Higher Education Tax Benefits and Incentives

This summary was issued by NASFAA using information provided by the Congressional Research Service dated February 11, 2011 (7-5700, RL32554)

Tax incentives that provide benefits to taxpayers for the expenditures they make on higher education in a given year can be divided into three groups:

• incentives for current year expenses
• incentives for preferential tax treatment of student loan expenses
• incentives for saving for college

Please consult your tax advisor to determine your eligibility for any of the tax benefits detailed below.

Incentives for Current Year Expenses

Tax Credits

• Hope Credit -- A nonrefundable credit that may be claimed for the college tuition and fees paid for each eligible student in the taxpayer's family. An eligible student is enrolled at least half-time in one of the first two years of postsecondary education in a program leading to a recognized educational credential. For tax year 2008, the amount of credit that may be claimed is equal to 100 percent of the first $1,200 of the taxpayer's out-of-pocket expenses for each student's tuition and fees, plus 50 percent of the next $1,200 of the taxpayer's out-of-pocket expenses for each student's qualified tuition and related expenses.
• American Opportunity Tax Credit (AOTC) -- A partially refundable credit that allows lower-income households with little or no tax liability to take advantage of the credit. Refundability is limited to 40 percent of the credit amount for which a taxpayer is eligible. Since the maximum per-student credit amount is $2,500, the maximum per-student credit refund is $1,000.
• Lifetime Learning Tax Credit -- This credit may be claimed for the qualified tuition and related expenses of the students in a taxpayer's family who are enrolled at eligible institutions. The credit amount is equal to 20 percent of the taxpayer's first $10,000 of out-of-pocket qualified tuition and related expenses. The maximum credit a taxpayer may claim is $2,000 and is not indexed for inflation. If a taxpayer is claiming a Hope credit (or AOTC) for a particular student, none of that student's expenses may be applied to the Lifetime Learning credit.

Deductions

• Above-the-line deduction for tuition and fees -- Sometimes referred to as the Higher Education Deduction, this deduction is subtracted from taxable income before other deductions or exemptions are claimed. One of the benefits of this above-the-line deduction is that it reduces the taxpayer's adjusted gross income (AGI).
• Work-related education deduction -- An individual taxpayer may qualify for this deduction if the education maintains or improves a skill in the taxpayer's present work and is required by the taxpayer's employer to maintain salary, status, or job.

Exclusions

• For scholarship and fellowship income -- A scholarship or fellowship is tax free if the recipient is a candidate for a degree at an educational institution and it is used to pay qualified education expenses, which includes tuition, fees, books, supplies, and equipment that are required for courses.
• Tuition reductions -- Below the graduate school level, the tuition reduction is tax free if the educational institution gives the reduction to its employees, or retirees, for their own education or that of their spouse or children. This benefit is applicable at primary and secondary schools as well. At the graduate level, a tuition reduction is tax free if it is given by an educational institution to a graduate student who teaches or does research for that college or university and the reduction is not given as payment for services rendered.
• Employer-provided education benefits -- Individuals may receive up to $5,250 each year in educational assistance from their employer tax free, only if it is provided in association with an educational assistance program.
• Personal exemption for student dependents aged 19 to 23 -- A taxpayer is allowed one exemption for each person claimed as a dependent. The exemption amount is $3,650 in 2010. Five tests must be met to claim the exemption.

Incentives for Preferential Tax Treatment of Student Loan Expenses

• Student loan interest deduction -- The interest paid is an above-the-line deduction. A maximum of $2,500 in paid student loan interest can be deducted annually. Taxpayers can deduct interest that they are required to pay as well as any interest payments made voluntarily, as long as they are not claimed as a dependent by another taxpayer or married and filing separate tax returns.
• Exclusion for student loans that have been forgiven -- A canceled loan qualifies for tax-free treatment if it contains a provision that all or part of the debt will be canceled if the taxpayer works for a certain period of time, in a certain profession, and for any of a broad class of employers. The loan must be made by a qualified lender.

Incentives for Saving for College 

• Qualified Tuition Plans (QTPs or 529 plans) -- Taxpayers contribute after-tax dollars, which are then allowed to grow on a tax-deferred basis. If funds are withdrawn to pay eligible higher education expenses, then no income tax will be due. There are generally two types of QTPs:
  • Prepaid plans allow individuals to purchase tuition years in advance of attendance at a discounted present day price.
  • Savings plans offer market-based returns based upon the type of investment selected by the plan owner.
• Coverdell Education Savings Accounts -- Tax-preferred savings accounts originally created for the purpose of paying for college. Parents can contribute a maximum of $2,000 per child (under age 18) annually. Contributions to Coverdell accounts are not tax deductible; however, the earnings on the account are tax free as long as the funds are used for qualified education expenses.
• Education savings bond program -- Taxpayers may be able to redeem qualified U.S. Savings Bond, without having to include in income some or all of the interest earned on the bonds, if the funds are use for qualified educational expenses for themselves, their spouse or a dependent for whom they claim an exemption on their tax return.
• Withdrawals from individual retirement accounts (IRAs) -- When the withdrawal is made for qualified higher education expenses, the taxpayer does not incur the 10 percent tax on early withdrawal. The withdrawn amount is, however, considered income and is subject to tax.
• The allowance of uniform transfers to minors -- gifts of up to $12,000  made by a donor during the calendar year to anyone are not included in the total amount of the donor's taxable gifts that year. This annual exclusion is available to all donors.