Whether you are a full-time student or are taking an employment related course, you may be able to take advantage of several federal tax benefits. Depending on your modified adjusted gross income (MAGI) and other circumstances discussed below, you might be able to take tax deductions for your tuition, fees, and other education related expenses.
TAX CREDIT VERSUS TAX DEDUCTION
As a preliminary matter, it is important to distinguish between a tax credit and a tax deduction. The difference between a “credit” and a “deduction” is that the credit reduces the tax you have to pay after your income and tax liabilities have been calculated. A deduction, on the other hand, is an amount that reduces your income upon which your tax liability is determined. If the amount of the deduction and the credit are the same (e.g. both are $1,000), the credit is worth more (because it reduces the tax which is a percentage of your income).
Here’s an example using low numbers to make calculation simple.
Assume Joe earns $10,000 in 2006 and (somehow) is in the 25% tax bracket. In that same year, Joe spent $1,000 on qualified educational expenses so that he qualifies for both the educational deduction and the Hope credit (both discussed below). Without applying a deduction or credit, Joe’s 2006 income tax liability (tax due) would be $2500 (25% of $10,000).
If Joe used the “deduction”, Joe’s taxable income would be reduced to $9,000. Applying the 25% tax rate, Joe’s income tax for 2006 would then be $2250, a savings of $250.
If, however, Joe used the “credit”, his taxable income would stay at $10,000 and his tax would be $2,500. Joe would then apply the $1,000 credit and his tax to be paid would be $1,500.
In this scenario, it would be smarter for Joe to take the $1,000 credit. However, whether you choose the credit or deduction will depend on your entire tax situation. You’ll need to look at the whole picture to determine what combination of credits and deductions you qualify for and that make sense for your particularly tax situation.
Finally, education credits are “nonrefundable” credits. This means that the credit can reduce your tax liability to $0, but, if your credit is more than your tax, any excess will not be refunded to you. Now, let’s get into the different benefits available.
EDUCATIONAL FEES AND EXPENSES DEDUCTION
If you are enrolled in an institution of higher education, you may be able to deduct up to $4,000 of your tuition, fees, and expenses. The benefit of this deduction is that you do not have to itemize in order to claim it. Instead, the amount directly reduces your taxable income (using Line 35 on your 2006 IRS Form 1040).
You may take the deduction as long as you are not filing as married/filing separately and no one else can claim you as a dependent. You cannot claim the deduction if your MAGI is over $80,000 (filing individually) or $160,000 (filing jointly), or if you also are claiming a Hope or Lifetime Learning credit for the same expenses during the same year. The expenses that can be used to reach the $4,000 maximum can be anything the institution requires you to purchase or pay for in order to take the class(es). You can also claim the deduction if you paid your qualified educational expenses with borrowed funds (but not gift or scholarship funds).
The Hope Credit is an educational benefit that can reduce your tax liability directly by up to $1650. The credit is available to taxpayers whose MAGI is under $55,000 (filing single, individual) or $110,000 (filing married, joint). The credit applies to each eligible student, whether that is the taxpayer or a dependant(s) of the taxpayer. Thus, if you just started a college degree at the same time as your two dependant twin children, then you can claim three Hope Credits.
The Hope Credit is a limited credit. You may only use it until the first two years of post-secondary education are completed. In order to qualify, the taxpayer or qualified dependent must be enrolled at least half time during at least one academic period during the tax year and be pursuing a degree or similarly recognized academic credential. The student must also not have a felony drug conviction on their record.
The second of the two education “credits” is the Lifetime Credit. If you qualify for both the Hope and Lifetime credits, you have to choose one or the other. You cannot take both. If your educational expenses are more than $7500, you probably should first look at the Hope Credit. Which credit you use will ultimately depend on your overall tax profile and strategy.
The Lifetime Credit is available to taxpayers who MAGI is under $55,000 (filing single, individual) or $110,000 (filing married, joint). Unlike the Hope Credit, the Lifetime Credit is based on each return. Borrowing the example used above, if you just started college with your two dependent twin children, then you would only be able to take a single Lifetime Credit. The difference is you could continue to take the credit each year for as long as qualified educational expenses are incurred, rather than only in the first two years as with the Hope Credit.
The Lifetime Credit is also different from the Hope Credit in that the former does not require the student to be enrolled at least half time and the student does not need to be pursuing a degree. In addition, the drug-felony rule does not apply.
STUDENT LOAN INTEREST DEDUCTION
If you had an outstanding qualified student loan that you paid interest on after December 31, 1997, then you may be eligible for the Student Loan Interest Deduction. Again, this is a deduction (reducing your taxable income) not a credit (reducing your tax liability).
To qualify your MAGI must be under $65,000 (filing single, individual) or $135,000 (filing married, joint). If the student loan was used to pay for qualified educational expenses for you or your dependant and the student was enrolled at least half-time, and your filing status is anything except married/filing separately, then you may be entitled to the deduction up to the maximum of $2500 (depending on your income level and the actual amount of interest you paid). The difference between this deduction and the Educational Fees Deduction discussed above is that the latter does not need to be itemized. However, to claim the Student Loan Interest Deduction you will have to itemize on Schedule A.
This deduction may be taken in addition to the other deduction and credits mentioned above (as long as you did not calculate student loan interest in your qualified expenses in applying the above deduction or credit). By January 31, 2007, your lending institution will send you a copy of IRS Form 1098-E, which will list the total amount of interest paid during the previous tax year (i.e. 2006).
BUSINESS EDUCATIONAL BENEFITS
If: 1) you incurred educational expenses that were a result of a employer or legal (e.g. continuing education for physicians or attorneys) requirement or that helped maintain or improve your skills needed for your present employment (even if not required), 2) the educational outcome serves a business purpose, and 3) the education is not part of a program that qualifies you for a new trade or business, then you may be able to deduct those expenses from your taxable income, thereby reducing your tax liability. The expenses that can be deducted include tuition, books, and required fees.
In order to qualify for the deduction, your qualified educational expenses and other work-related itemized expenses must be greater than 2% of your adjusted gross income. In addition, your adjusted gross income must be less than $150,000. As with the Student Loan Interest Deduction, the Business Educational Benefits Deduction must be itemized on Schedule A.
If you qualify for the Business Educational Benefits Deduction, you may also qualify for the other benefits discussed above. You may, for example, also claim the Lifetime Credit, so long as you use separate expenses to do so. You cannot use the same expenses to qualify for two different benefits.
If you are able to claim a business deduction for work-related educational expenses and you drive your vehicle to and from school, then you can deduct the miles at the rate of 44.5 cents per mile in 2006. This is in addition to the deductible expenses discussed above.
There are many federal tax benefits for U.S. students pursuing a post-secondary education. However, Internal Revenue Service regulations covering student benefits are complex. In order to make sure you stay within the rules, but also to make sure you realize the maximum benefits, you should consult a tax professional. In addition, I have included links to the relevant IRS publications dealing with student benefits.
See IRS publication 970 and other supplemental information, available online at:
This summary article is provided for illustrative purposes only and is not intended to constitute individual tax or legal advice. If you have questions about your tax obligations and/or legal rights, you should contact an accountant and/or attorney specializing in this area.