Education-related tax credits & deductions are often overlooked. Be aware of these 6 Education-related tax items you need to know for 2023. College tuition is expensive. Taxes often make up a large part of a family’s budget. When you have a chance to save on taxes, it’s worth exhausting all options available to you.
1) Student loan interest deduction:
The Internal Revenue Service (IRS) allows borrowers to write off the student loan interest they pay in a given year as a deduction to their income at tax time. There are a few general stipulations, such as the maximum you can deduct is $2500/year. It does phase out based on your Modified Adjusted Gross Income (MAGI), and the loan must be a qualified student loan (can’t be a loan from a friend or family).
The Internal Revenue Service (IRS) phases out the student loan interest deduction for the tax year 2023. For MFJ, the phaseout begins at $155k and ends at $185k, after which they can’t deduct anything. For single filers, the phaseout begins at $75k and ends at $90k.
A common misconception is that you need to itemize your deductions in order to claim this interest. The IRS allows taxpayers to apply this as an income deduction, so it can be used despite taking the standard deduction. Therefore, it’s worth keeping track of the 1098-E, which your student loan provider should mail to you.
Something that can help ensure that you are eligible (if your income is close to that maximum MAGI), is to find ways to lower your modified adjusted gross income. Two good examples that are also beneficial from a savings perspective are to consider increasing 401(k)/403(b) contributions. The other is to contribute to an employer-based HSA. These will lower your MAGI and can help allow you to qualify for some or the maximum benefit available.
2) American Opportunity Tax Credit:
The American Opportunity Tax Credit (AOTC) is, in my opinion, the most overlooked tax credit available to parents of student children.
The rules are as follows: it is available for up to four taxable years for students enrolled (at least half-time) who are pursuing a degree or credential. The AOTC has a maximum value of $2,500 per student per year (up to $10,000 in tax relief over four years). The credit provides a 100 percent match for the first $2,000 of eligible expenses and a 25 percent match for the next $2,000 of eligible expenses. Forty percent of the resulting credit, thus a maximum of $1,000, is refundable and available to all taxpayers with expenses regardless of tax liability. The remaining 60 percent is nonrefundable.
Similar to the student loan interest deduction, there is a phaseout of $80k-$90k for single filers, and $160k-$180k for MFJ filers. Similar to the Student Loan Interest deduction as well, it’s also based on your MAGI, so the same recommendations apply to finding ways to lower your MAGI to be eligible to claim the credit.
In order to claim the credit, you cannot use tax-deferred dollars. Therefore, you must pay with after-tax funds, such as from a savings account, cash flow, or from a loan. You cannot claim the credit if you’ve only paid for college from your 529 account, since those accounts are tax-deferred, and the IRS would consider that “double-dipping.”
The beauty of this is it’s a credit, so for example, if I put in $2,000 of after-tax money to pay for my child’s education, I will get that money back (dollar for dollar) in a tax credit at year’s end, assuming I’m under the $160k MFJ or $80k single MAGI threshold.
3) Lifetime Learning Credit:
The LLTC works as follows – it is available for an unlimited number of years of education and does not require that the qualifying students be pursuing a degree or credential. The LLTC has a maximum value of $2,000 per tax return. The IRS matches 20% of up to $10,000 of expenses per return. Unlike the AOTC, it is nonrefundable and therefore it is not available to many low-income families.
You can only claim one or the other of the LLTC or AOTC in any given tax year.
4) Who should invest in a Coverdell:
Coverdell’s have benefits to them, but in general are more restrictive than a 529 plan. One main benefit of the Coverdell is that you can use it for K-12 & college expenses.
That said, it is restrictive in 2 ways – 1 – there is a $2,000 max contribution limit per year and 2- there is an income phase out of $95k-$110k for single filers, and $190k-$220k for MFJ filers.
Coverdell accounts must always be paid to the beneficiary established for the child’s sole benefit, and the child must liquidate them before turning 30 or face a 10% penalty and taxable interest if they don’t use the proceeds for a qualified education expense.
I would recommend a Coverdell for a select group of individuals who don’t plan on saving significant dollars per year for their child.
5) Who should use a 529 account:
529 accounts have become increasingly popular and continue to do so due to legislation changes. State-sponsored programs offer a variety of benefits. Parents and/or close family members have seen the 2023 529 plan contribution limits increase, so it mostly means that a married couple can contribute up to $34,000 ($17k from each parent) to one child with no federal gift tax implications whatsoever. Should parents want to go beyond that, it’s possible to do so. The only thing to consider is that it could run you into the $12.92 million lifetime gift tax exclusion – which . If you want to contribute more than $17,000 a year, you won’t owe any gift tax as long as you don’t exceed $12.92 million in your lifetime. However, each state sets their own contribution limits.
You can also “super-fund” a 529 plan, over a 5 year period. The IRS will treat a one-time contribution to a child’s 529 plan as spread over 5 years if you elect the 5-year option. This enables you to apply a sizable inheritance, bonus, etc. to the plan without worrying about gift tax reporting, but you must report it with a Form 709 over the next five years and cannot contribute more than the initial contribution amount during that period. If you’re going to do this, you want to make sure it’s possible to do for state tax purposes as well, by reading each applicable state tax law.
Savers (may) have a couple different options. Each state administers its own 529 plans, and only residents of certain states, such as New Jersey, can contribute to their state’s plan and receive a state tax deduction. Some states (like PA), allow you to receive a state tax deduction regardless of which state’s 529 plan you contribute to.
Parental Considerations of a 529 Plan
In addition to a state tax deduction, savers should be looking to avoid paying commissions to a broker. A sales charge could apply to each contribution if set up through a broker. Advisors will likely charge fees, but they should be transparent and should be focusing on low cost funds.
Parents should also know the time horizon of the child, and base their investment choice accordingly. Vast market swings can cause a decrease in the balance for children who are only a couple years away from college.
Parents should consider a number of factors before saving into a 529 plan. If the parent or child does not use the funds for a qualified education expense, the 10% penalty and taxable income will apply to the earnings amount. California imposes an additional 2.5% state income tax penalty on earnings that aren’t used for qualified educational expenses.
529 plans offer transferability, allowing you to transfer the unused balance to another child or family member. Consider these plans for your college savings.
6) IRA to pay for education:
Roth IRA’s are a popular choice for saving for college, and they can help keep assets hidden when applying for financial aid. The IRS usually imposes a 10% penalty for early withdrawal of earnings from a Roth IRA, but it waives the penalty for expenses related to higher education.
Conclusion
Saving on education and tax is never a bad strategy. But making sure you’re doing it correctly and aware of all options to save is critical. Be sure to get in contact with me if you’re ready to start saving today.
