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As the new school year kicks off, families may be eligible for a wide range of educational tax benefits, including several enhanced by recent federal tax legislation. Here’s a roundup of several key tax breaks that you may want to take advantage of this year.
American Opportunity tax credit
Formerly known as the Hope Scholarship Credit, the American Opportunity tax credit (AOTC) provides a maximum dollar-for-dollar reduction of $2,500 on your 2021 federal tax return. This applies to qualified expenses like tuition, room and board, books, computer equipment, and supplies.
The maximum credit is available for up to four years of study for every student in the family. So, if you have two children in college this year, you can claim a total $5,000 credit.
However, the AOTC is phased out for moderate- to upper-income taxpayers. The phaseout occurs between $80,000 and $90,000 of modified adjusted gross income (MAGI) for single filers and between $160,000 and $180,000 for joint filers. (These figures aren’t indexed for inflation.)
Lifetime Learning Credit
Alternatively, parents with children in college may claim the Lifetime Learning credit (LLC). Unlike the AOTC, the maximum credit is $2,000 and is applied on a per-taxpayer basis. Accordingly, for two children in school, your credit is still $2,000 — not $4,000. On the plus side, the LLC is available for all years of study, instead of for only four years.
Previously, the LLC was phased out at lower levels than the AOTC. But the Consolidated Appropriations Act, signed into law in late 2020, leveled the playing field. Beginning in 2021, the phaseout ranges for the LLC match those for the AOTC.
One caveat: Generally, you can claim the AOTC or the LLC, but not both. Unless your child stays in school longer than four years, the AOTC remains the preferred choice for most taxpayers.
Section 529 plans
If you’ve been trying to save for a child’s college education, you may be intimidated by the daunting costs. One way to accumulate tax-favored savings is through a state-operated Section 529 plan. And this savings technique is now available for tuition payment for some pre-college students.
States have established generous contribution limits. Any payouts for qualified expenses — such as tuition and room and board — are exempt from tax. In addition, under the Tax Cuts and Jobs Act, a Sec. 529 plan can be used to pay up to $10,000 annually for tuition at an elementary or secondary school (for example, at a private or religious school).
Coverdell Education Savings Accounts
Unlike Sec. 529 plans with contribution limits reaching into six figures, the annual contribution limit for a Coverdell Education Savings Account (ESA) is comparatively low — just $2,000. Nevertheless, you still can accumulate funds in a Coverdell ESA to pay for qualified expenses without any tax erosion.
The ability to contribute to a Coverdell ESA is phased out, but at relatively high levels. Tax bonus: This type of plan isn’t limited to college students. It also can be used to pay expenses of children in kindergarten through high school.
If your child qualifies for a college scholarship, there’s some tax icing on the cake. The scholarship is exempt from tax if the student is a degree candidate at an eligible school and the scholarship:
- Doesn’t exceed school expenses,
- Is used for tuition, and
- Doesn’t represent payment for teaching, research or other services required as a condition for receiving the scholarship (unless an exception applies).
Warning: The tax exemption for a scholarship may be forfeited if the money is used for other purposes, such as room and board.
Student loan interest
Generally, a borrower can deduct up to $2,500 of student loan interest paid during the year, subject to a phaseout based on MAGI. The deduction may be claimed above-the-line by a borrower legally obligated to repay the debt. Thus, it’s often the student — not the parents — who benefits tax-wise.
Some students can do even better. Usually, loan forgiveness results in taxable income to the debtor. But recent legislation has carved out tax exemptions for student loan forgiveness in specific situations.
In addition, required payments on student loans were paused through September 30, 2021. The American Rescue Plan Act allows the president to authorize tax forgiveness of public and private student loans made from 2021 through 2025. Stay tuned for more developments.
Take a break
This is just a general overview of some education-related tax breaks. It’s important to educate yourself about the possibilities to ensure you’re maximizing the tax benefits for your family. Of course, you’ll need to obtain expert guidance that applies to your tax and financial situation.