Can college debt save me money on my taxes?

As a recent graduate with an armful of student loans, you could save some money on April 15. See more debt pictures.

If you are or ever were a college student, you probably already know your way around the world of textbook savings -- buying used whenever possible. In fact, you might have even wondered what a fellow classmate was thinking when he came in with a new copy of a book if buying a used copy was an option. It could be that he just hasn't learned the strategies you have. The day you learned them, though, you likely never looked back. Well, that just might be what's happening with your taxes, except you're the student in need of learning a new money-saving tactic. It's true; your college debt can potentially save you money on your taxes. And, once you're in the know on how to take advantage of this savings opportunity, you won't ever leave the money you're due on the table again.

In this article, you'll learn about three savings avenues potentially available to you -- tax credits, tax deductions and savings accounts. However, let's do some cramming on the helpful definitions you'll need to know before you can get started.

  • Tax credit - A tax credit is a set amount of money you subtract from your tax liability. Note that your tax liability is the same thing as your tax bill.
  • Tax deduction - A tax deduction is a set amount subtracted from your income before your tax liability is calculated, which brings that amount down.
  • Adjusted gross income - An adjusted gross income is your total gross income minus any deductions you're taking, such as a health savings account deduction.
  • Modified adjusted gross income - A modified adjusted gross income is achieved by adding certain deductions back to your adjusted gross income.
  • Dependent - A dependent is an individual, such as a child or elderly parent, for whom you are financially responsible. Your tax liability can be lowered by the credit you can take on your taxes as a result of this responsibility.

Now that you're familiar with these key terms, continue to the next section to learn about the Hope/American Opportunity and Lifetime Learning tax credits.

 

Tax Credits

Through the Hope/American Opportunity and Lifetime Learning tax credits, recipients can reduce their federal income tax bill. Keep in mind, though, that you can't claim both of these tax credits in the same year. However, the credits can be applied to multiple people in one household within a year.

First, let's go over the Hope/American Opportunity Tax Credit. When Congress passed the American Recovery and Reinvestment Act of 2009, it expanded the Hope Credit -- now known as the American Opportunity Tax Credit -- for 2009 and 2010. Before, the potential $2,500 credit was available for two years of postsecondary education; now, it can be claimed for four years with an expanded income eligibility [source: The College Board]. Here's how it works:

  • Enrollment rule - The student must be enrolled at least half time, working toward an undergraduate degree or legitimate education credit.
  • Credit amount - The credit is up to $2,500 and is also refundable up to $1,000, meaning that up to $1,000 could be paid back to lower-income taxpayers when the credit exceeds their tax bill [source: IRS.gov].
  • Income requirement - The credit is phased out for individuals with a modified adjusted gross income between $80,000 and $90,000 or greater on single returns, or between $160,000 and $180,000 or greater on joint tax returns [source: USA Funds].
  • Credit recipients - If a student's parents/guardians claim him/ her as a dependent, the parents/guardians can claim the credit. If the student claims himself/ herself as a dependent, it is all his/ hers to claim.

Now, turn your attention to the Lifetime Learning Tax Credit. This credit is available for all years of postsecondary education and job skills courses. Here's the scoop:

  • Enrollment rule - This credit is available even if the student is taking just one course toward improving job skills. However, the credit can be claimed only on tuition and fees.
  • Credit amount - Credit can be claimed for 20 percent of up to $10,000 in tuition and fees [source: IRS.gov].
  • Income requirement - The available credit is phased out for people with modified adjusted gross incomes between $50,000 and $60,000 on single tax returns or $100,000 and $120,000 on joint returns[source: The College Board].
  • Credit recipients - The same rules apply as for the Hope/American Opportunity Tax Credit.

You now have background on the credits available to you on education expenses. Head to the front of the class -- or just to the next section -- to learn about possible deductions on your scholarly pursuits.

Tax Deductions

Could your college debt translate to tax savings?
Could your college debt translate to tax savings?

When it comes to federal taxes, there are three education deductions: student loan deduction, deduction on qualified higher education, and excluded income on employer education assistance.

For the student loan deduction, if you meet requirements, you can deduct up to $2,500 in interest per tax return, not person [source: The College Board]. The loan must be for higher education costs, such as tuition and fees, supplies and lodging. The student must be enrolled at least half time in a program that meets the U.S. Department of Education's guidelines and leads to a degree, certificate or credit. Note the following:

  • Duration - Interest can be deducted annually as long as the loan is for education and not being deducted in another manner.
  • Filing status and income - Your filing status must be married filing jointly, head of household, single or qualifying widow or widower -- not married, filing separately. The deduction amount depends on modified adjusted gross income, which must be less than $70,000 on single returns and less than $145,000 on joint returns [source: IRS.gov].
  • Deduction recipient - If the student is a dependent, the parent takes the deduction; if the student is not a dependent, he or she takes the deduction.

Next up is the deduction for up to $4,000 on higher education costs, such as tuition and fees, but not room and board. To qualify, your modified adjusted gross income must be at or less than $65,000 on single returns or $130,000 on joint returns. However, if your modified adjusted gross income is at or less than $80,000 single/$160,000 joint, you may still qualify for a maximum $2,000 deduction [source: USA Funds]. Keep in mind you cannot claim this deduction for the same student in a single calendar year if you are already taking one of the credits outlined on the previous page. Parents can qualify for this deduction if their student child is listed as a dependent on their tax returns.

Lastly, you can potentially exclude up to $5,250 annually in assistance your employer provides for higher education costs, such as tuition, fees and supplies [source: USA Funds]. When your employer calculates your final compensation for the year for tax purposes, it would not include that amount and you do not need to claim it as income. This tax-free money cannot be used in combination with other education deductions or credits.

You may be all set with your taxes, but you can also save money on your college debt by investing in the future. Click on over to the next section to learn more.

Savings Accounts

In addition to tax credits and deductions, you also have two programs available for investing for the future for educational expenses and watching those funds grow tax-free. These two programs are known as the Coverdell Education Savings Account and the 529 college savings plan.

For the Coverdell Education Savings Account, you can invest up to $2,000 each year for elementary, secondary or postsecondary education expenses to a savings account for a beneficiary who is either younger than 18 or has special needs [source: USA Funds]. You can claim the Hope/American Opportunity or Lifetime Learning Credit and take a withdrawal from your account in the same calendar year; however, the funds cannot be used on an expense for which a tax credit was taken. The funds you put in this account are not tax deductible, but you do not pay taxes on withdrawals.

Just as with some of the prior programs discussed, there are income requirements for the Coverdell Education Savings Account. Here's the breakdown:

  • Individuals who can contribute full amount - Those with a modified adjusted gross income at or less than $95,000 for single returns and $190,000 for joint returns [source: USA Funds]
  • Individuals whose contribution levels will be phased out - Those with a modified adjusted gross income of less than $110,000 but greater than $95,000 for single returns and less than $220,000 but greater than $190,000 for joint returns [source: USA Funds].

With 529 college savings plans, you may also invest after taxes and then withdraw funds tax-free to pay for qualified higher-education costs, such as tuition and fees, supplies and books. A main difference with these plans, though, is that there are no income restrictions. States administer their own plans, but you can invest with any state. With 529 plans, you have the choice of prepaid plans, where you pay for a portion or a full year of tuition ahead of time -- locking in that price for the future -- or investment plans, where you choose how to invest your funds and then have the ability to use it toward educational costs at a variety of places.

With these savings accounts and the tax savings potentially available to you through your education debt, school costs are just a little bit more manageable. And now that you are in the know, you can put that money back in your book bag -- right next to your less-expensive, used books!

For more information on saving money and other personal finance topics, visit the links on the next page.

Related HowStuffWorks Articles

Sources

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