Income Tax Incentives for Education

by Jesse Schroeder
Heinold Banwart, Ltd.

Soon, the swimming pools will close, vacations will come to an end and daylight hours will shorten. It happens every year. These harbingers signal summer is nearly over and school is right around the corner. The start of the school year can bring a wide range of emotions for students—from pure excitement to nail-biting anxiety. Parents and guardians can feel the emotions too, especially when it comes to affording the increasing cost of education.

Fortunately, federal and state income tax laws have created a number of savings plans, tax credits and tax deductions that make education more affordable—and paying for it less emotional. Because of the scope and complexity of today’s educational incentive landscape, this article will address the most popular opportunities and summarize their key features.

Savings Plans
Certain savings plans allow taxpayers to make contributions without being taxed on the earnings of or distributions from the account:

  • Qualified Tuition Programs. Also known as Section 529 plans, these programs allow taxpayers to either prepay or contribute to an account for paying a student’s post-secondary education expenses. Distributions to pay for qualified higher education expenses are tax-free. Qualified higher education expenses include tuition, fees, books, supplies and equipment. They also include the cost of computers and room and board. Special gift tax rules allow a taxpayer to contribute up to $70,000 for each beneficiary in a single year without federal gift tax consequences.
  • Coverdell Education Savings Accounts. Similar to a traditional IRA, Coverdell Education Savings Accounts allow taxpayers to save today for future educational expenses. The funds can be used for K-12 and higher education expenses, which include tuition, fees, and room and board. The maximum annual contribution is limited to $2,000. For 2016, the allowable contribution was phased out ratably for taxpayers with a modified adjusted gross income between $95,000 and $110,000 (between $190,000 and $220,000, if filing jointly).

Federal Income Tax Credits
Two federal tax credits can often help taxpayers reduce the costs of higher education by reducing the federal income taxes they pay:

  • American Opportunity Tax Credit. The AOTC is available for each eligible student for the first four years of post-secondary education at an eligible institution. The credit is equal to 100 percent of the first $2,000 and 25 percent of the next $2,000 (for a maximum credit amount of $2,500 per eligible student) in tuition, fees and course materials paid by the taxpayer. For 2016, the credit amount was phased out ratably for taxpayers with a modified adjusted gross income between $80,000 and $90,000 (between $160,000 and $180,000, if filing jointly). Up to 40 percent of the credit may be refundable.
  • Lifetime Learning Credit. The LLC is available for qualified education expenses paid for all eligible students. It is available for all years of post-secondary education and for courses to acquire or improve job skills. The credit is generally equal to 20 percent of the taxpayer’s first $10,000 in qualified education expenses paid by the taxpayer for tuition and fees. Whereas the maximum AOTC is $2,500 per eligible student, the maximum LLC is $2,000 per return. For 2016, the credit amount was phased out ratably for taxpayers with a modified adjusted gross income between $55,000 and $65,000 (between $111,000 and $131,000, if filing jointly). The credit is nonrefundable, which means it is limited to the amount of tax a taxpayer must pay on his or her taxable income.

Federal Income Tax Deductions
Similarly, two federal tax deductions often help taxpayers reduce their federal taxable income by subtracting certain education expenses:

  • Student Loan Interest Deduction. This deduction is available for taxpayers who pay interest on a student loan used solely to pay for qualified education expenses. These expenses are the total cost of attending an eligible educational institution and include tuition and fees, room and board, books, supplies, equipment and other necessary expenses. For 2016, the deduction amount was phased out ratably for taxpayers with a modified adjusted gross income between $65,000 and $80,000 (between $130,000 and $160,000, if filing jointly).
  • Tuition and Fees Deduction. This deduction can reduce the amount of a taxpayer’s income subject to tax by up to $4,000. Qualified expenses for the deduction include tuition, fees, and course-related books, supplies and equipment. The deduction cannot be claimed in the same year the AOTC or LLC is claimed; however, the taxpayer may choose the education benefit that will result in the lowest tax. For 2016, the deduction amount was phased out ratably for taxpayers with a modified adjusted gross income between $65,000 and $80,000 (between $130,000 and $160,000, if filing jointly). Cautionary note: Unless Congress extends this benefit, it will not be available for 2017.

Illinois Income Tax Credit
For Illinois residents, a particular tax credit can help taxpayers reduce the costs of primary or secondary education by reducing the Illinois income taxes they pay:

  • Education Expense Credit. This credit is available for qualified primary and secondary expenses paid in excess of $250 for tuition, book fees and lab fees. To claim the credit, the taxpayer must be the parent or legal guardian of a full-time student who attends kindergarten through 12th grade at a public or non-public school in Illinois during the tax year. It is also available for homeschooled students. The credit is equal to 25 percent of qualified expenses after the first $250. The maximum credit is $750 per tax year, regardless of the number of qualifying students. Any unused credit is nonrefundable.

Illinois Income Tax Subtraction
Likewise, a particular tax subtraction can help Illinois taxpayers reduce their Illinois taxable income by deducting certain education expenses:

  • College Savings Plans Subtraction. This subtraction is available for contributions made to the Bright Start College Savings Pool, the College Illinois Prepaid Tuition Program or the Bright Directions College Savings Pool. The total amount of the contribution subtraction may not exceed $10,000 ($20,000 if filing jointly). Furthermore, the contributions and any earnings are not subject to Illinois income tax while they remain in the account, and when amounts are withdrawn for qualified educational expenses, they are not subject to federal or Illinois income tax.

While the aforementioned incentives do not comprise an exhaustive list, hopefully any anxious taxpayers will find some peace of mind in knowing a number of plans, credits and deductions exist to help make education more affordable. To better navigate the various options and take full advantage of them, consult with your professional tax advisor. iBi

Jesse Schroeder, CPA, CGMA, CFP® is a manager in Heinold Banwart, Ltd.’s Business Services Department. He may be reached at jschroeder@hbcpas.com or (309) 694-4251. For more information, visit hbcpas.com.

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