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Four Tax Advantages to Consider While Paying for College

September 20, 2017
Judith Ward, CFP®, Senior Financial Planner
A coordinated plan to tackle the costs of college can provide you peace of mind as your child marches toward graduation.

Key Points

  • 529 college savings plans go beyond tuition and fees and extend to covering expenses around room and board.
  • 529 accounts aren’t limited to colleges within your state.
  • Some of the tax credits such as the American Opportunity Tax Credit and the Lifetime Learning Tax Credit have income restrictions, so it’s important to know if you qualify.
  • The interest on federal student loans may be tax-deductible.
  • Grants and scholarships are generally tax-free as long as certain conditions are met.

By now, college students are tucked in their dorms and parents have already paid the first tuition installment.

The average total cost for four years at a public, in-state institution in 2016 exceeded $80,000—and at private colleges, more than $180,000—according to the College Board’s trends in college pricing. Families may find a combination of savings, income, and debt are needed to fully fund a child’s college experience. Each of these sources has tax benefits that are important for you to know.

A coordinated plan to tackle the costs of college can provide you peace of mind as your child marches toward graduation.

Grants and scholarships

It is very beneficial for your child to explore all grant and scholarship possibilities as they don’t need to be paid back. Typically, the term “grant” refers to need-based financial aid, whereas scholarships are usually based on merit. Grants and scholarships could cover about 35% of college costs according to Sallie Mae® How America Pays for College 2017.  

Generally, this money is tax-free as long as certain conditions are met:

  • The student must be in a degree or vocational program.
  • This money is going toward qualified education expenses, including tuition and course-related expenses, such as fees, books, and supplies. (Note: Room and board is not considered a qualified education expense.)

529 college savings plans

You may be aware of 529 college savings plans. These accounts are a great way to save for your child’s college education because of the potential tax benefits. Important tips to know include:

  • Any growth of the money you save in a 529 college savings account is tax-deferred.
  • Distributions are tax-free when used for qualified expenses. Qualified expenses go beyond tuition and related fees and include room and board, which could be as much or more than tuition.
  • You may receive a state income tax deduction for your contributions. It’s a good idea to check out your state’s plan first, and then search more broadly if your state plan is not satisfactory.

Keep in mind that you can use money from your 529 account to cover the costs of nearly any college across the country. You aren’t limited to colleges within your state.

Saving in a 529 account has relatively little impact on financial aid eligibility if the account is held in the parent’s name (with the child as the beneficiary). Using a 529 account is a good way to reduce reliance on loans.

If the funds aren’t fully needed to pay for undergraduate school, they can be used for graduate school or transferred to another family member.

Tax credits and deductions

A tax credit reduces your tax bill dollar for dollar, whereas deductions are subtracted from your taxable income. They each have different benefits and may be helpful if using regular savings or income to pay for college costs while the child is enrolled.

Credit/Deduction Annual Benefit* Highest Income Eligible  
American Opportunity Tax Credit Federal income tax credit up to $2,500 per eligible student, per year. Can be claimed for only four tax years of post-secondary education for qualified expenses such as tuition, course-related books, supplies, and equipment. Modified adjusted gross income (MAGI) is less than $90,000 for single filers, $180,000 for joint returns.

Lifetime Learning Tax Credit


 

Federal income tax credit up to $2,000 per tax return.

No limit on the number of years you can claim the credit for qualified tuition and related expenses.  

MAGI is less than $65,000 for single filers, $131,000 for joint returns.
Tuition and fees deduction You may be able to reduce taxable income up to $4,000 per return for higher education tuition and required enrollment fees (even if you don’t itemize). MAGI is less than $80,000 for single filers, $160,000 for joint returns.

*Tax-free grants and scholarships may reduce qualified education expenses.

No double (or triple) dipping! Wouldn’t it be great if we could take a tax-free distribution from our 529 account, then claim a tax credit and deduct tuition expenses? Of course it would, but it’s not allowed. You can’t take more than one education tax benefit for the same student and the same expenses.

It’s important to have a coordinated plan and consider which option(s) might provide the best tax advantage for you. An advisor can help you navigate these options.

Student loans

Many college kids today are graduating with large amounts of student loan debt. According to the Project on Student Debt, 68% of college seniors graduating in 2015 had student loan debt. The average debt was close to $30,000. That’s a payment north of $300 a month over a 10-year term.

Starting out in debt is certainly not ideal; however, it may take a small loan amount to help fund college. If possible, limit this debt to federal student loans and stay away from private loans. Federal loans offer more consumer protection and flexible repayment options.

When paying back these loans, the interest may be tax-deductible up to $2,500 if MAGI is less than $80,000 for single filers or $160,000 for joint returns. You can claim this deduction even if you don’t typically itemize deductions.

Multiple sources, multiple benefits

While this is by no means an exhaustive list with every conditional detail included, it’s certainly a start. It usually takes multiple resources to invest in your child’s future. Understanding these benefits may help make the cost of college more manageable.

Please note that a 529 plan’s disclosure document includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing.

This material has been prepared by T. Rowe Price for general and educational purposes only. This material does not provide fiduciary recommendations concerning investments or investment management. T. Rowe Price, its affiliates, and its associates do not provide legal or tax advice. Any tax-related discussion contained in this material, including any attachments/links, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalties or (ii) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or professional tax advisor regarding any legal or tax issues raised in this material.

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