Tax Breaks for Students and New Grads
If you’re a college student (or the parent of one), you should know about some key tax breaks that are available to you when you do your taxes.
Tax Credits
There are two tax credits for higher education. They’re targeted at different types of students, so it pays to know the differences.
American Opportunity Credit
The American Opportunity Credit (AOC) is for students earning an undergraduate degree. The credit is specifically limited to those expenses incurred in the first four years of college.
The AOC is worth $2,500; the really good news is that $1,000 of that is refundable, meaning you could get that back as a refund even if you don’t owe any taxes. There’s an $80,000 income ceiling for single filers to qualify for the credit ($160,000 if you’re married filing jointly). If your income is more than those amounts, the credit starts to decrease.
The American Opportunity Credit is available through the 2017 tax year.
Lifetime Learning Credit
Where the American Opportunity Credit is limited to the first four years of college, the Lifetime Learning Credit (LLC) has a wider availability. This credit can be used for graduate school, undergraduate expenses, even professional or vocational courses. Plus, there’s no limit to how many years you can claim it.
The Lifetime Learning Credit, however, is nonrefundable, which means it’s limited to your tax liability. For example, if you qualified for the full $2,000 Lifetime Learning Credit, but had a tax liability of $500 for the year, you’d only get a credit for $500.
Credits vs. deductions: What’s the difference?
Tax breaks for higher education come in two basic forms: credits and deductions.
Credits reduce the amount of tax that you owe on your tax return.
Deductions reduce the amount of income that’s considered taxable. Less income taxed means less income tax.
Deductions
The two deductions below are not available if you are married and filing separately, or if someone else – such as a parent – claims you as a dependent on his or her return. Parents can still claim the deductions, provided they paid the expenses.
Tuition and Fees Deduction
If you don’t qualify for one of the education credits, you may still be able to deduct your tuition and fees. The deduction can cut your taxable income by up to $4,000. It’s taken as an adjustment to income, which means you can claim this deduction even if you don’t itemize deductions.
This deduction begins to phase out when modified adjusted gross income reaches $65,000 for single taxpayers and $135,000 for married filing jointly.
Student Loan Interest Deduction
The Student Loan Interest Deduction helps to cover the interest you have on your student loans. This deduction can reduce your taxable income by up to $2,500. Like the tuition and fees deduction, the Student Loan Interest Deduction is taken as an adjustment to income, so you can claim it even if you don’t itemize deductions.
One Per Customer, Please
One thing to remember, though: For each student, you can claim either the American Opportunity Credit, or the Lifetime Learning Credit, or the tuition and fees deduction. The IRS won’t let you take more than one of these particular tax breaks for the same person on the same return.
But: Parents claiming two or more college kids as dependents on their return can claim one of these tax breaks for one student and another for a different student.
And: You can still take the student loan interest deduction even if you’re claiming one of the other tax breaks.
How to Claim Education Tax Breaks
When you’re doing your taxes with 1040.com, you can apply for either education credit or the tuition and fees deduction on our Form 1098-T and Education Expenses screen. As for student loan interest, report it on line 33 of our Form 1040 – Adjustments Section screen. Our tax return interview will help you fill out the right screens.
How to Deduct Student Loan Interest
Paying back your student loan won’t generate any tax breaks, but paying the interest on that student loan can, by reducing your income tax. The max deduction is $2,500. This max is per return, not per taxpayer, even if both spouses on a joint return qualify for the deduction.
The student loan interest amount goes on line 33 of our Form 1040 – Adjustments Section screen. When you enter the interest amount, we’ll figure the deduction for you automatically.
You must meet all of these requirements:
You paid interest during the tax year on a qualified student loan.
Your filing status is not married filing separately.
Your modified adjusted gross income (MAGI) must be less than $65,000 if filing single, head of household or qualifying widow(er) (the deduction phases out at $80,000). For married filing jointly, the MAGI must be less than $135,000, and the deduction phases out at $165,000.
You are not claimed as a dependent on someone else’s return.
Note: In times past you had to be responsible for the loan debt and pay it back yourself in order to qualify for the deduction. But nowadays, if your parents pay back the loan, the IRS lets you claim the deduction if your parents don't claim you as a dependent. Also remember that the deduction is for the person who took out the student loan. So, if your parents actually got the loan, but you pay it back, the deduction is theirs.
Which is Better, the Tuition Deduction or an Education Credit?
When it comes to getting some of your college expenses back in your pocket, there are basically two options at income tax time: claim one of the two education credits, or the tuition and fees deduction. The question is, which is best for you?
Not How Much, But Where
The key to finding the best option for your taxes is to know how each one of those options works.
Let’s look at the two credits first. No matter which of the two education credits you qualify for – the American Opportunity Tax Credit or the Lifetime Learning Tax Credit – they both operate from the same principle. Tax credits reduce your tax bill by the actual amount of the credit. In other words, once our software figures your total income tax for the year, one of these credits is taken right off the top, cutting your tax bill dollar-for-dollar.
The tuition and fees deduction, on the other hand, is subtracted from your taxable income. Your tax will be lower, but not dollar-for-dollar like a credit. Bottom line, it's generally better to use a tax credit than a deduction, but do your math to get your personal bottom line. Your mileage may vary.
How the Education Tax Breaks Measure Up
When it comes to sizing up the three education tax breaks, reading the fine print pays off. Just going for the option with the biggest number mentioned may not give the best results for you.
The tuition and fees deduction sounds good on the surface; it offers a deduction of up to $4,000. This option is open even if you don’t itemize deductions. But since the deduction is for the taxpayer, not the student, it may not be the most beneficial for those with more than one student in the family.
The American Opportunity Credit is good for four years of undergraduate higher education, and it will pay up to $2,500 for qualifying expenses for each qualifying student. So, a family with two college students could get $5,000 trimmed off its final tax bill – and that’s where the difference with the tuition and fees deduction becomes apparent.
Let’s say a married couple with a taxable income of $75,000 has two college students who qualify under both the American Opportunity Credit and the tuition and fees deduction. Without either, they would have a $6,191 tax bill.
The $4,000 tuition and fees deduction would reduce the taxpayers’ taxable income to $46,000 and leave them still owing $5,591 — a net savings of just $600.
But the American Opportunity Tax Credit is subtracted directly from that $6,191 tax bill, leaving the family with just $1,191 to pay in taxes. That's a whopping net savings of $5,000 for our example family.
The Lifetime Learning Credit is figured a little differently. This credit is equal to 20 percent of the first $10,000 of qualified education expense. The credit is limited to a maximum of $2,000 per year per taxpayer return, not per student. Using our example family, even though there are two qualifying students, the total credit is still just $2,000. In our example, the American Opportunity Credit still comes out on top.
But the Lifetime Learning Credit and the tuition and fees deduction have their place. The Lifetime Learning credit works for those in post-graduate classes, or for taxpayers who take courses to stay current or to advance in their jobs. And the tuition and fees deduction might be more useful if your income is higher than the income limits of the two education credits.
Making Your Choice at Tax Time
When you’re doing your taxes with 1040.com, you can apply for either education credit or the tuition and fees deduction on our Form 1098-T and Education Expenses screen. Our tax return interview will help you fill out the right screens.
How to Fill Out the Education Tax Forms
1098-T and Education Expenses
Think of our 1098-T and Education Expenses screen as one-stop-shopping for most education credits and deductions. You’ll find the American Opportunity credit, the Lifetime Learning credit, and the tuition and fees deduction all on this one form. For each student, though, you have to choose just one of the three. (We cover the choices more thoroughly in Which is Better, the Tuition Deduction or an Education Credit?)
If you accidentally choose more than one credit, we’ll use the one that helps you the most.
Getting Started
Now let’s walk through how to fill out this form.
Education tax breaks are student-specific, so at the top of the screen, you’ll need to select the appropriate student. If the student is not available in the list, that means the student has not yet been added as a dependent on your return. So for a child, you need to first fill out the Dependent screen.
Next are one or more questions that determine whether you can claim the American Opportunity Credit or the Lifetime Learning Credit. Additional questions may appear, depending on your answers. Read these carefully, and if you need help along the way, check the Help box on the right side of the screen.
Filling in Amounts
This section is straightforward. Just provide information from your school, which you can find on a Form 1098-T from the school.
You should provide information for each school the student attended. If the student attended three separate colleges during the year (and claimed expenses from all of them), you’ll need to fill out a screen section for all three. If you need to add another college, click the link, “Add another educational institution.”
Near the bottom of the screen is a field where you can adjust your to modified adjusted gross income (MAGI). This could be needed if you’re also reporting Foreign Earned Income using the Form 2555-series or on Form 4563. Check the Help text on the right side of the page for complete instructions.
There are also a few checkboxes some taxpayers may find useful. One is to denote that the taxpayer is the dependent of another, but that person is not claiming either the exemption or the education credit. If that applies to you, checking this box could let you still claim a credit, provided you qualify otherwise.
Next is a checkbox that makes the American Opportunity Credit non-refundable on your return. This comes into play for upper-income taxpayers who want the credit, but don’t want complications from the alternative minimum tax (AMT).
The last checkbox on the form denotes that all the expenses entered are for an undergraduate degree only. This is necessary on some state returns, but is not needed on federal tax returns.
What About Student Loan Interest?
That goes on line 33 of our Form 1040 – Adjustments Section screen. Don’t worry, our tax return interview will help you fill out the right screens.
What Are Qualifying Education Expenses?
“Qualifying” education expenses are amounts paid for tuition, fees and other related expenses for an eligible student. That sounds like it covers a lot, but there are limitations.
For example, these expenses do not qualify:
Room and board
Insurance
Medical expenses (including student health fees)
Transportation
Similar personal, family or living expenses
Generally, expenses for sports, games, hobbies or other non-credit courses don't qualify, unless the course or activity is part of the student’s degree program.
You can claim an education credit for qualifying education expenses you paid by cash, check, credit or debit card, or with money from a loan. If a loan was used, you take the credit for the year you paid the expenses – not the year you get the loan, or the year you repay it.
A couple of fine points should be explained here, because they are particular to the specific credit or deduction you want to use on your income tax return:
For the American Opportunity Credit, expenses for books, supplies and equipment count as qualified education expenses – even if purchased off-campus.
As mentioned above, expenses for sports, games, hobbies or other non-credit courses are not generally allowed as qualifying expenses, but for the Lifetime Learning Credit, these expenses can qualify if the course helps the student acquire or improve job skills. Also, while most education credits say the student’s expenses must be for higher education that results in a degree or some other recognized education credential, the Lifetime Learning Credit accepts expenses that merely improve the student’s job skills.
Common Pitfalls to Avoid
Here are the top errors the IRS sees when taxpayers claim education credits:
A student claiming the credit is listed as a dependent or spouse on another tax return.
A student claiming the credit doesn’t have a Form 1098-T showing they attended an eligible education institution.
A student claiming the credit did not pay qualifying education expenses.
The tax return claiming an education credit is for a student who wasn’t attending a college or other higher education institution.
When it comes to deciding which education credit or deduction to take, remember that for each student you can claim only one of the three choices: the American Opportunity Credit, the Lifetime Learning Credit, or the tuition and fees deduction. If you choose more than one of the options, we'll automatically use the one that gives you the biggest benefit.
Is My Scholarship Taxable?
It could be both part taxable and part tax-free.
Your scholarship or fellowship is tax-free if you are a full-time or part-time candidate for a degree at an eligible educational institution. This can be a primary, secondary or post-secondary school. But there are very definite limits on what the award can be used for and still be tax-free. Your scholarship or fellowship can be considered non-taxable if it was used only for tuition, fees, books, supplies and equipment that are all required for your courses.
If any part of your award was used for room and board, travel, research, clerical help or equipment, that portion is taxable. So if your scholarship covers tuition as well as room and board, the amount spent on room and board is considered taxable; the amount spent on tuition is not.
Reporting the taxable part of your scholarship is easy on 1040.com. Go to our Form 1040 – Income Section screen and put the taxable amount of the year’s scholarship on line 7, Taxable Scholarships Not Reported on a W-2.
If you only had tax-free scholarship income for the year, there’s no need to file a return.
Other Types of Education Assistance
Pell grants and Fulbright grants are generally treated the same as scholarships when figuring how much is tax-free. Need-based grants, such as Pell and other Title IV grants, are generally tax-free if used for qualifying education expenses.
Veterans’ benefits — such as payments for education, training or subsistence — are all tax-free and should not be reported as income.
But payments to armed service academy cadets are different. An appointment to a U.S. military academy is not a scholarship in the eyes of the IRS. Payment received as a cadet or midshipman at an armed services academy is pay for personal services, and will be reported on a W-2.
Saving for College? Here’s the Plan
Planning for college – for yourself or for a child – involves the inevitable explorations of how to pay for it. Your best bet is is to start a savings plan ahead of time to handle future expenses. Obviously, the more you can save ahead of time, the less debt you’ll take on in student loans. Plus, you can get certain tax benefits with college savings plans. Here’s how.
The 529 Plan
Just about every state has what is called a 529 plan (the IRS calls them Qualified Tuition Plans), which is an education savings plan operated either by an educational institution or by the state itself. The name comes from Section 529 of the tax code, which authorizes this type of plan. But even though just about every state has an education savings plan, there can be differences, so it pays to compare.
There are two types of 529 plans:
Savings programs, where the entire account can be used at any accredited college or university. It’s a lot like an IRA account, where the contributions are socked away in some sort of investment vehicle, like mutual funds.
Prepaid plans, where the in-state tuition is paid in up-front. Initially, this type of plan was set up with a particular college or university in mind. But many states now allow them to be transferred to another institution (although it may be at a lower rate, depending on the state). And colleges themselves can also offer a 529 prepaid tuition program.
Federal & State Tax Implications
You can’t deduct your contributions to a 529 plan on your federal tax return, but the earnings in the account are tax-deferred, and distributions used to pay for the beneficiary’s college expenses are tax-free.
State tax benefits vary. Some states allow accumulated earnings to grow tax-free until you take the money out, some allow the distribution to be taken tax-free, and still others designate both earnings and distributions as non-taxable. The terms of your plan will explain how your state treats the funds.
A 529 plan can be used to pay qualifying expenses for a student who is enrolled at least half-time. Qualifying expenses include tuition and fees; books, supplies and equipment; and room and board. Computers are included, but only if required by the college for the courses taken.
The donor of the account – the person who is making the contributions to the plan – is the administrator for the plan. The beneficiary – the student, usually – doesn’t have any rights to the funds. The donor decides when distributions are made and for how much. A 529 plan may impact financial aid. If the parent is the plan administrator, the calculation is relatively simple; in cases where the student is actually the administrator, the process is more complicated.
Since a 529 savings plan is pretty much on auto-pilot once it’s set up, the donor won’t see a reporting statement for taxes (such as Form 1099) until withdrawals begin.
Coverdell Education Savings Accounts
The Coverdell Education Savings Account lets you set aside up to $2,000 per year for the beneficiary and can be used tax-free not only for college, but for K-12 expenses as well. The student beneficiary must be under age 18 when the account is created.
There are some limitations:
Each ESA has a custodian – usually the financial institution where the account is located.
The individual opening the account can make decisions on contributions and distributions, but distributions are always paid to the student beneficiary.
If any money is left in the account when the student reaches age 30, the balance must be paid out at that time. That amount is taxable, and if no qualified education expense was incurred that year, is assessed an additional 10 percent penalty on the interest accrued. So spend all the funds in the Coverdell ESA before the student turns 30.
A Coverdell ESA is considered a parent’s asset by the financial aid system, just like a 529 savings plan. But where you may get a state tax deduction for a 529 plan, it’s unlikely you’ll see any state tax breaks for an ESA.
Other Ways to Pay for College
While student loans and educational savings accounts are the most common ways to finance higher education, there are a couple of other options you may want to consider.
U.S. Savings Bonds
Generally, you have to pay tax on the interest you earn from U.S. savings bonds. It’s payable either in the year the interest is earned, or in the year that the bonds are cashed. But when you cash in a savings bond under an education savings bond program, you might be able to exclude the interest from taxable income. You must meet these conditions:
You must pay qualifying education expenses for yourself, your spouse or a dependent.
Your modified adjusted gross income (MAGI) must be less than the amount specified for your filing status. For most taxpayers, MAGI is adjusted gross income (AGI) as figured on their federal tax returns without taking into account this interest exclusion.
Your filing status must not be married filing separately.
In order for the bond itself to qualify, the owner must be at least 24 years old before the bond’s issue date printed on the front.
What can the savings bond interest pay for? Tuition and fees, contributions to a Coverdell Education Savings Account (ESA) or to a Qualified Tuition Program (such as a 529 plan). The IRS says you’ll have to deduct any tax-free benefits you’ve received, such as scholarships, VA benefits and 529 plan distributions before figuring how much savings bond interest can be designated tax free.
Borrowing from an IRA
Another strategy is to borrow from an IRA to pay all or part of college expenses. While the rules allow this, be warned that this could set your retirement fund back and have hidden costs. On the other hand, if paid back within the five years allowed, the impact on retirement could be low.
The pro-loan camp touts the convenience of a IRA plan loan, which is actually a loan to yourself, so it doesn’t involve a credit check. Many times, you can set up such a loan online with the plan’s financial institution. Loan costs are modest – some plans only charge a small administration fee.
Bur remember that the key to a successful loan is that you can pay the loan back into your IRA in time to avoid penalty.
Tax Deductions and Your First Job
If you meet the qualifications, you can deduct much of the cost of finding – and moving for – a new job. But what about your first job after graduating from college?
Finding Your First Job
College students unfortunately can’t deduct the costs of searching for that new job after graduation. You have to already be employed to qualify for this deduction. And even if you are employed full-time, job search expenses, combined with various other expenses, have to exceed 2 percent of your adjusted gross income before they can can start to produce any tax savings.
Moving to Your New Job
The IRS lets you deduct much of the expense of moving for a new job. And that applies to moving to that first job after college, as long as the new position requires you to live at least 50 miles away from your old address, and your move is made within a year of starting employment. You’ll need to keep all receipts and bills related to your move, for documentation.
Report your moving expenses on our Form 3903 – Moving Expenses screen. Our tax return interview will help you fill out the right screens.
How to Write Off Job Search Expenses
Job search expenses aren’t one of the more common deductions, probably because of the specific rules about what can and can't be deducted.
To qualify for a deduction, your expenses must be for a job search within your current occupation. Looking for a new line of work won’t qualify.
You can deduct employment and placement agency fees while looking for a job in your present occupation. If your employer pays you back in a later year for employment agency fees, you’ll need to include the amount you received in your gross income, up to the amount of your tax benefit in the earlier year.
You can deduct the costs of preparing and mailing copies of your résumé to prospective employers, as long as it’s for work in your present occupation.
If you have to travel to look for a new job, you may be able to deduct your expenses to and from your destination. The trip must be primarily to seek employment within your existing occupation.
You cannot deduct job search expenses if there was a substantial break between when your last job ended and when you started looking for a new one.
You cannot deduct job search expenses if you’re looking for your first job.
In order to be deductible, the amount that you spend for job search expense, combined with other various expenses, must exceed a certain threshold. Job search expenses are considered a miscellaneous itemized deduction. The amount of your miscellaneous deduction that exceeds 2 percent of your adjusted gross income (AGI) is what can be deductible.
When you do your taxes with 1040.com, enter job search expenses on our Job, Tax and Other Expenses screen, on line 23, Other Expenses. Our tax return interview will direct you to the screen.
Taxes and Your First Job
When you get your first job, it may be surprising – and disappointing – just how much youhave to pay, before you get what’s left over.
For starters, Uncle Sam dips into your pay for income tax, Social Security tax and Medicare tax. And depending on where you live, you can also count on state and maybe even local taxes. What started out at a reasonable figure (we hope) has been somewhat … diminished, hasn’t it?
Here’s how this withholding business works.
A Matter of Withholding
When you start your new job, you’ll be asked to fill out a Form W-4, Employee’s Withholding Allowance Certificate. Your boss will use this to figure how much in federal taxes to withhold. Not sure how to fill it out? Use the IRS’ Withholding Calculator to get a better idea. There’s also a worksheet on the form that can help you work out what’s best in your situation.
If you live in a state that has income tax — most do — you’ll also have to fill out a similar form for withholding state income taxes.
Side note for the self-employed: You’ll have to hold out taxes for yourself from the payments you get from clients, and send them in regularly – or be prepared to pay up when you file your income taxes at the end of the year. We don’t recommend that last way – it’s likely to get you slapped with a penalty for not paying your tax all along. Pay-as-you-go is definitely the way to go.
Other Withholding
Having your first full-time job probably also means you’ll need to make some decisions on benefits for the first time. Depending on the size of the company that employs you, there could be choices on retirement, health insurance and other items that you may not have faced before. So here are a few guidelines.
Retirement – Since this is your first full-time job, saving for retirement is probably not on your radar right now, but it should be. The earlier you start saving for retirement, the more you'll have when it's time to use that money. If your employer offers a 401k plan, enroll as soon as you’re eligible. Even if you don’t think you can afford the entire allowable withholding amount, contribute enough to qualify for the employer match.
Health Insurance – If your employer offers a health insurance plan, take part in it. Many times, the company will pay some – or even all – of the premium amounts. But even if you have to pay the entire premium, it’s still worth the expense. And with the Affordable Care Act, it’s also now the law.
Some employers also offer flexible spending accounts as part of their health package. These allow you to put money aside for medical expenses, such as deductibles. Most accounts do not roll over funds from one year to the next, so you have to use it or lose it by the end of the year.
Other Benefits – These can include term life insurance, disability insurance, even pet insurance. There’s lots of variety in this area, and lots of other ways withholding can show up on your paycheck.
Summer Jobs
You may not earn enough from your summer job to owe income tax. If that’s pretty clear when you’re filling out Form W-4, you may be exempt from federal income tax withholding – but you still have to fill out the form. But if you’re working for someone else, your employer will usually still have to withhold Social Security and Medicare taxes from your pay. (If you’re self-employed, you have to pay those taxes yourself.)
And even if you didn’t earn enough money to file a return, you may want to anyway. If your employer withheld income tax from your pay, you’ll have to file a return to get those taxes refunded.
If you’re a college student (or the parent of one), you should know about some key tax breaks that are available to you when you do your taxes.
Tax Credits
There are two tax credits for higher education. They’re targeted at different types of students, so it pays to know the differences.
American Opportunity Credit
The American Opportunity Credit (AOC) is for students earning an undergraduate degree. The credit is specifically limited to those expenses incurred in the first four years of college.
The AOC is worth $2,500; the really good news is that $1,000 of that is refundable, meaning you could get that back as a refund even if you don’t owe any taxes. There’s an $80,000 income ceiling for single filers to qualify for the credit ($160,000 if you’re married filing jointly). If your income is more than those amounts, the credit starts to decrease.
The American Opportunity Credit is available through the 2017 tax year.
Lifetime Learning Credit
Where the American Opportunity Credit is limited to the first four years of college, the Lifetime Learning Credit (LLC) has a wider availability. This credit can be used for graduate school, undergraduate expenses, even professional or vocational courses. Plus, there’s no limit to how many years you can claim it.
The Lifetime Learning Credit, however, is nonrefundable, which means it’s limited to your tax liability. For example, if you qualified for the full $2,000 Lifetime Learning Credit, but had a tax liability of $500 for the year, you’d only get a credit for $500.
Credits vs. deductions: What’s the difference?
Tax breaks for higher education come in two basic forms: credits and deductions.
Credits reduce the amount of tax that you owe on your tax return.
Deductions reduce the amount of income that’s considered taxable. Less income taxed means less income tax.
Deductions
The two deductions below are not available if you are married and filing separately, or if someone else – such as a parent – claims you as a dependent on his or her return. Parents can still claim the deductions, provided they paid the expenses.
Tuition and Fees Deduction
If you don’t qualify for one of the education credits, you may still be able to deduct your tuition and fees. The deduction can cut your taxable income by up to $4,000. It’s taken as an adjustment to income, which means you can claim this deduction even if you don’t itemize deductions.
This deduction begins to phase out when modified adjusted gross income reaches $65,000 for single taxpayers and $135,000 for married filing jointly.
Student Loan Interest Deduction
The Student Loan Interest Deduction helps to cover the interest you have on your student loans. This deduction can reduce your taxable income by up to $2,500. Like the tuition and fees deduction, the Student Loan Interest Deduction is taken as an adjustment to income, so you can claim it even if you don’t itemize deductions.
One Per Customer, Please
One thing to remember, though: For each student, you can claim either the American Opportunity Credit, or the Lifetime Learning Credit, or the tuition and fees deduction. The IRS won’t let you take more than one of these particular tax breaks for the same person on the same return.
But: Parents claiming two or more college kids as dependents on their return can claim one of these tax breaks for one student and another for a different student.
And: You can still take the student loan interest deduction even if you’re claiming one of the other tax breaks.
How to Claim Education Tax Breaks
When you’re doing your taxes with 1040.com, you can apply for either education credit or the tuition and fees deduction on our Form 1098-T and Education Expenses screen. As for student loan interest, report it on line 33 of our Form 1040 – Adjustments Section screen. Our tax return interview will help you fill out the right screens.
How to Deduct Student Loan Interest
Paying back your student loan won’t generate any tax breaks, but paying the interest on that student loan can, by reducing your income tax. The max deduction is $2,500. This max is per return, not per taxpayer, even if both spouses on a joint return qualify for the deduction.
The student loan interest amount goes on line 33 of our Form 1040 – Adjustments Section screen. When you enter the interest amount, we’ll figure the deduction for you automatically.
You must meet all of these requirements:
You paid interest during the tax year on a qualified student loan.
Your filing status is not married filing separately.
Your modified adjusted gross income (MAGI) must be less than $65,000 if filing single, head of household or qualifying widow(er) (the deduction phases out at $80,000). For married filing jointly, the MAGI must be less than $135,000, and the deduction phases out at $165,000.
You are not claimed as a dependent on someone else’s return.
Note: In times past you had to be responsible for the loan debt and pay it back yourself in order to qualify for the deduction. But nowadays, if your parents pay back the loan, the IRS lets you claim the deduction if your parents don't claim you as a dependent. Also remember that the deduction is for the person who took out the student loan. So, if your parents actually got the loan, but you pay it back, the deduction is theirs.
Which is Better, the Tuition Deduction or an Education Credit?
When it comes to getting some of your college expenses back in your pocket, there are basically two options at income tax time: claim one of the two education credits, or the tuition and fees deduction. The question is, which is best for you?
Not How Much, But Where
The key to finding the best option for your taxes is to know how each one of those options works.
Let’s look at the two credits first. No matter which of the two education credits you qualify for – the American Opportunity Tax Credit or the Lifetime Learning Tax Credit – they both operate from the same principle. Tax credits reduce your tax bill by the actual amount of the credit. In other words, once our software figures your total income tax for the year, one of these credits is taken right off the top, cutting your tax bill dollar-for-dollar.
The tuition and fees deduction, on the other hand, is subtracted from your taxable income. Your tax will be lower, but not dollar-for-dollar like a credit. Bottom line, it's generally better to use a tax credit than a deduction, but do your math to get your personal bottom line. Your mileage may vary.
How the Education Tax Breaks Measure Up
When it comes to sizing up the three education tax breaks, reading the fine print pays off. Just going for the option with the biggest number mentioned may not give the best results for you.
The tuition and fees deduction sounds good on the surface; it offers a deduction of up to $4,000. This option is open even if you don’t itemize deductions. But since the deduction is for the taxpayer, not the student, it may not be the most beneficial for those with more than one student in the family.
The American Opportunity Credit is good for four years of undergraduate higher education, and it will pay up to $2,500 for qualifying expenses for each qualifying student. So, a family with two college students could get $5,000 trimmed off its final tax bill – and that’s where the difference with the tuition and fees deduction becomes apparent.
Let’s say a married couple with a taxable income of $75,000 has two college students who qualify under both the American Opportunity Credit and the tuition and fees deduction. Without either, they would have a $6,191 tax bill.
The $4,000 tuition and fees deduction would reduce the taxpayers’ taxable income to $46,000 and leave them still owing $5,591 — a net savings of just $600.
But the American Opportunity Tax Credit is subtracted directly from that $6,191 tax bill, leaving the family with just $1,191 to pay in taxes. That's a whopping net savings of $5,000 for our example family.
The Lifetime Learning Credit is figured a little differently. This credit is equal to 20 percent of the first $10,000 of qualified education expense. The credit is limited to a maximum of $2,000 per year per taxpayer return, not per student. Using our example family, even though there are two qualifying students, the total credit is still just $2,000. In our example, the American Opportunity Credit still comes out on top.
But the Lifetime Learning Credit and the tuition and fees deduction have their place. The Lifetime Learning credit works for those in post-graduate classes, or for taxpayers who take courses to stay current or to advance in their jobs. And the tuition and fees deduction might be more useful if your income is higher than the income limits of the two education credits.
Making Your Choice at Tax Time
When you’re doing your taxes with 1040.com, you can apply for either education credit or the tuition and fees deduction on our Form 1098-T and Education Expenses screen. Our tax return interview will help you fill out the right screens.
How to Fill Out the Education Tax Forms
1098-T and Education Expenses
Think of our 1098-T and Education Expenses screen as one-stop-shopping for most education credits and deductions. You’ll find the American Opportunity credit, the Lifetime Learning credit, and the tuition and fees deduction all on this one form. For each student, though, you have to choose just one of the three. (We cover the choices more thoroughly in Which is Better, the Tuition Deduction or an Education Credit?)
If you accidentally choose more than one credit, we’ll use the one that helps you the most.
Getting Started
Now let’s walk through how to fill out this form.
Education tax breaks are student-specific, so at the top of the screen, you’ll need to select the appropriate student. If the student is not available in the list, that means the student has not yet been added as a dependent on your return. So for a child, you need to first fill out the Dependent screen.
Next are one or more questions that determine whether you can claim the American Opportunity Credit or the Lifetime Learning Credit. Additional questions may appear, depending on your answers. Read these carefully, and if you need help along the way, check the Help box on the right side of the screen.
Filling in Amounts
This section is straightforward. Just provide information from your school, which you can find on a Form 1098-T from the school.
You should provide information for each school the student attended. If the student attended three separate colleges during the year (and claimed expenses from all of them), you’ll need to fill out a screen section for all three. If you need to add another college, click the link, “Add another educational institution.”
Near the bottom of the screen is a field where you can adjust your to modified adjusted gross income (MAGI). This could be needed if you’re also reporting Foreign Earned Income using the Form 2555-series or on Form 4563. Check the Help text on the right side of the page for complete instructions.
There are also a few checkboxes some taxpayers may find useful. One is to denote that the taxpayer is the dependent of another, but that person is not claiming either the exemption or the education credit. If that applies to you, checking this box could let you still claim a credit, provided you qualify otherwise.
Next is a checkbox that makes the American Opportunity Credit non-refundable on your return. This comes into play for upper-income taxpayers who want the credit, but don’t want complications from the alternative minimum tax (AMT).
The last checkbox on the form denotes that all the expenses entered are for an undergraduate degree only. This is necessary on some state returns, but is not needed on federal tax returns.
What About Student Loan Interest?
That goes on line 33 of our Form 1040 – Adjustments Section screen. Don’t worry, our tax return interview will help you fill out the right screens.
What Are Qualifying Education Expenses?
“Qualifying” education expenses are amounts paid for tuition, fees and other related expenses for an eligible student. That sounds like it covers a lot, but there are limitations.
For example, these expenses do not qualify:
Room and board
Insurance
Medical expenses (including student health fees)
Transportation
Similar personal, family or living expenses
Generally, expenses for sports, games, hobbies or other non-credit courses don't qualify, unless the course or activity is part of the student’s degree program.
You can claim an education credit for qualifying education expenses you paid by cash, check, credit or debit card, or with money from a loan. If a loan was used, you take the credit for the year you paid the expenses – not the year you get the loan, or the year you repay it.
A couple of fine points should be explained here, because they are particular to the specific credit or deduction you want to use on your income tax return:
For the American Opportunity Credit, expenses for books, supplies and equipment count as qualified education expenses – even if purchased off-campus.
As mentioned above, expenses for sports, games, hobbies or other non-credit courses are not generally allowed as qualifying expenses, but for the Lifetime Learning Credit, these expenses can qualify if the course helps the student acquire or improve job skills. Also, while most education credits say the student’s expenses must be for higher education that results in a degree or some other recognized education credential, the Lifetime Learning Credit accepts expenses that merely improve the student’s job skills.
Common Pitfalls to Avoid
Here are the top errors the IRS sees when taxpayers claim education credits:
A student claiming the credit is listed as a dependent or spouse on another tax return.
A student claiming the credit doesn’t have a Form 1098-T showing they attended an eligible education institution.
A student claiming the credit did not pay qualifying education expenses.
The tax return claiming an education credit is for a student who wasn’t attending a college or other higher education institution.
When it comes to deciding which education credit or deduction to take, remember that for each student you can claim only one of the three choices: the American Opportunity Credit, the Lifetime Learning Credit, or the tuition and fees deduction. If you choose more than one of the options, we'll automatically use the one that gives you the biggest benefit.
Is My Scholarship Taxable?
It could be both part taxable and part tax-free.
Your scholarship or fellowship is tax-free if you are a full-time or part-time candidate for a degree at an eligible educational institution. This can be a primary, secondary or post-secondary school. But there are very definite limits on what the award can be used for and still be tax-free. Your scholarship or fellowship can be considered non-taxable if it was used only for tuition, fees, books, supplies and equipment that are all required for your courses.
If any part of your award was used for room and board, travel, research, clerical help or equipment, that portion is taxable. So if your scholarship covers tuition as well as room and board, the amount spent on room and board is considered taxable; the amount spent on tuition is not.
Reporting the taxable part of your scholarship is easy on 1040.com. Go to our Form 1040 – Income Section screen and put the taxable amount of the year’s scholarship on line 7, Taxable Scholarships Not Reported on a W-2.
If you only had tax-free scholarship income for the year, there’s no need to file a return.
Other Types of Education Assistance
Pell grants and Fulbright grants are generally treated the same as scholarships when figuring how much is tax-free. Need-based grants, such as Pell and other Title IV grants, are generally tax-free if used for qualifying education expenses.
Veterans’ benefits — such as payments for education, training or subsistence — are all tax-free and should not be reported as income.
But payments to armed service academy cadets are different. An appointment to a U.S. military academy is not a scholarship in the eyes of the IRS. Payment received as a cadet or midshipman at an armed services academy is pay for personal services, and will be reported on a W-2.
Saving for College? Here’s the Plan
Planning for college – for yourself or for a child – involves the inevitable explorations of how to pay for it. Your best bet is is to start a savings plan ahead of time to handle future expenses. Obviously, the more you can save ahead of time, the less debt you’ll take on in student loans. Plus, you can get certain tax benefits with college savings plans. Here’s how.
The 529 Plan
Just about every state has what is called a 529 plan (the IRS calls them Qualified Tuition Plans), which is an education savings plan operated either by an educational institution or by the state itself. The name comes from Section 529 of the tax code, which authorizes this type of plan. But even though just about every state has an education savings plan, there can be differences, so it pays to compare.
There are two types of 529 plans:
Savings programs, where the entire account can be used at any accredited college or university. It’s a lot like an IRA account, where the contributions are socked away in some sort of investment vehicle, like mutual funds.
Prepaid plans, where the in-state tuition is paid in up-front. Initially, this type of plan was set up with a particular college or university in mind. But many states now allow them to be transferred to another institution (although it may be at a lower rate, depending on the state). And colleges themselves can also offer a 529 prepaid tuition program.
Federal & State Tax Implications
You can’t deduct your contributions to a 529 plan on your federal tax return, but the earnings in the account are tax-deferred, and distributions used to pay for the beneficiary’s college expenses are tax-free.
State tax benefits vary. Some states allow accumulated earnings to grow tax-free until you take the money out, some allow the distribution to be taken tax-free, and still others designate both earnings and distributions as non-taxable. The terms of your plan will explain how your state treats the funds.
A 529 plan can be used to pay qualifying expenses for a student who is enrolled at least half-time. Qualifying expenses include tuition and fees; books, supplies and equipment; and room and board. Computers are included, but only if required by the college for the courses taken.
The donor of the account – the person who is making the contributions to the plan – is the administrator for the plan. The beneficiary – the student, usually – doesn’t have any rights to the funds. The donor decides when distributions are made and for how much. A 529 plan may impact financial aid. If the parent is the plan administrator, the calculation is relatively simple; in cases where the student is actually the administrator, the process is more complicated.
Since a 529 savings plan is pretty much on auto-pilot once it’s set up, the donor won’t see a reporting statement for taxes (such as Form 1099) until withdrawals begin.
Coverdell Education Savings Accounts
The Coverdell Education Savings Account lets you set aside up to $2,000 per year for the beneficiary and can be used tax-free not only for college, but for K-12 expenses as well. The student beneficiary must be under age 18 when the account is created.
There are some limitations:
Each ESA has a custodian – usually the financial institution where the account is located.
The individual opening the account can make decisions on contributions and distributions, but distributions are always paid to the student beneficiary.
If any money is left in the account when the student reaches age 30, the balance must be paid out at that time. That amount is taxable, and if no qualified education expense was incurred that year, is assessed an additional 10 percent penalty on the interest accrued. So spend all the funds in the Coverdell ESA before the student turns 30.
A Coverdell ESA is considered a parent’s asset by the financial aid system, just like a 529 savings plan. But where you may get a state tax deduction for a 529 plan, it’s unlikely you’ll see any state tax breaks for an ESA.
Other Ways to Pay for College
While student loans and educational savings accounts are the most common ways to finance higher education, there are a couple of other options you may want to consider.
U.S. Savings Bonds
Generally, you have to pay tax on the interest you earn from U.S. savings bonds. It’s payable either in the year the interest is earned, or in the year that the bonds are cashed. But when you cash in a savings bond under an education savings bond program, you might be able to exclude the interest from taxable income. You must meet these conditions:
You must pay qualifying education expenses for yourself, your spouse or a dependent.
Your modified adjusted gross income (MAGI) must be less than the amount specified for your filing status. For most taxpayers, MAGI is adjusted gross income (AGI) as figured on their federal tax returns without taking into account this interest exclusion.
Your filing status must not be married filing separately.
In order for the bond itself to qualify, the owner must be at least 24 years old before the bond’s issue date printed on the front.
What can the savings bond interest pay for? Tuition and fees, contributions to a Coverdell Education Savings Account (ESA) or to a Qualified Tuition Program (such as a 529 plan). The IRS says you’ll have to deduct any tax-free benefits you’ve received, such as scholarships, VA benefits and 529 plan distributions before figuring how much savings bond interest can be designated tax free.
Borrowing from an IRA
Another strategy is to borrow from an IRA to pay all or part of college expenses. While the rules allow this, be warned that this could set your retirement fund back and have hidden costs. On the other hand, if paid back within the five years allowed, the impact on retirement could be low.
The pro-loan camp touts the convenience of a IRA plan loan, which is actually a loan to yourself, so it doesn’t involve a credit check. Many times, you can set up such a loan online with the plan’s financial institution. Loan costs are modest – some plans only charge a small administration fee.
Bur remember that the key to a successful loan is that you can pay the loan back into your IRA in time to avoid penalty.
Tax Deductions and Your First Job
If you meet the qualifications, you can deduct much of the cost of finding – and moving for – a new job. But what about your first job after graduating from college?
Finding Your First Job
College students unfortunately can’t deduct the costs of searching for that new job after graduation. You have to already be employed to qualify for this deduction. And even if you are employed full-time, job search expenses, combined with various other expenses, have to exceed 2 percent of your adjusted gross income before they can can start to produce any tax savings.
Moving to Your New Job
The IRS lets you deduct much of the expense of moving for a new job. And that applies to moving to that first job after college, as long as the new position requires you to live at least 50 miles away from your old address, and your move is made within a year of starting employment. You’ll need to keep all receipts and bills related to your move, for documentation.
Report your moving expenses on our Form 3903 – Moving Expenses screen. Our tax return interview will help you fill out the right screens.
How to Write Off Job Search Expenses
Job search expenses aren’t one of the more common deductions, probably because of the specific rules about what can and can't be deducted.
To qualify for a deduction, your expenses must be for a job search within your current occupation. Looking for a new line of work won’t qualify.
You can deduct employment and placement agency fees while looking for a job in your present occupation. If your employer pays you back in a later year for employment agency fees, you’ll need to include the amount you received in your gross income, up to the amount of your tax benefit in the earlier year.
You can deduct the costs of preparing and mailing copies of your résumé to prospective employers, as long as it’s for work in your present occupation.
If you have to travel to look for a new job, you may be able to deduct your expenses to and from your destination. The trip must be primarily to seek employment within your existing occupation.
You cannot deduct job search expenses if there was a substantial break between when your last job ended and when you started looking for a new one.
You cannot deduct job search expenses if you’re looking for your first job.
In order to be deductible, the amount that you spend for job search expense, combined with other various expenses, must exceed a certain threshold. Job search expenses are considered a miscellaneous itemized deduction. The amount of your miscellaneous deduction that exceeds 2 percent of your adjusted gross income (AGI) is what can be deductible.
When you do your taxes with 1040.com, enter job search expenses on our Job, Tax and Other Expenses screen, on line 23, Other Expenses. Our tax return interview will direct you to the screen.
Taxes and Your First Job
When you get your first job, it may be surprising – and disappointing – just how much youhave to pay, before you get what’s left over.
For starters, Uncle Sam dips into your pay for income tax, Social Security tax and Medicare tax. And depending on where you live, you can also count on state and maybe even local taxes. What started out at a reasonable figure (we hope) has been somewhat … diminished, hasn’t it?
Here’s how this withholding business works.
A Matter of Withholding
When you start your new job, you’ll be asked to fill out a Form W-4, Employee’s Withholding Allowance Certificate. Your boss will use this to figure how much in federal taxes to withhold. Not sure how to fill it out? Use the IRS’ Withholding Calculator to get a better idea. There’s also a worksheet on the form that can help you work out what’s best in your situation.
If you live in a state that has income tax — most do — you’ll also have to fill out a similar form for withholding state income taxes.
Side note for the self-employed: You’ll have to hold out taxes for yourself from the payments you get from clients, and send them in regularly – or be prepared to pay up when you file your income taxes at the end of the year. We don’t recommend that last way – it’s likely to get you slapped with a penalty for not paying your tax all along. Pay-as-you-go is definitely the way to go.
Other Withholding
Having your first full-time job probably also means you’ll need to make some decisions on benefits for the first time. Depending on the size of the company that employs you, there could be choices on retirement, health insurance and other items that you may not have faced before. So here are a few guidelines.
Retirement – Since this is your first full-time job, saving for retirement is probably not on your radar right now, but it should be. The earlier you start saving for retirement, the more you'll have when it's time to use that money. If your employer offers a 401k plan, enroll as soon as you’re eligible. Even if you don’t think you can afford the entire allowable withholding amount, contribute enough to qualify for the employer match.
Health Insurance – If your employer offers a health insurance plan, take part in it. Many times, the company will pay some – or even all – of the premium amounts. But even if you have to pay the entire premium, it’s still worth the expense. And with the Affordable Care Act, it’s also now the law.
Some employers also offer flexible spending accounts as part of their health package. These allow you to put money aside for medical expenses, such as deductibles. Most accounts do not roll over funds from one year to the next, so you have to use it or lose it by the end of the year.
Other Benefits – These can include term life insurance, disability insurance, even pet insurance. There’s lots of variety in this area, and lots of other ways withholding can show up on your paycheck.
Summer Jobs
You may not earn enough from your summer job to owe income tax. If that’s pretty clear when you’re filling out Form W-4, you may be exempt from federal income tax withholding – but you still have to fill out the form. But if you’re working for someone else, your employer will usually still have to withhold Social Security and Medicare taxes from your pay. (If you’re self-employed, you have to pay those taxes yourself.)
And even if you didn’t earn enough money to file a return, you may want to anyway. If your employer withheld income tax from your pay, you’ll have to file a return to get those taxes refunded.
