Board of Equalization Member Jerome Horton (file photo)
People are asking, “What can I do to build wealth and help educate my children if I don’t make millions of dollars?” One strategy to build wealth is to use public dollars to pay for your children’s college education and then apply the savings to pay down your debt.
The ScholarShare 529 account, which allows your college savings to grow free of federal and state taxes, can result in up to 25% more money for higher education that can be used for certain college expenses. In addition, when filing your return, as an employee and the recipient of educational assistance payments from your employer, you can claim an exclusion from taxable income for up to $5,250 a year. Then if you take these tax savings and pay down your debt, you save even more. For example, if you have a 30 year mortgage of $100,000 at 4% interest and you pay an additional $100 a month on your mortgage over the life of the loan, you could save $33,975.
Much to my dismay, California does not allow a deduction for tuition and fees, and it does not have any credits similar to the federal education credits. However, the following five tax strategies will allow qualified taxpayers to defer or reduce federal taxes on money paid or saved for college, regardless of your state(s) of residence or where your children are attending college.
- The ScholarShare 529 College Savings Planallows you to invest money for your children’s college education and avoid paying taxes on the interest and distribution of the money toward qualified education expenses. Contributions to a ScholarShare account may help you reduce the taxable value of your estate and, together with all other gifts from the account owner to the beneficiary, may qualify you for an annual federal gift tax exclusion of up to $14,000 per donor ($28,000 for married contributors) per beneficiary. If an account owner’s contribution to a Plan account for a beneficiary in a single year exceeds $14,000 ($28,000 for married contributors), the account owner may elect to treat up to $70,000 of the contributions ($140,000 for joint filers) as having been made over a period of up to five years for the federal gift tax exclusion.
- The American Opportunity Tax Credit (AOTC)is worth as much as $2,500 a year per student for up to four years. If you meet the low-to-middle income requirements, the AOTC is worth 100% of the first $2,000 of qualifying education expenses and 25% of the next $2,000. Effectively, if you pay $4,000 or more in tuition and other qualifying expenses, the government will give $2,500 of it back to you as a credit. If you claim the credit on your return, 40% of it – up to $1,000 – is refundable, meaning you get it even if you owe no taxes. In order to take the credit, the student must be enrolled in a degree or certificate program, must be taking classes on at least a half-time basis, have no felony drug convictions, and must be in the first four years of postsecondary education. If a student has already completed four years of college, he or she is no longer eligible, regardless of whether the credit was used for those four years. The credit phases out above a modified adjusted gross income (MAGI) of $80,000 for single taxpayers ($160,000 married filing jointly), and disappears completely above MAGI of $90,000 and $180,000, respectively.
- The Lifetime Learning Credit (LLC) is designed for low-to-middle income taxpayers who paid qualifying education expenses but cannot meet the requirements of the AOTC. Unlike the AOTC, the LLC does not require the student to be pursuing a degree or attending classes at least half-time, or to be within the first four years of higher education. In other words, the student can take a single college course and claim the LLC. However, the MAGI phase-out thresholds are significantly lower, at $55,000-$65,000 (single) and $110,000-$130,000 (married filing jointly). If you qualify, the credit is worth 20% of up to $10,000 in qualified tuition expenses per year. Another important distinction is that this limit is per return, not per student. The maximum credit of $2,000 isn’t that much different from the AOTC, but you’ll have to spend more to get the full amount. You can use the credit to reduce the tax you owe, but it isn’t refundable if you owe no tax
- The Tuition and Fees Deduction is generally used by taxpayers who would otherwise qualify for the LLC but whose incomes are too high. This deduction has significantly higher phase-out thresholds than the LLC, at $65,000-$80,000 for single filers ($130,000-$160,000 married filing jointly), and allows you to exclude up to $4,000 in qualifying tuition and fee expenses from your income, depending on your tax bracket. If you’re in the 25% marginal tax bracket, for example, this translates to up to $1,000 less in tax liability. Keep in mind that this is an above-the-line tax deduction, meaning that you can take it even if you don’t itemize.
- The student loan interest deductionallows you to deduct the actual amount of interest you paid on your qualified student loans, up to $2,500 annually. Like the tuition and fees deduction, this is an above-the-line deduction, so you can take it regardless of whether you itemize or not. For purposes of this deduction, your student loan qualifies if it was taken out for the sole reason of paying for qualified higher education expenses within a reasonable time frame after the loan was taken out. The deduction has the same MAGI phase-out thresholds as the tuition and fees deduction, of $65,000-$80,000 for singles ($130,000-$160,000 for married joint filers).
It’s important to mention that in claiming these tax breaks, you should only use the amount you paid during the calendar year, not the amounts billed by the school. Specifically, if your classes start during the first three months of 2018, but you pay the bill in 2017, you can apply the amount paid to calculate your 2017 tax benefits. These strategies may be quite helpful in reducing your federal taxes, so be sure to discuss them with your tax advisor as the tax filing season begins.