Deducting College Expenses
The Economic Growth and Tax Relief Reconciliation Act of 2001 created a new tax deduction for college expenses. For 2002 and 2003, taxpayers could deduct up to $3,000 in qualified higher education expenses.
However, the tax deduction was only available for four years, beginning in 2002. The amount of the deduction was also subject to income limits. For 2002 and 2003, you could take the maximum allowable deduction of $3,000 if your adjusted gross income (AGI) was $65,000 or less. If you were married and filing a joint return, the AGI limit was twice that amount, or $130,000.
Married persons filing a separate return were not eligible for the deduction. In addition, you could not deduct those expenses that were claimed for the Hope credit or lifetime learning credit, or that had been paid for with distributions from a Section 529 plan, education savings account, or savings bonds whose interest you deducted for paying college expenses.
For 2004 and 2005, the maximum allowable deduction increased to $4,000. For persons earning more than $65,000 and not more than $80,000, the allowable deduction was cut in half to $2,000. (For married persons filing jointly, the respective limits were $130,000 and $160,000.) For single taxpayers earning more than $80,000 or married filing joint taxpayers earning more than $160,000, no deduction was available.
The Tax Relief and Health Care Act of 2006 extended tuition deduction through 2007. The deductible amounts and income limitations remain the same as they were for 2004-2005.
The money that you invested in yours, your spouse's, or a dependent's higher education translates into direct tax savings. The new tax deduction was an above-the-line deduction. This means you didn't have to itemize or limit the deduction to amounts that exceeded 2% of your AGI.
The following table calculates the tax savings and future value for two investors. One investor is in the 25% tax bracket. The other investor is in the 28% tax bracket. Both investors can earn a 5% rate of return. Future value is calculated for a five-year period for a taxable and tax-exempt account.
Value of $4,000 tax deduction for 25% and 28% tax brackets:
|Adjusted gross income:||$30,000||$55,000|
|Savings interest rate:||5%||5%|
|Future value (5 years):||--||--|
If you are in the higher bracket, $4,000 in deductions saves you $1,120 in taxes this year. Invested in a tax-exempt account at 5% compounded yearly, this amount grows to $1,429. Invested in a taxable account at 5%, it grows to $1,337.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.