Death & Taxes

Education Expenses, Taxes, and You

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By Roy Lewis
October 26, 2001

In the Taxpayer Relief Act of 1997, education was king. There were many provisions, most taking effect in 1998, that allowed for expanded deductions and credits for qualified education expenses. There are even more goodies that go into effect in 2002 with the advent of new tax legislation. So if you have education-related expenses, discussed below are some ways to offset those costs with tax savings.

It's always been the case that a deduction is available if the education maintains or improves the skills related to your trade or business. Educational costs are also deductible if the education is required (by law or by your employer) to keep your current position or job.

On the other hand, educational costs are generally not deductible if the education is required to get into a particular field (as opposed to staying in the field) or qualifies you for a new trade or business. And regardless of the new law, that statement is still basically true. What the new law does provide for, beginning in 2002, is a deduction for qualified higher-education expenses (generally college expenses, but other forms of higher education are also eligible).

For example, under the old laws, a lawyer couldn't deduct basic law school costs because a law degree is required to enter the legal field. Once she becomes a lawyer, however, any courses she takes to keep current or learn new techniques are deductible. But beginning in 2002, if those law school expenses are categorized as "qualified" under the new rules, and the student's income (or the dependent student's parent's income) isn't over the limits, then a deduction for these higher-education expenses would be allowed. 

The expenses of becoming a specialist within a field may or may not be deductible. Let's take a doctor. If the goal all along was to become a psychiatrist and the individual went straight through medical school, internship, and then into a psychiatric residency, all of the costs would be treated as being required to enter the field and would not be deductible.

But, an internist who has already been practicing medicine for a period of time can deduct the costs of a psychiatric program he enters as improving skills within his profession. See how the line could be a little bit hazy? And it can get even more confusing with the advent of the deduction for higher-education expenses that begins in 2002.

In many cases, some tax research will be needed to see if your expenses will be deductible. And, many times, if the situation is truly unique, or the money involved is substantial, the assistance of a qualified tax pro could be in your best interest.

In the case of an employee, education expenses that are deductible under the above tests can be claimed as an itemized deduction, but only to the extent the expenses, along with other miscellaneous itemized deductions, exceed 2% of the taxpayer's adjusted gross income (AGI). And if these education expenses do qualify as business expenses, then you might also be eligible for ancillary education expenses such as travel, meals, and lodging associated with this business education. But again, in order to claim these business deductions, you must first itemize your deductions, and then they must be greater than 2% of your total AGI.

It can get more complicated for taxpayers with high AGIs, because itemized deductions are subject to a further overall limit. While your education expenses might be deductible, because of how they must be reported on your tax return, you could find that you receive little or no actual tax benefit for those expenses. Before you undertake virtually any education expenses, you might want to check your tax status to determine what positive tax impact these deductions will actually have.

What happens if you find that your education expenses are not deductible? Or you find that, while the expenses are deductible, your tax issues are such that you receive very little (or no) tax benefit. Do you just hang your head, pay your taxes, and move on? Not necessarily. That's where many of the education provisions in the new Tax Act kick in:

  • Did you know that you might be able to claim a deduction of up to $2,500 for interest that you paid for qualified student loans-- without even having to itemize your deductions?
  • Did you know that you might qualify for a HOPE tax credit of up to $1,500 per year for the first two years of undergraduate education at an eligible educational institution?
  • Did you know that you might qualify for a Lifetime Learning Credit of up to $1,000 per year ($2,000 in tax year 2003 and later) for any post-high school education at an eligible educational institution?
  • Did you know that your employer might be able to pay for some of your education-related expenses and those payments would not be deemed taxable income to you?
  • Did you know that in 2002 there will be a brand-new deduction for expenses paid for higher education? That's right -- finally, a deduction will be available for "normal" college expenses.
  • Did you know that you can put money away for college education purposes, and qualified distributions from that account will be tax-free? Welcome to the world of Qualified Tuition Programs (or QTPs), also known as 529 plans.
  • Did you know that you can put money away in a type of IRA account and use those funds to pay for qualified expenses for not only college expenses, but also elementary, junior high, and high school expenses? Even if the school is a public, private, or religious school? And any earnings on that account can be taken tax-free?

All of these provisions are interrelated in some form or another, so it will be important to identify the combination of deductions and credits that will allow you the greatest tax benefit.

Confusing? It sure can be. If you want to read more about deductible education expenses, check out IRS Publication 508 and our other articles on the various credits, deductions, and education IRAs, and how they all interrelate.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.

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