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Education Tax Deductions: A Savings Nudge from Your Uncle Sam

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March 28, 2018
Raised hands: Education expenses tax deductions and tax credits
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Two questions: Do you have kids or grandchildren? Are you looking for a way to potentially reduce your tax burden? Your dear Uncle Sam might be able to help by offering education tax deductions.

There are a number of different tax benefits for education, but they fall into two general categories:

  • Tax-advantaged college savings plans. Two popular choices are 529 plans and Coverdell Education Savings Accounts (ESAs).
  • Tax credits for current college students. There are different ways to take advantage of these education expense tax deductions.

The first thing to know is how education expense tax deductions and credits work. Each has its intricacies, especially after last year’s changes in the tax code. (Here’s a little background on the difference between tax credits and tax deductions.)

New Tax Reform Law Expands 529 Plans

A 529 plan is an education savings plan operated by a state or educational institution. It can be used at a qualified college in any state—and now, because of the new tax law, also for K-12 educational expenses. That means tuition for private grade school can be covered by a 529 plan. These plans vary by state, but they offer federal tax-deferred growth and qualified withdrawals free from federal income taxes. There are no income or age limits, and many plans do not limit contributions. They can be a great way to help maximize your tax savings.

Parents and grandparents can each open their own accounts, or grandparents can contribute to an account in the parents’ names. Withdrawals from parent-owned 529 accounts aren’t usually considered part of your adjusted gross income and shouldn’t affect financial aid eligibility.

Amy Heller, senior specialist for retirement and 529 products at TD Ameritrade, says parents who want to use 529 plans for grade school and high school should check with their tax advisor and their state to see what state laws allow as qualified deductions. The 529 industry is still working through all the changes created by the latest law.

When thinking about a 529 plan, keep in mind some of the rules, such as a 10% Internal Revenue Service penalty on withdrawals not used for qualifying college expenses.

The 529 plan’s expansion could give Coverdell accounts a run for their money, so to speak. Before the changes with the 529 plans, a way parents could save money in tax-sheltered accounts for K-12 was through the Coverdell, and only up to $2,000 annually. Plus, the allowable contribution amount phases out between $95,000 and $110,000 for single filers and $190,000 to $220,000 for joint filers, according to the IRS.

However, Heller says parents may not want to completely ditch their Coverdell accounts. So far it appears the only qualified expense for K-12 students with 529 plans is tuition, and up to $10,000 a year per beneficiary, she says.

Coverdells may still be an option for educational incidentals like books and school uniforms.

Learn more about 529 plans and Coverdell ESAs here.

Tax Credits, Too

While you’re saving, don’t overlook higher education tax credits. The new tax law preserved the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC). The AOTC is a credit for qualified education expenses paid for an eligible student for the first four years of higher education, up to $2,500 per eligible student.

LLC is for qualified tuition and related expenses paid for eligible higher-education students enrolled in an eligible educational institution, with no limit on the number of years you can claim the credit. It’s worth up to $2,000 per tax return. Since the LLC isn’t limited to the first four years of college, it’s of particular value to students pursuing graduate degrees.

When considering education tax credits, it’s important to know the difference between a refundable and a nonrefundable credit. According to the IRS:

  • Nonrefundable tax credits allow you to get a refund only up to the amount you owe in taxes. So if a tax credit is worth up to $1,000, but you only owe $500, you may only claim $500 of the credit.
  • Refundable tax credits allow you to claim the full credit regardless of what you owe.

The LLC is nonrefundable. So although the maximum benefit is $2,000, if that figure exceeds your tax bill for the year, you may not claim the entire amount.

The AOTC is partially refundable. If the AOTC pays your tax down to zero, you can have 40% of the remaining amount of the credit refunded to you, up to $1,000. 

Saving for Junior’s schooling can be tough for parents, but education deductions and tax credits might at least lend a hand. 

Educational Resources, All in One Place

The cost of college is high, but an education account can help you invest toward paying for your child’s college expenses down the road.

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