Which Federal Tax Breaks Still Apply To College Costs?

May 01, 2023

When it comes to education, most financial planning centers around saving and investing for college. This focus makes sense because we’d all like to be able to cover our education expenses that way in an ideal world and not need to borrow a dime. But in the real world, that’s rarely the case.

Fortunately, parts of the tax code can help lift some of that burden if you know how to use them. As you can imagine, this is an area that we get a lot of questions about during the tax-filing season. So let’s take a look at some of these tax breaks and how you might be able to qualify for them.

The American Opportunity Credit (AOTC)

Since it’s a credit, you can deduct this one right off your taxes up to $2,500 (100% of the first $2k of eligible expenses and 25% of the next $2k) per student (you, your spouse, or a dependent) for up to 4 years of undergraduate tuition and required fees and materials, including books.

However, the credit phases out once your modified AGI reaches $80k for those filing single or $160k for joint filers. On the other hand, 40% of it is refundable for people who don’t earn enough to owe income taxes.

The Lifetime Learning Credit (LLC)

This credit is similar to the American Opportunity Credit, but it’s a little smaller. This credits up to $2k or 20% of the first $10,000 in expenses. That amount begins to phase out when MAGI exceeds $80k or $160k. These amounts will not adjust for inflation for the foreseeable future. It’s also a nonrefundable credit, whereas the AOTC may be refundable. The credit max of $2,000 is per tax return (per family) and not per student.

However, it’s more flexible since it’s not limited to undergraduate education. Thus, you can use it for graduate or qualified job-related programs or just a few courses you take here and there. Unfortunately, you cannot take Both credits for the same student in the same year.

Tuition and fees deduction

This deduction expired at the end of 2017 and was renewed retroactively in December 2019. So, if you had tuition and fees that were deductible from 2018 to 2020 that you didn’t claim (because they had not extended the law at that time), it’s worth looking into amending your tax return to request a refund.

No double-dipping

It’s important to point out that you can only use one of these tax breaks (assuming you qualify). These tax breaks also don’t apply if you’ve used funds from another tax-free account, like a 529 plan or Coverdell account. They also don’t apply if you’ve used other forms of tax-free educational assistance like Pell grants or Veterans’ programs.

In other words, there’s no double-dipping allowed. (This restriction doesn’t apply to funding sources that are generally tax-free, like loans or inheritances and gifts.) So the trick here is to withdraw money from a 529 or Coverdell account for no more than the amount of qualified expenses that aren’t covered by one of these other tax breaks.

Student loan interest deduction

The tax benefits don’t necessarily stop with the tuition bills. Suppose no one can claim you as a dependent on someone’s tax return. Your MAGI is also less than $85k or $170k joint (with phase-out beginning at $70k or $140k joint). In that case, you can deduct (without having to itemize) up to $2,500 of interest yearly on student loans that you’re legally obligated to pay. That last part means you can’t deduct interest for loans in your children’s names even if you make the payments.

Education is expensive and is rising faster than inflation. The good news is that we can offset some of that cost on our taxes. The bad news is that these breaks can be complex. So, unless you have a good tax preparer, you’ll have to take some time to understand them, which can be an education in itself. So why isn’t there a special tax break for that?

Easy Income Tax Strategies

February 26, 2022

As always, I seem to owe a bit extra each year (that’s by design) when doing my taxes. This annual ritual has me thinking about which strategies might help me shave off tax dollars now and next year. Here are a few strategies that come to mind.

Contribute more to your retirement plan at work

Regardless of how Congress tweaks the tax code, there is a critical tool in most of our tax toolboxes. This tool is the ability to shelter some current earnings from income taxes. You can do this by making pre-tax contributions to a retirement plan at work (401k, 403b, etc.). Contribution limits increased to $22,500 per year in 2023. Annual catch-up contributions for workers aged 50+ are $7,500. Contribute at least as much as your employer will match. Aspire to increase your contribution rate to 10% or more of earnings over time.

Remember, if your goal is to minimize taxes NOW, make sure you select the pre-tax option and not the Roth.

Maximize your health savings account (HSA) contributions

An often-overlooked last-minute tax-saving strategy is to make more HSA contributions for the previous tax year. You have until April 15th to make the contributions. First, however, you must have been covered by a high-deductible health insurance plan during the year to qualify. Then, if you didn’t contribute the maximum, you may have some extra tax savings available. The maximum for 2022 is $3,650 for individuals or $7,300 for family coverage. The maximum for 2023 is $3,850 for individuals or $7,750 for family coverage. There is a catch-up contribution of $1,000 for those aged 55+.

Be sure to notify your HSA provider that you want them to code your contribution for the 2022 tax year. The IRS will include your contributions as an adjustment to gross income on your tax return. This works to lower your taxes for that year.

Make deductible contributions to a traditional IRA

This option is available if you are working but not covered by a qualified plan at work (e.g., 401k or 403b), or if you are participating in a plan and have income below certain limits.

If you don’t have a retirement plan through work or do but meet the income limits, you can deduct your contributions to a traditional IRA, and investments can grow tax-deferred until withdrawn.

Itemize & maximize deductions (if you still can)

Under current tax law, you may find it is just not worth it to itemize deductions. Thanks to recent tax reforms, the standard deduction amount has increased for everyone. The deduction is $12,950 for single filers ($13,850 in 2023) and $25,900 ($27,700 in 2023) for married couples filing joint returns.

Home mortgage interest has traditionally been a huge deduction for itemizers. You can deduct home mortgage interest on up to $750,000 of mortgage loans ($375,000 if married filing separately). You can’t deduct interest for home equity loans unless you used the money to remodel or improve your home.

If your itemized deductions are close to the standard deduction amount, itemizing might be better if you make charitable contributions. Some taxpayers are electing to “bundle” their deductions by pushing them to the next tax year. This way they can have larger amounts of itemized deductions every other year and take the standard deduction in-between years.

Make the most of flexible spending accounts (FSAs) for child and healthcare

A Dependent Care FSA (DCFSA) is a pre-tax savings account where you automatically deduct money from each paycheck BEFORE TAX. This gives you a pot of tax-free cash you can use to pay for childcare expenses during the year. Under current IRS rules, you can set aside $5,000 each year, regardless of how many children you have.

Similarly, if you anticipate having regular or one-time healthcare expenses, why not use some tax-free cash for those, too? Healthcare flexible spending account limits increased to $3,050 in 2023. The same contribution is applicable to limited-purpose FSAs restricted to dental and vision care services. You can use this along with health savings accounts (HSAs) tied to high-deductible health insurance plans.

Update your personal spending plan (a.k.a., “The Budget”)

I know; it seems like every financial topic is a reason to talk about budgets. Then again, staying informed and aware of your current and future spending plans will help you identify which dollars might represent additional tax savings. Specifying precisely how much you can afford to redirect to tax advantaged strategies will help you adapt to those pesky tax law changes and maybe even enjoy a few more dollars in your pocket.

3 Ideas To Help You Pay Less In Taxes

January 24, 2022

When it comes to tax strategies, sooner is better than later.

Disclaimer: Consult with a tax professional before taking action.

Let’s take a look at three easy tax strategies that might save you substantial amounts of money come tax time.

Give your paycheck a checkup

It is always a good time to double-check your W-4 withholding elections. However, checking as early as possible will help you plan the year better. You want to make sure you aren’t paying too little in taxes along the way or paying too much. The idea is to find a balance so you won’t owe the IRS penalties OR pay too much. That would be like giving the government an interest-free loan!

Fortunately, there are two free tools available online to help you calculate how much to withhold. Gather copies of your pay stubs and last year’s tax return. You will need information from these documents to use the IRS withholding calculator or the TurboTax W-4 calculator. Both of these tools will help you see how many withholding elections to select on your W-4.

Max out your traditional retirement plan contributions

This tried-and-true method of lowering your tax bill still works just fine. The more you contribute to a traditional (not Roth) retirement plan at work, the less taxable income you will have with every paycheck. The new annual contribution limit for 2023 is $22,500 for 401(k) and similar plans.

Older workers (ages 50+) can save up to $7,500 each year with an additional IRA catch-up contribution of $1,000. Another strategy is to contribute to your HSA if you are signed up for a health insurance plan that’s eligible.

Get your deductions in a bunch

Itemizing your tax deductions might no longer be your best strategy. The standard deduction is now practically double what it was before the most recent tax reform. There are also new limits on home equity loan deductions, miscellaneous itemized deductions, and other changes. Then again, it might be a good strategy if you are able to bunch your deductions.

How does this strategy work? The idea is to time certain deductible expenses so you squeeze more of them into a single year (e.g., estimated state income taxes, property taxes, medical bills, etc.). If the bunched deductions are larger than your revised, larger standard deduction, then bunch up your deductions and itemize. This might mean on alternate years you take the standard deduction one year and itemize the next. Lather, rinse, repeat.

There you have it. Three relatively easy ways to save money on taxes for the new year. Your tax professional may have other recommendations as well. Give him or her a call.

Is It The Right Time To Convert To Roth?

December 09, 2019

Are you wondering if you should convert your retirement account to a Roth by the end of the year? After all, there’s no income limit on IRA conversions and many employers are now allowing employees to convert their company retirement plan balances to Roth while they’re still working there. At first glance, it may sound appealing since the earnings in a Roth can grow tax free, and who doesn’t like tax free? However, here are some reasons why now might not be the time for a Roth conversion:

3 reasons you might not convert to Roth this year

1) You have to withdraw money from the retirement account to pay the taxes. If you have to pay the taxes from money you withdraw from the account, it usually doesn’t make financial sense as that money will no longer be growing for your retirement. This is even more of a tax concern if the withdrawal is subject to a 10% early withdrawal penalty.

2) You’ll pay a lower tax rate in retirement. This can be a tricky one because the tendency is to compare your current tax bracket with what you expect it to be in retirement. There are a couple of things to keep in mind though. One is that the conversion itself can push you into a higher tax bracket. The second is that when you eventually withdraw the money from your non-Roth retirement account, it won’t all be taxed at that rate.

Let’s take an example where you retire with a joint income of $125,900 in 2022. Because of the $25,900 standard deduction for married filing jointly, your taxable income would be no more than $100,000. Of your taxable income, the first $20,550 would only be taxed at 10%, and everything from there up to $83,550 is taxed at 12%. Only the income over $83,550 is taxed at the 22% rate. As a result, you would be in the 22% bracket but actually pay only about 13% of your income in taxes.

You can calculate your marginal tax bracket and effective average tax rate here for both your current and projected retirement income. (Don’t factor in inflation for your future retirement income since the tax brackets are adjusted for inflation too.) The tax you pay on the conversion is your current marginal tax bracket, but the tax you avoid on the Roth IRA withdrawals is your future effective average tax rate.

3) You have a child applying for financial aid. A Roth conversion would increase your reported income on financial aid forms and potentially reduce your child’s financial aid eligibility. You can estimate your expected family contribution to college bills based on your taxable income here.

Of course, there are also situations where a Roth conversion makes sense:

6 reasons to consider converting to Roth this year

1) Your investments are down in value. This could be an opportunity to pay taxes on them while they’re low and then have a long-term investment time horizon to allow them to grow tax free. When the markets give you a temporary investment lemon, a Roth conversion lets you turn it into tax lemonade.

2) You think the tax rate could be higher upon withdrawal. You may not have worked at least part of the year (in school, taking time off to care for a child, or just in between jobs), have larger than usual deductions, or have other reasons to be in a lower tax bracket this year. In that case, this could be a good time to pay the tax on a Roth conversion.

You may also rather pay taxes on the money now since you expect the money to be taxed at a higher rate in the future. Perhaps you’re getting a large pension or have other income that will fill in the lower tax brackets in retirement. Maybe you’re worried about tax rates going higher by the time you retire. You may also intend to pass the account on to heirs that could be in a higher tax bracket.

3) You have money to pay the taxes outside of the retirement account. By using the money to pay the tax on the conversion, it’s like you’re making a “contribution” to the account. Let’s say you have $24k sitting in a savings account and you’re going to convert a $100k pre-tax IRA to a Roth IRA. At a 24% tax rate, the $100k pre-tax IRA is equivalent to a $76k Roth IRA. By converting and using money outside of the account to pay the taxes, the $100k pre-tax IRA balance becomes a $100k Roth IRA balance, which is equivalent to a $24k “contribution” to the Roth IRA.

Had you simply invested the $24k in a taxable account, you’d have to pay taxes on the earnings. By transferring the value into the Roth IRA, the earnings grow tax free. This calculator helps you crunch your own numbers.

4) You want to use the money for a non-qualified expense in 5 years or more. After you convert and wait 5 years, you can withdraw the amount you converted at any time and for any reason without tax or penalty. Just be aware that if you withdraw any post-conversion earnings before age 59½, you may have to pay income taxes plus a 10% penalty tax on them.

5) You might retire before age 65. 65 is the earliest you’re eligible for Medicare so if you retire before that, you might need to purchase health insurance through the Affordable Care Act. The subsidies in that program are based on your taxable income so tax-free withdrawals from a Roth account wouldn’t count against you.

6) You want to avoid required minimum distributions (RMDs). Unlike traditional IRAs, 401(k)s, and other retirement accounts that require distributions starting at age 72 (or 70½, depending on your age), Roth IRAs are not subject to RMDs so more of your money grows tax-free for longer. If this is your motivation, remember that you can always wait to convert until you retire, when you might pay a lower tax rate. Also keep in mind, Roth conversions are not a one-time-only event. You can do multiple conversions and spread the tax impact over different tax years if you are concerned about pushing your income into a higher tax bracket in any particular year.

There are good reasons to convert and not to convert to a Roth. Don’t just do what sounds good or blindly follow what other people are doing. Ask yourself if it’s a good time for you based on your situation or consult an unbiased financial planner for guidance. If now is not the right time, you can always convert when the timing is right.

How Taxes Work On Assets You Inherit

May 02, 2019

The death of a loved one is often a very emotional and stressful experience. Doubts about finances can compound that stress. One common concern is understanding what is owed in taxes on the financial assets that are left behind. Consulting with an estate planning professional is best, but here are some fundamental concepts about taxes on inherited assets that can help allay your concerns.

Income taxes take a back seat

Most of us are familiar with the concept of income taxes. It is the tax on the income we earn on our jobs, and therefore, the tax we worry about the most. In helping one client deal with the death of her mother, she expressed fear that the value of her mother’s assets would be added to her income for that year, and therefore, would increase the amount she would have to pay in income taxes.

She was relieved when I told her that estate tax rules are different from income tax rules, and therefore, she was most likely not subject to income tax in this situation. Generally speaking, this is true of most things that you inherit.

Step-up in basis

In her mother’s case, most of the money she left behind in investments was subject to the step-up in basis rule. For instance, if her mom owned a stock that she bought at $5 and it grew to be worth $100 at her death, her daughter will inherit that stock at $100, and her cost basis would now be $100. That means if her daughter sold the stock at $100, instead of paying capital gains taxes on the $95 in growth that her mom would have paid, she would pay nothing in tax. Also, any growth from that point forward would not be taxed at income tax rates but at long-term capital gains rates. Despite recent legislative chatter about removing the step-up in basis rules, currently, no laws have changed.

Where income taxes show up

One major exception to this is assets in retirement plans like traditional 401(k)s and traditional IRAs. They are taxable at the income tax rate of the person who inherits the asset. This means if someone inherits a traditional IRA, withdrawals are taxable as income to the beneficiary who makes the withdrawal. In this case, you have multiple options on how to distribute the assets in order to control your taxation.

What about the ‘death tax?’

Federal estate taxes, sometimes called death taxes, are generally not a concern until the person who passed away has a net worth that exceeds a certain threshold. For 2022 that threshold is $12,060,000 per person. (Most spouses receive an unlimited exemption, which means no estate taxes if the money is going to your surviving husband or wife).

This federal estate and gift tax exemption excludes most Americans from having to pay Uncle Sam for money they are passing along to heirs upon their death.

Moving target

It is good to remain aware of the estate tax exclusion number because once an estate exceeds it, the tax rate is usually significantly higher than regular income tax rates. The exclusion is pretty high now, but it’s something that Congress likes to mess around with occasionally. As recently as 2001, the threshold was $675,000, and it affected a much larger percentage of Americans. When tax bills are passed, that number tends to move up or down depending on the political climate.

Not just federal

While the clear majority will avoid federal estate taxes, there could still be estate or inheritance taxes at the state level. Many states still have estate taxes, and the exemption levels may or may not be tied to the federal exemption.

That means that while the federal exemption is a little over $12 million, your state exemption may be much less. In addition, some states impose an inheritance tax, which heirs would have to pay. Like the federal estate tax, state transfer taxes are a moving target with several states rescinding their estate taxes in recent years to become more tax-friendly to retirees.

Talk to an expert

If you are dealing with the death of a loved one and you’re not sure about all of this, consulting with an accountant or estate planning attorney can be very valuable. If you are unsure where to find a professional, contact your employer’s financial wellness benefit or EAP, and they can often help you find the right person to advise you.

Avoid These Three Financial Pitfalls When Switching Jobs

May 01, 2019

For people who strive to put the maximum amounts away into accounts with annual limits such as 401(k)/403(b) plans and Health Savings Accounts, switching jobs mid-year requires some additional diligence to make sure you’re not going over.

Most company benefits departments will take steps to ensure you don’t go over the limit with contributions from your paycheck, but if you already made deposits to accounts at your prior job that year, your new job won’t automatically know to factor that in – you have to take steps to guard against that. (these issues can also arise if you have more than one job with benefits)

Keep track of your contributions in these 3 areas

Problem: over-contributing to a 401(k) or 403(b)

This issue sometimes doesn’t come to light until after the end of the year when you’re filing your taxes and your tax accountant or software points out that you put more than the annual limit into your 401(k)’s. It’s important to know that the limits are across all accounts, not per account.

401(k) & 403(b) contribution limits
	2022	2021
Amount you can put in via payroll	$20,500	$19,500
Additional if you’re age 50 or older	$6,500	$6,500

What to do if you over-contributed: First of all, it’s important that you act quickly – there is a deadline to fix this without incurring penalties, which is April 15th of the year following the over-contribution.

Send copies of both W-2’s to the plan administrator (aka the company that manages the 401(k) or 403(b)) where you wish to make the withdrawal as evidence of your over-contribution, then request that they send you the extra money.
You’ll receive a check for the amount you over-contributed, including any associated earnings.
You’ll also receive a Form 1099-R, showing the amount you withdrew.
Include the overage amount on your tax return for the year your over-contributed.
Include earnings, if any, on the tax return for the current year when you received the check.

For example, let’s say you over contribute by $5,000 and the administrator attributes $500 worth of growth to that amount – you’ll receive a check for $5,500 and include $5,000 on last year’s tax return to reflect the return of your deposit and $500 on next year’s return to reflect the income on that deposit.

As long as you do this by April 15th, you will avoid any penalties. Waiting until after could incur a 10% early withdrawal penalty or even 100% double taxation of the amount you over-contributed, so you’ll want to get this done ASAP.

Why you might intentionally go over and put yourself in this position: One reason you might intentionally over-contribute to your retirement when switching jobs is if your new job offers a better match than your previous job, and you’d be sacrificing some of the available match if you contributed less.

If that’s the case, you may decide to max out your new match, then withdraw from your old job’s account to reconcile it. If you’re planning to do this, you’ll want to wait until after you’ve successfully withdrawn your overage before rolling your old account into your new plan or an IRA.

Problem: over-contributing to Health Savings Accounts

There are several ways this can happen, especially if you switch mid-year into or out of an HSA-eligible plan. For example, if you had already put the maximum amount into your HSA before switching jobs only to find that your new job doesn’t have an HSA-eligible option, you may want to calculate the eligible amount and withdraw the excess before you file your tax return for that year.

Health Savings Account contribution limits

	2022	2021
Limit for individual	$3,650	$3,600
Limit for family	$7,300	$7,200
Additional for 55 or older	$1,000	$1,000

What to do if you over-contributed: As long as you catch this before you file your federal tax return (including extensions), you can simply request that the additional funds be returned to you, then make sure you include them in your income for the year they were contributed. Similar to retirement fund overage withdrawals, if there are any earnings attributed to the amount you over-contributed, those will also be distributed and taxed as regular income.

If you decide not to do this or miss the deadline, then you can leave the excess contributions in the HSA and pay a 6% excise tax on the amount over-contributed. Note that if you have your account invested for aggressive growth, you may find that paying the excise tax still leaves you ahead in the long run, but for the majority of people these days who simply use the savings account feature of HSAs, they usually opt to withdraw the excess rather than pay 6% tax on it.

Problem: over-paying into Social Security

This can happen if you have higher income or received a very large bonus that would take your total wages for the year over the annual Social Security withholding limit. Most people don’t know this, but you don’t pay Social Security on every penny you earn – it stops when you get to a certain limit. For 2022, that limit is $147,000 or $9,114 in tax.

Employers are required to withhold FICA tax according to the wages they pay you, so if you have more than one job during the year and your total wages exceed the limit, you’ll need to claim the excess as a credit against your income tax when you file your return. (IRS Publication 505 has more on this) If you only have one job and your employer made the mistake, then you should first try to get them to refund you the money and if not, then you’ll need documentation to file Form 843.

How’s Your Financial Life?

January 06, 2017

With today being my first post of 2017, it’s a great time to spend an hour or two over this weekend looking back at the year that was and looking forward to the year that is just starting. I have an annual tradition that I started long ago and will continue for as long as I am lucid. Feel free to use my annual process as a starting point, tweak it, and make it your own.

Each year, I put together a quick “How’s my financial life?” spreadsheet. I only need a few reference sources and in less than 30 minutes, I feel like I have a much clearer understanding of where I stand financially. Along the top of the spreadsheet, I list the year and on the vertical (Column A), I list the things I want to measure annually. Here are the things I measure and where I find the information:

Total Assets – I use this Financial Organizer. The goal is for this to increase each year. Tracking the dollar and percentage increases are things I’ve added to my simple spreadsheet over time.

Total Debt – This is also found on the Financial Organizer. The goal is for this to decrease annually and eventually get to $0!

Net Worth – This is simply the total assets minus total debt. An increasing net worth is my primary financial goal each year. This is another thing I track in dollar and percentage terms.

Annual Income – I use my last pay stub of the year. This is a number that should go up each year and if it doesn’t – that could be a warning sign. Or it could mean that you’ve happily retired or downsized your work stress level.

Estimated Mortgage Payoff Date – I pay a bit of extra principal with each payment and at year end, my mortgage company can calculate when the mortgage will be paid in full at my current level of extra principal payments. You can also build this yourself with an “amortization calculator.” (If you Google that term, you’ll find a bunch of them). This is important to me because when my mortgage is paid off, I’ll consider myself financially secure. At that point, my embedded cost of living will be property taxes, insurance, utilities, food and fun.

401(k) Balance and 401(k) Contributions for the Year – For the contributions, I need my last pay stub for the year and for the balance, I can either log on to the website of my 401(k) provider or quickly check Mint for my balance. Each year, I enjoy seeing the balance go up! (I wasn’t so happy with this back in 2008, though.)

Savings Balance – This is one I like to track in order to make sure I have an adequate emergency fund. I enjoy seeing it go up, although it took a big step backward last year because I used a chunk of savings as the down payment on a house. So while I wasn’t ecstatic when I saw that the balance went down, I understand why it did and will work to build it back in short order. I can check this balance in Mint while I get my 401(k) balance, so locating the info is the easiest part of the job.

Life Insurance Death Benefit – I check this each year to ensure that should this be my last year on the planet, my mortgage can be paid off, my kids’ college can be handled without loans and there could be something left over for them to have a little head start in life, along with a few of my favorite charities getting a few bucks to do the great work that they do. I have to check a file in my desk to make sure that my information is up to date. We had a change in benefits at work and I replaced one policy with another last year so this is a data point that is in flux.

Date of Last Will Update – This is another item that I need to look in my desk drawer files to confirm. Looking at it this year, I’m probably due for an update. The last update of mine was almost 10 years ago, right after my ex-wife and I separated. (It’s amazing how quickly a decade can fly by when you’re having fun!) Hitting the 10 year mark or a significant life change are my triggers for updating this important document, along with my powers of attorney and healthcare directives.

Those are the data points that I can put together in the time that it takes me to watch one college basketball game. (Hey, it’s nice to have a pleasant distraction while working on your financial life.) So pick a game to watch and get busy.