How to Get Tax Relief for College Expenses

May 30, 2012

We’ve been talking for the last few months about the challenges of sending a child to college. First comes the choice of savings vehicles from the hundreds of options: state-sponsored 529s, private plans, Coverdell accounts, and self-managed investments. Then comes the crash course in financial aid, where parents and students have to figure out their eligibility for grants, scholarships, and government and private loans.  

When the day finally comes to unload the family car and wave goodbye to your college freshman – that is, if she happens to notice you’re leaving – you’ll probably feel a huge sense of relief that the complexity is behind you. Not so fast, however. In the months and years ahead there is a whole new round of decisions to be made, beyond choosing what color to paint the new spare bedroom.

The question becomes:  can I write college expenses off on my federal taxes?  The good news is that there are at least a dozen different federal tax benefits for those saving and/or paying for college. Higher education is clearly considered a national priority by our Congress, and there is probably a tax advantage waiting for you.

For tax year 2011, parents and students basically had two tax credits and two tax deductions they could use to lower their tax liability:

  • The American Opportunity Tax Credit (AOTC) allows a subtraction of up to $2,500 from federal income taxes for qualified expenses related to a student’s first four years of college
  • The Lifetime Learning Credit (LLC) provides a tax credit of up to $2,000 for post-secondary educational expenses
  • The Tuition and Fees Deduction (TFD) allows a subtraction of up to $4,000 from income, whether or not the taxpayer itemizes deductions, for payments made for college tuition or required fees
  • The Student Loan Interest Deduction (SLID) permits an adjustment to income of up to $2,500 for interest paid on college loans. Like the TFD, this applies to non-itemizers as well.

The TFD technically expired at the end of 2011, and the AOTC will disappear in 2013, but for our purposes, let’s assume that Congress will re-institute both going forward as they are currently structured.

Unfortunately you cannot order a la carte off this menu of credits and deductions. Each benefit is subject to specific requirements concerning the types of allowed expenses, the status of the student, and the income of the taxpayer. Further, the AOTC, the LLC, and the TFD are governed by complex coordination rules that preclude double counting the same expenses for different tax benefits. There are also overall maximums for the LLC and the TFD that cap the benefit, even if expenses were paid for more than one student.

If ever devils lived in details, it would undoubtedly be in the pages of IRS Publication 970 which covers all the “ifs, thens, ands, and buts” of these education benefits. Available at www.irs.gov, this 87-page manual is recommended bedtime reading for insomniac parents. Otherwise for sound sleepers, make sure you use good tax software, or a qualified tax professional, to get the maximum deduction or credit for your circumstances.

Nevertheless, it is possible to do some tweaking and smart financial planning that can optimize your use of these credits and deductions, within the strict IRS rules.

  • Adjust your income to keep it below the allowed maximums. All the educational credits and deductions have income limitations such that taxpayers making more than a stated amount may lose eligibility for the benefits. This suggests that delaying income to later tax periods may be a good idea for many parents of college students. Examples of income that can be postponed:  realization of capital gains, ROTH conversions, and asset sales (through an installment sale).
  • Be aware that deductions lower taxable income, while credits lower your tax liability. This makes credits generally better than deductions; however, your eligibility for financial aid is based on your income, not your tax liability. Consider if taking a deduction might increase the amount of aid for your student, resulting in a higher overall savings than the credit.
  • Talk to your college student about his “10-year” college plan. Taking the leisurely route through the first four years of college may make sense to your 18 year-old, but not for you. The AOTC, which is generally the most valuable credit to taxpayers, is only applicable to students enrolled at least halftime for the four college years.
  • Do the math: how much is that dependent exemption really worth? For taxpayers making too much to qualify for the credits or deductions, it may make sense to forego the exemption for your student and let him get the tax benefit on his own tax return. Compare the tax increase as a result of foregoing the exemption to the tax savings to the student of the credit or deduction. If less, then the student should take the benefit – assuming, of course, you as parent have made it clear that some of this benefit should come back to you!
  • Keep careful records of your different expenses, segregating room and board fees from tuition. This is important if you are using 529 plans to fund college. The IRS allows tax-free withdrawals from 529s for both tuition and room and board. The AOTC, LLC, and the TFD allow a benefit only for tuition and required fees. The tax-free nature of 529 distributions is lost if used for expenses that are also used for the credits or deduction. Therefore use your 529 plans for room and board expenses, saving tuition and fees for the credits or deduction.

For the most part, it’s a matter of “pass” or “fail” when it comes to using the tax benefits accorded to higher education benefits:  you are either eligible or not, given the very specific rules. However, it’s possible to pass with flying colors and maximize those benefits by some strategic, longer term planning. Talk to a CFP® professional about what’s possible, not just permitted, when it comes to being a smart parent of your very smart college student.