So You're Taking Classes: Higher Education Tax Benefits and Limitations

There are many tax benefits associated with saving and paying for higher education, which is great to hear for prospective, current, and even former students. But it's also confusing as to who qualifies for what, and what benefit someone should claim if you potentially qualify for more than one. To offer some clarity on the matter, here's an overview of the five benefits that can be claimed on a federal tax return by current and former students, and who qualifies for them. (Titles link to the IRS pages associated with each credit or deduction. Note that there are )

First, some qualifications and limitations that are common to all the benefits:

• You can only claim one benefit. No double-dipping! (Well, except for student loan interest. You can claim a student loan interest deduction and one of the other benefits at the same time, although very few people are paying back student loans at the same time they're in class.)
• The person who can claim the personal exemption for the student gets to claim the benefit, and the other person cannot claim the benefit. That means parents of dependent students get to claim the benefit, and the student can't. (And if the parent is ineligible due to income phaseouts, then no one gets to claim the benefit.) On the other hand, if the student doesn't qualify as a dependent - and many students might not, if they are working a part-time job and taking out loans to pay for school while in school - then the parent can't claim the benefit, only the student can.
• You need to have actually paid for qualified charges (or interest) during the tax year in question. Taking out loans counts. Receiving a gift to pay the charges counts too. Receiving a scholarship or payment from an employer doesn't. 
  • Qualified charges generally means charges incurred at an eligible educational institution that were required for enrollment (tuition, mandatory fees) but never includes housing, meals, insurance, or travel charges. (Interest on student loans used to pay for those things counts, though.)
  • Eligible educational institution generally means an institution that is authorized to disburse federal student aid.

American Opportunity Credit

• Amount: Up to $2,500
• Who: For the most part, students pursuing an undergraduate degree
• Phaseout Range: $80,000 to $90,000 of income*
• Limitations:
  • Student must attend at least half-time
  • Can only be claimed for degree-granting programs
  • Can only be claimed for the first four years of post-secondary study
  • Students with felony drug convictions ineligible

This is best of the benefits, if you can qualify for it. On the positive side, the credit is 40% refundable, so even if you had no tax liability or payments, you can get a refund of up to $1,000 based on claiming this credit. You also don't have to have much in tuition payments to claim this benefit: It is a dollar-for-dollar credit for the first $2,000 paid, and then a 25% credit for the next $2,000 paid. So you can qualify for the maximum amount of the credit with only $4,000 in qualified expense payments, and 80% of the credit with only $2,000 of payments. However, beyond the limitations already articulated above, to claim the credit the student (and taxpayer, if a different person) must have TINs and must provide the educational institution's EIN (usually obtained through Form 1098-T).

Lifetime Learning Credit

• Amount: Up to $2,000
• Who: Anybody taking courses towards a degree or to improve job skills
• Phaseout Range: $56,000 to $66,000 of income*

A great benefit due to its flexibility, and for most taxpayers will be the second-best benefit, after the American Opportunity Credit. It can be taken for any number of years, regardless of how many courses or credits the student takes in a given semester, and even non-degree and non-credit job skills programs qualify. The only downsides here are the low income phaseout, and the fact that you only get a credit for 20% of the qualified expenses paid, so you need $10,000 in outlays to qualify for maximum amount of the credit.

Tuition and Fees Deduction

• Amount: Deduction of up to $4,000
• Who: Anybody who paid tuition and fee expenses
• Phaseout Range: $65,000 to $80,000 of income*

Even more flexible than the Lifetime Learning Credit (no requirement that the tuition and fees be for courses towards a degree or to improve job skills) and has a higher phaseout range of income. And it's a dollar-for-dollar deduction, so you only need to pay $4,000 to obtain the maximum benefit. However, because it is a deduction and not a credit, it's value is significantly less than the Lifetime Learning Credit for most taxpayers. The value of a deduction depends on the marginal tax rate of the taxpayer; the highest marginal tax rate before the phaseout range is 25%. So the maximum dollar value is tax reduction this benefit can have is $1,000. 

Work-Related Tuition Expense Deduction

• Amount: Deduction of up to the total amount paid
• Who: People who take classes to maintain or improve job skills
• Phaseout Range: None
• Limitations:
  • Classes must be primarily for employer's benefit
  • Can't be classes to meet the minimum requirements of current job
  • Can't lead to qualification for a new trade or business
  • Typically claimed as an itemized deduction (unreimbursed employee business expense)
  • Only can be claimed to the extent the expense exceeds 2% of AGI

This benefit can be extremely beneficial to qualifying taxpayers with high incomes, since it's the only benefit without a meaningful phaseout. It can also be particularly beneficial to taxpayers paying extremely high tuition rates, since the amount isn't limited. However, take a long look at the list of limitations, and then consult with a tax professional to see if you really qualify before ponying up $75,000 for that executive MBA.

Student Loan Interest Deduction

• Amount: Deduction of up to $2,500
• Who: Anybody who paid student loan interest
• Phaseout Range: $65,000 to $80,000 of income*

Again, this benefit is a deduction, not a credit, so it's true dollar value depends on the marginal income tax rate of the taxpayer, and essentially caps out at $625. But it doesn't need to be claimed as an itemized deduction, and is the only benefit that is available to former students. 

*Phaseout ranges listed for taxpayers filing as Single. The phaseout range is double what is listed for Married-Filing-Jointly taxpayers. Married-Filing-Separately taxpayers cannot claim any of these benefits except for the work-related tuition expense deduction.