The summer is coming to a close, and back-to-school time is right around the corner. If you or your child is getting ready to head to college, here are some tax tips that can help you save money – now and in the future.
1. Three different tax breaks for tuition and expenses
There are three main tax breaks you could take for paying your tuition and other required college expenses (or that parents can take for paying expenses of a child). The right one for you depends primarily on your status in school and your income. Here's a quick rundown of the three:
- American Opportunity Credit: This credit is only available for the first four years of undergraduate study, and is also the most lucrative, worth up to $2,500 per year, 40% of which is refundable, meaning it can be paid even if the taxpayer has no tax liability. To qualify, the student must be enrolled on at least a half-time basis, and the person claiming the credit must have a modified adjusted gross income (MAGI) under $90,000 ($180,000 if married). Qualified expenses for the credit include tuition and fees, as well as books, supplies, and equipment needed for course study.
- Lifetime Learning Credit: Similar to the American Opportunity Credit, but with a few key differences. For starters, there is no limit to the number of years the credit can be taken, or what the student's status in school is (undergraduate/graduate/non-degree), The credit is worth up to $2,000, is non-refundable, and the MAGI limits are $55,000 for singles and $110,000 for joint filers.
- Tuition & Fees Deduction: This is generally used by people who can't qualify for either of the tax credits. The deduction has relatively high MAGI limits of $80,000/$160,000 and can result in up to a $4,000 adjustment to income. Like the Lifetime Learning Credit, the deduction isn't limited to just the first four years of college.
Obviously, there is more to each of these that I can write in a few sentences, so here's a more complete discussion.
It's important to point out that some college expenses cannot be included for any of these. "Room and board is the big one," says Dave DuVal, VP of TaxAudit.com. "Other expenses such as insurance, medical expenses (including student health fees), transportation to/from school, or any personal living expenses never qualify even if they're required to be paid to the school."
Just be sure you have the right documentation to claim the appropriate tax break, and beware that the definition of the "right documentation" has changed recently. "Thanks to the PATH Act, you now have to have the physical 1098-T form in your possession. And, you can't use the amount in box 2 (the amount billed), you need to use the amount listed in box 1 (amount paid)," says DuVal.
2. Use your college savings right
If you have college savings in an account such as a 529 or Coverdell, or you're planning to withdraw from an IRA under the education expenses exemption, make sure your expenses qualify. Just as with all of the tax breaks discussed earlier, tuition, fees, and materials required for attendance can be included.
Unlike the tax breaks, however, room and board can be included as long as the student attends school on at least a half-time basis. Off-campus housing is deductible, but only to the extent of the amount listed in the school's published cost of attendance.
Perhaps the most important point is that you're able to document each qualified expense – this is especially important for expenses paid from college savings, as it can include costs that aren't included in the student's bill. Failure to do so could potentially result in a hefty penalty from the IRS.
3. Set your future self up for tax savings
One of the smartest things you can do while you're in college, if you're working a part-time job, is to start saving money in an IRA. I know what you're thinking...college is way too early to start thinking about retirement, right? Hear me out.
First, your money will never have any more long-term potential than it does right now. If you start saving for retirement at age 30, you'll need to set aside $345 per month to end up with $1 million by age 65, based on the stock market's historic rate of return. Starting at 25, you'll only need to save $217 per month, and starting during college at age 20 means you'll only need $135 per month to retire a millionaire.
Second, by contributing to an IRA, there are some pretty great tax benefits to be had -- either now or later. Contributions to a traditional IRA can be deductible on your current-year tax return. On the other hand, Roth IRA contributions are not deductible, but any qualified withdrawals of your investment gains will be 100% tax-free. Plus, Roth IRAs allow you to withdraw your contributions early without penalty, a great feature if you don't necessarily want your money tied up until retirement.
Since most college students are in one of the lowest tax brackets, a Roth IRA is usually the most beneficial option. Chances are you'll be in a higher tax bracket as you approach retirement. As of the 2016 tax year, you can contribute up to $5,500 or your total earned income for the year, whichever is less.
Parents can help their kids get started, too. If your child has earned income, you can actually make an IRA contribution on their behalf, as long as it doesn't exceed their earnings for the year or the $5,500 limit. This way, they'll get a head start on saving, and can still use the income from their job for living expenses (just books and study materials, right?).
College is expensive, so every penny counts
Tuition costs have never been higher, and aren't showing any signs of dropping. So, it's important to save every penny you can, either through the education tax breaks I mentioned or by using the money you've saved for college in tax-advantaged accounts correctly. And, one of the smartest moves college-age individuals can make is to start saving for the future while their investment dollars still have decades to grow.