are low, these bonds are also exempt from state income taxes.
Most states offer a deduction in calculating state income taxes for contributions to that state’s Sec. 529 plan. A few states offer a credit instead of a deduction (see tinyurl.com/ctum3fy).
Tax benefits that help families bear the high and growing cost of higher education include deductions and credits, as well as tax-favored savings plans.
It is usually beneficial for the tax liability of the family as a whole for a child in college to be claimed by his or her parents as a dependent. Families should review the tests for qualifying children who are full-time college students.
Payments of student loan interest of up to $2,500 per year are deductible “above the line,” as are up to $4,000 in qualified tuition and fees. Both deductions are subject to modified adjusted gross income phaseouts.
In most cases, however, the American opportunity tax credit and/or the lifetime learning credit will yield a higher tax benefit for qualified educational expenses. Notably, eligible expenses for the American opportunity credit include required course materials such as books and supplies.
If families have a Sec. 529 or Coverdell education savings account, they should consider using distributions to cover college room and board, which are not eligible expenses for purposes of the credits or deduction.
Joseph D. Beams (email@example.com) is an associate professor of accounting at the University of New Orleans. John W. Briggs (firstname.lastname@example.org) is an associate professor of accounting at James Madison University in Harrisonburg, Va.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at email@example.com or 919-402-4434.
The Tax Adviser article
“Dependency Exemption Issues for College Students,” Aug. 2010, page 546
CPA Client Bulletin (#CB_FI12, #CB_FN12, #CB_LN12, #CB_IF12, #CBDXX12 and #CBEXX12)
CPA Client Tax Letter (#CTLFI12, #CTLFN12, #CTLLF12, #CTLLN12 and #CTLDXX12)
AICPA’s 1040 Tax Return Workshop by Sid Kess (#735226)
AICPA’s 2011 Individual Tax Review Series: Beyond the Basics (#733634)
AICPA’s 2011 Individual Tax Review Series: Nuts and Bolts (#733654)
For more information or to make a purchase, go to cpa2biz.com or call the Institute at 888-777-7077.
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