Congratulations! Your child or grandchild has taken the next big step in life. Many parents and grandparents saved for years in tax-favored accounts to send their children to college. Did you know that there are a number of tax breaks that you may be able to claim once your child begins attending college or post-secondary school?
Learn more about these tax break options below.
Tuition tax credits
You can take the American Opportunity Tax Credit (AOTC) of up to $2,500 per student for the first four years of college — a 100% credit for the first $2,000 in tuition, fees, and books, and a 25% credit for the second $2,000. You can take a Lifetime Learning Credit (LLC) of up to $2,000 per family for every additional year of college or graduate school — a 20% credit for up to $10,000 in tuition and fees.
The AOTC is 40% refundable up to $1,000 (meaning you can get a refund if the credit amount is greater than your tax liability). Note that both credits are phased out for married couples filing jointly with modified adjusted gross income (MAGI) between $160,000 and $180,000, and for singles with MAGI between $80,000 and $90,000.
Only one credit can be claimed per eligible student in any given year. To claim the education tax credits, a taxpayer must receive a Form 1098-T statement from the school. Other rules may apply.
Scholarships
Scholarships are exempt from income tax if certain conditions are satisfied. The most important is that the scholarship generally can’t be compensation for services, and it must be used for tuition, fees, books and supplies (not for room and board).
However, a tax-free scholarship reduces the amount of expenses that may be taken into account in computing the AOTC and LLC and may reduce or eliminate those credits.
Employer educational assistance
If your employer pays your child’s college expenses, the payment is a fringe benefit, and is taxable to you as compensation, unless it’s part of a scholarship program that’s “outside of the pattern of employment.” Then, the payment will be treated as a scholarship (if the requirements for scholarships are satisfied).
Tuition payments by grandparents and others
If someone gives you money to pay your child’s college expenses, the person is generally subject to gift tax, to the extent the payments exceed the annual exclusion of $17,000 per recipient for 2023. Married donors who split gifts may exclude gifts of up to $34,000 for 2023.
However, if the person (say, a grandparent) pays your child’s tuition directly to an educational institution, there’s an unlimited exclusion from gift tax for the payment. This unlimited gift tax exclusion applies only to direct tuition costs (not room and board, books, supplies, etc.).
Retirement account withdrawals
You can take money out of your IRA or Roth IRA any time to pay college costs without incurring the 10% early withdrawal penalty that usually applies to distributions before age 59½. However, the distributions are subject to tax under the usual IRA rules.
You also may be able to borrow against your employer retirement plan or take withdrawals from it to pay for college. But before you do so, make sure you understand the tax implications, including any penalties that you may incur.
Plan ahead
As with all tax breaks, there are stipulations. Use of the tax breaks mentioned above may limit use of other options in the same year, and some of them reduce the amounts that qualify for other breaks. It takes some analysis and planning to determine the most beneficial strategy when it comes to these educational tax breaks.
Contact your Rudler, PSC advisor at 859-331-1717 if you’d like to discuss any of the above options, or other alternatives.
RUDLER, PSC CPAs and Business Advisors
This week's Rudler Review is presented by Joshua Myers, Staff Accountant and Audrey Goetz, CPA, CVA.
If you would like to discuss your particular situation, contact Josh or Audrey at 859-331-1717.
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