Learning About Learning Costs: Making Sense of Education Expense Tax Deductions and Credits

If you have kids, you already know that education can be expensive. But your dear Uncle Sam has offered up a number of tax deductions and tax credits to help you.

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Key Takeaways

  • There are several potential tax benefits for education expenses—some in the form of credits and others as deductions
  • Recent tax law changes made 529 plans more flexible
  • Review your situation to see which tax benefits work for you

With all that’s been going on in the world, it’s hard to keep up with what’s new—especially in the world of taxes and education. Laws enacted in the last few years, as well as the response to the COVID-19 pandemic, have expanded the definition of education expense tax deduction and tax credit opportunities. Here’s more information about tax-deductible education savings.

Tax Benefits for Education

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

  • Tax-advantaged college savings plans. Two popular choices are 529 plans and Coverdell Education Savings Accounts. Contributions to these accounts aren’t education tax deductions at the federal level, although the funds in the accounts can grow tax-free when used for qualified expenses. Check with your state, though, as you might get a state income tax deduction for contributions to a 529.
  • Tax credits for current college students. There are different ways to take advantage of these education tax credits, which could reduce your tax bill dollar-for-dollar.
  • Tax deductions for education expenses. It’s possible to deduct tuition and fees up to $4,000 without itemizing, as long as you meet the income requirements and other qualifiers set forth by the Internal Revenue Service (IRS).

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

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 tax law that went into effect in 2018, may also be used for K-12 tuition. (Some states limit the use of 529s for higher education only, so there could be tax implications if you use them for K-12.) But 529 plans seem to always raise some questions. Here are a few. 

What education expenses are tax-deductible?

  • Tuition for private grade school may be covered by a 529 plan. These plans vary by state, but any growth is federally tax deferred and qualified withdrawals are 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.
  • Some equipment for education, such as a computer to use at college, can be purchased with the help of money from a 529 plan. For students increasingly relying on distance learning, and continued concerns about the impact of COVID-19 on distance learning, a new laptop might be something to consider. But be sure to consult your tax advisor. The IRS has specific guidelines for education-related expenses. For a computer to qualify, the IRS stated it must be “a necessary requirement for enrollment or attendance.” The SECURE Act also expanded the use of 529s for apprenticeship programs and using distributions to pay back loans (depending on the state).

How do parents (and grandparents) contribute?

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 the parents’ adjusted gross income and shouldn’t affect financial aid eligibility.

Because 529s may now be used for grade school and high school, are Coverdell ESAs still a thing?

Yes. Before the changes with the 529 plans, a way parents could save money in tax-sheltered accounts for K-12 was through the Coverdell, but only up to $2,000 annually. Plus, there’s an income phase-out. For the 2020 tax year, 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. So high-income earners are shut out of Coverdell eligibility.

But here’s the thing about 529s and K-12 expenses: The 529 can only be used for K-12 tuition—not books, school uniforms, or laptops for remote learning—up to $10,000 per year per beneficiary. 

Coverdells, however, may be used for all qualified education expenses. So if you qualify, the Coverdell might be worth considering. Learn more about 529 plans and Coverdell ESAs here.

What 529 distribution pitfalls should I be aware of?

If money is taken out of a 529 and not used for a qualifying education expense, the IRS will assess a 10% penalty. For example, if you withdraw funds from a 529 to pay tuition but then receive a tuition reimbursement, you generally have 60 days to redeposit the funds into the 529 account. Otherwise, it’s not considered an education expense, and thus you’d be on the hook for the tax penalty. 

This became an issue in 2020 amid the COVID-19 pandemic, as many universities offered full or partial tuition reimbursement well after tuition bills were initially paid. 

SECURE Act, 529s, and Student Loans

One of the provisions of the SECURE Act, passed at the end of 2019, allows 529 participants to use up to $10,000 from an account to pay off student loans without penalty. Because it’s possible to change beneficiaries fairly easily, if there’s money leftover in the 529 after your children or grandchildren graduate, you could potentially put some of that money toward paying down student loans.

Another consideration, in light of the COVID-19 pandemic, is that federal student loans have been granted a deferral extension (and aren’t accruing interest) through January 31, 2021. If you happen to have a 529 and a student loan deferral, you might consider looking into whether it’s worth tackling some of that debt now because more of the payment would go toward principal instead of interest.

Now, on to Tax Credits

While you’re saving, don’t overlook higher education tax credits. The 2018 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. Because the LLC isn’t limited to the first four years of college, it’s of particular value to students pursuing graduate degrees.

For eligible students, these tax credits are taken by whomever claims the student as a dependent (typically the student, a parent, or guardian). Both credits are phased out above certain income levels. Visit the IRS website to compare the specifics of the LLC and the AOTC. 

When considering education tax credits (or any tax credit, really), 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. 

Bottom Line on Education Expenses, Tax Deductions, and Tax Credits

Saving for Junior’s schooling can be tough for parents, and with college savings, everything counts. But there are education expense tax deduction and credit opportunities that can ease some of the pain. 

Education savings might be one of many goals you have between now and retirement. Need help managing it all? A complimentary goal planning session with a TD Ameritrade Financial Consultant can help you stay on target. 

Miranda Marquit is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.

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Key Takeaways

  • There are several potential tax benefits for education expenses—some in the form of credits and others as deductions
  • Recent tax law changes made 529 plans more flexible
  • Review your situation to see which tax benefits work for you

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