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posted by: Radnor Financial Advisors

Five Tax Tips for College-Bound Students and their Families

College visitations are an exciting ritual for high school students and their families. The tests and applications that precede the admissions process are not so fun. Trying to figure out how pay for college is probably the most stressful part of the process. Fortunately, the federal and state governments do offer some tax relief and assistance for those saving and paying for college. Here are five tax tips for college-bound students and their families.

1.   Contribute to a 529 Plan

The most tax efficient way to save for college is to use a 529 plan. At both the federal and state levels, investments within a 529 plan can grow and be distributed (see #2) tax-free. Additionally, many states offer tax benefits for residents that contribute to their state’s 529 plan. Of the 43 states that impose an income tax, all but 8 allow for a deduction or credit up to a certain contribution amount. Setting up a 529 account is a fairly simple process as well.

Similar to an employer-sponsored retirement plan, each 529 plan provides a variety of funds across allocations in which to invest. A popular strategy is to invest in equity funds (higher expected return with a higher risk tolerance) when the child is younger; the allocation is then shifted toward fixed income to minimize risk and preserve the asset base as the child approaches college-age. There are a number of 529-related planning and contribution strategies that assist in maximizing a 529 plan’s benefits.

The power and flexibility of a 529 account make it the most important tool for saving for college.

2.   Understand which expenses are considered qualified for 529 Plan distributions…and which are not

As noted above, distributions for qualified expenses are not considered taxable income. The following higher education expenses are considered qualified:

Qualified Nonqualified
–      College tuition and fees –      College application and testing fees
–      Room and board (including meal plans) –      Transportation and travel costs
–      Books and supplies –      Costs related to extracurricular activities
–      Computer and internet
–      Special needs equipment

In addition, new laws allow qualified distributions for up to $10,000 of primary and secondary school expenses annually.

It is important to keep track of the expenses you use 529 funds to cover, as the IRS frequently requests documentation to support the qualified distributions. Typically a college will issue a Form 1098-T, which reports the qualified expenses billed or paid for each tax year and assists in tracking qualified expenses.

3.   Take advantage of the available tax credits and deductions

For out of pocket expenses (not covered by a 529 account), there are certain tax benefits that may be available.

American Opportunity Tax Credit (AOTC) – A credit is allowed for the first $2,000 of qualified education tuition/fees and 25% of the next $2,000, for a max credit of $2,500 per child. Up to 40% of the credit is refundable, which means that if the credit fully eliminates your tax liability, you can still claim a refund up to $1,000. There a few requirements:

–      The student must not have completed 4 years of post-secondary education

–      The student must be enrolled at least half-time in an accredited institution leading to a degree, certificate, or other recognized credential

Lastly, the credit is phased out for taxpayers at a certain income level; taxpayers with an adjusted gross income of $90,000 (or $180,000 for joint filers) cannot claim the credit. The phase-out thresholds are not currently indexed for inflation.

Lifetime Learning Credit (LLC) – Complimenting the AOTC, the LLC allows for a credit of 20% of the first $10,000 of tuition, fees, and course materials, for a maximum credit of $2,000. Unlike the AOTC, the LLC is nonrefundable. The LLC does have more relaxed requirements:

–      The credit may be taken for expenses relating  to any level of post-secondary education for courses to acquire or improve job skills

–      The student must be enrolled in at least one course during the year

The phase-out thresholds are lower than the AOTC, but are indexed for inflation. For 2018, individuals with an adjusted gross income above $67,000 ($134,000 for joint filers) are unable to claim the credit.

Either the student or the parent can claim the AOTC and LLC credits for the qualified expenses paid, but not both. Additionally, students claimed as dependents are unable to claim the deduction on their own return. Given the elimination of dependent exemptions and relatively small “other dependent credit” ($500 subject to phase-out), it may be more advantageous for the parents to NOT include the student as a dependent and allow the student to claim the credit on their own return. This strategy is most applicable to students with earned income and whose parents are unable to claim the credits due to income restrictions.

For more information and to determine if you are eligible for the credit, the IRS has a quiz you can take here.

Student Loan Interest Deduction – After graduation (or perhaps before), students may have to start paying back their student loans. An above-the-line deduction can be taken for interest paid up $2,500. (Above-the-line means that the deduction is factored into your adjusted gross income and you don’t need to itemize to receive the benefit.) The ability to take this deduction is fully phased out for those with an adjusted gross income of $80,000 ($165,000 for joint filers).

It is important to keep in mind that only interest from qualified student loans is deductible. Interest from other forms of debts (credit cards, home equity or personal line of credit, personal loans, etc.) is NOT deductible. Additionally, if you refinance or consolidate qualified students loans to a nonqualified loan, the interest will no longer be deductible.

For anyone claiming the deduction or aforementioned credits, it is important to retain a copy of the Form 1098-E (loan interest payments) and Form 1098-T (tuition payments) issued by the lenders and qualified institutions and provide copies to your tax preparer. This will assist your tax preparer in claiming the tax benefits and as well as providing support to the IRS if requested.

4.   Take the FAFSA!

While not specifically tax-related, the  Free Application for Federal Student Aid (FAFSA) is a prerequisite for receiving federal assistance to fund a college education. Students are require to complete the FAFSA in order to receive grants, work-study positions, federal loans, and certain scholarships. There is a common misconception that only those from middle- and low-income families should bother completing the FAFSA. While it is true that federal grants and work-study opportunities are generally reserved for those from families below certain income thresholds, many schools and other scholarship- issuing organizations require that you complete the FAFSA when applying. Not completing the FAFSA could preclude you from receiving non-income-based scholarships for which you were otherwise eligible. (To bring it back to tax – scholarships used to pay for qualified education expenses are always tax-free!) Additionally, the FAFSA needs to be completed in order to receive a Federal Student Loan, subsidized or unsubsidized.

The FAFSA can be a daunting process, but at the very least all students should complete the FAFSA in advance of their first year. The process opens on October 1st of the year prior to the start of the academic year (ex. October 1, 2019 for the 2020-21 school year). While the federal deadline technically is not until the end of the academic year (June 1st), the earlier the FAFSA is submitted, the better chance the student has for receiving assistance. It is recommended that the FAFSA be submitted as close to the October 1st open date as possible.

5.   Keep track of all those little jobs and internships

It may be surprising, but a college student’s tax return can quickly turn complicated even if the total income level isn’t that high. Picture the following scenario:

The O’Donnells are life-long residents of Pennsylvania. Barry O’Donnell is currently a full-time student at The Culinary Institute of America in Napa Valley. During the school year, Barry works at restaurant owned by one of the local vineyards. Each summer, Barry works for a different restaurant in a different part of the country. This year, he spent his summer in New Orleans learning how to cook the local favorites.

Each state determines tax residency differently. Some states base tax residency on domicile (where your roots are, where you are registered to vote and drive, etc.), others utilize a physical presence test, and yet others rely on some combination of the two. In Barry’s case, he is a resident of Pennsylvania and a nonresident of California and Louisiana. He will have to file tax returns in all three states. On the California and Louisiana returns, he will only report the income earned in the respective state and pay tax accordingly. On the Pennsylvania return, he will report income earned from all three states as well as his savings account interest and investment income.  He does receive a credit on the Pennsylvania return for taxes paid to the other states, so he is not double-taxed on the California and Louisiana income.

As illustrated above, it is not that difficult for a college student to find himself or herself with a more complicated tax situation. For students studying and working out of state, it is important to track days in each nonresident state and whether any income was earned in that state. It is also important to provide all of the W-2s and 1099s  received for such work to your tax preparer.  Such information  is reported  to the state  and local taxing authorities, who will be looking for a return  to be filed. As noted above, each states’ rules regarding tax residency are different, and you should talk to your tax advisor if you have any questions.

Author: Mike Valenti, Senior Tax Associate