Traditional college students generally matriculate directly after high school, live on campus, attend college full time, and rely on their parents to finance their college expenses. According to a recent survey by the U.S. Department of Education, however, nearly 74% of college students in the academic year 2011/12 did not fall into the category of traditional college students. In fact, 55% of the students had two or more nontraditional characteristics, such as part- or full-time jobs or being independent of their parents (Alexandria Walton Radford, Melissa Cominole, and Paul Skomsvold, “Demographic and Enrollment Characteristics of Nontraditional Undergraduates: 2011–12,” 2015, http://bit.ly/2vuyjWF).
Because nontraditional students represent the majority of the student body and likely file tax returns separately from their parents, this article discusses tax planning implications and strategies that more specifically relate to these individuals. The article first focuses on the educational tax credits available, then follows with a discussion of potentially unexpected tax consequences when educational assistance is involved. Second, it discusses tax issues for veterans and for investment planning. Finally, it provides information on changes implemented under the Tax Cuts and Jobs Act of 2017 (TCJA).
Educational Tax Credits
Educational tax credits available for traditional and nontraditional students include the American Opportunity Credit (AOC) and the Lifetime Learning Credit (LLC). Because the IRS prohibits a taxpayer from claiming both credits based on his education expenses in the same year, the taxpayer must choose only one credit when eligible to claim either credit. The AOC offers more tax benefit than the LLC (Joseph D. Beams and John W. Briggs, “Tax Planning for Parents of College Students,” Journal of Accountancy, March 2012, http://bit.ly/2MrBmVX), and nontraditional students should always claim the AOC when they are eligible. A taxpayer can only claim the AOC in the first four years of post-secondary studies, but there is no such constraint for the LLC. Therefore, because nontraditional students are likely to take more than four years to complete their undergraduate studies, they should claim the AOC in the first four years of their studies and claim the LLC afterwards.
The AOC allows a maximum credit of $2,500 per student per year in a degree program. The credit equals the first $2,000 of qualified education expenses and 25% of the next $2,000. Qualified education expenses include tuition, fees, and course-related books, supplies, and equipment. Forty percent of the AOC is refundable. A taxpayer can claim the AOC in the first four years of her post-secondary education, which can include both undergraduate and graduate studies. For example, if a taxpayer finishes college in three years, she can claim the credit in her first year of graduate studies. The AOC is, however, subject to phase-out; if a taxpayer files as single and has modified adjusted gross income (MAGI) between $80,000 and $90,000 (between $160,000 and $180,000 for married filing jointly), the credit is gradually reduced. Taxpayers with MAGI over $90,000 ($180,000 for married filing jointly) cannot claim the AOC. For most tax-payers, MAGI is the same as adjusted gross income (AGI) from their federal income tax return. Taxpayers with foreign income exclusions or deductions, however, may need to add the exclusion or deduction to AGI to calculate MAGI. IRS Publication 970 provides detailed guidelines about how to calculate a taxpayer’s MAGI (http://bit.ly/2CBXnfc).
The LLC allows a maximum credit of $2,000 per year and does not require a taxpayer to enroll in a degree program. The credit is equal to 20% of the first $10,000 in qualified education expenses and is not limited to the first four years of post-secondary education. Qualified education expenses include tuition and fees, but do not include course-related books and supplies unless those costs are paid directly to the educational institution. Unlike the AOC, the LLC is not refundable; however, it is subject to phaseout. If a taxpayer files as single and has a MAGI between $56,000 and $66,000 (between $112,000 and $132,000 for married filing jointly), the credit is gradually reduced. Taxpayers with MAGI over $56,000 ($132,000 for married filing jointly) cannot claim the LLC. This phaseout threshold is lower than that of the AOC, but has increased steadily over the years, while the AOC’s phaseout threshold has been the same since its inception.
How to Utilize the Refundable Portion of the AOC
Because 40% of the AOC is refundable, this credit could provide additional support for nontraditional students. A nonrefundable tax credit, such as the LLC, can only offset tax up to a taxpayer’s tax liability; any tax credit over the liability amount is forfeited. In contrast, a refundable tax credit allows a taxpayer to claim a refund for all or part of the credit that is over the taxpayer’s total tax liability, or even when the taxpayer does not owe any tax. Many nontraditional students are low-income taxpayers and may owe no tax or have a smaller tax liability than their entire AOC. In contrast, the refundable portion of the credit is likely less applicable for traditional students, many of whom depend on their parents for financial support. Since their parents are already paying their tuition, their parents’ income may be high enough that their tax liability is more than their AOC. Moreover, a taxpayer does not qualify for the refundable portion of the AOC if—
- the taxpayer is younger than age 24 and has earned income that is less than half of the support for all living and education expenses,
- at least one parent is alive, and
- the taxpayer does not file a return as married filing jointly.
Nontraditional students are thus more likely to be eligible for the refundable portion of the credit because they are more likely to be over 25, provide more than half of their financial support, or file as married filing jointly.
The Exhibit illustrates hypothetical examples of the refundable and nonrefundable portions of the AOC for a student named Karl. In Case 1, Karl has a qualified education expense of $4,000 and can claim an AOC of $2,500. The refundable and nonrefundable portions of the credit are $1,000 and $1,500, respectively. Before applying the AOC, Karl has a tax liability of $1,600. The liability is first reduced by Karl’s nonrefundable portion of the AOC, and the net tax liability becomes $100. Karl then applies the refundable credit of $1,000 to the net liability and has a tax refund of $900.
Refundable and Nonrefundable Portions of the American Opportunity Credit
In Case 2, Karl’s qualified education expense is $3,000 and his AOC is $2,250. The refundable and nonrefundable portions of the credit are $900 and $1,350, respectively. Karl’s tax liability before applying any tax credit is $1,000. Because the nonrefundable credit is $350 more than Karl’s tax liability, the extra $350 is forfeited. Karl can, however, still receive a refund of $900 from his refundable portion of the AOC.
In Case 3, Karl is not eligible to claim the AOC, but can claim the LLC instead. He has a qualified education expense of $3,000, which gives him a LLC of $600. Karl’s tax liability before applying for the LLC is $500. Since the LLC is nonrefundable and is more than Karl’s tax liability, any portion of the credit that is over Karl’s tax liability is forfeited. Karl’s tax liability after applying the credit becomes $0.
Avoiding Unexpected Taxes
Educational assistance may be taxable.
Examples of educational assistance include scholarships, grants, fellowships, Fulbright grants, Pell grants and other Title IV need-based education grants, payment to service academy cadets, and veteran’s benefits. Many taxpayers have the impression that educational assistance is tax-free; however, this is not always true. Educational assistance is only tax-free if it is used to pay for qualified education expenses. For example, scholarships are tax-exempt as long as they are used to pay for qualified education expenses, which include tuition and fees and required expenses but exclude room and board. A taxpayer must include the portion of scholarship funds used to pay for nonqualified education expenses as taxable income. For example, if John receives a scholarship of $5,000, of which he pays $3,000 for tuition and $2,000 for room and board. His qualified education expense is thus $3,000 due to the tuition payment; he can exclude $3,000 of the scholarship from his taxable income, but the remaining $2,000 of the scholarship is taxable.
Double benefits are prohibited.
A taxpayer cannot use one education expense as a basis to claim two or more tax benefits. For example, Brian attended a university this year to obtain his graduate degree. He paid $12,000 in tuition and fees and did not receive any educational assistance, implying a qualified education expense of $12,000. He is only eligible to claim the LLC, since he has already claimed four years of the AOC. If Brian’s expense is reimbursed and deducted as a business expense by his employer, then Brian cannot claim any education credit based on this expense. If the expense is not reimbursed by his employer, Brian can claim the LLC based on the expense.
Many taxpayers have the impression that educational assistance is tax-free; however, this is not always true.
Tax Planning with Employer-Provided Educational Assistance
As noted above, nontraditional students may receive educational assistance from their employers. The education can either help the taxpayers maintain their current job qualifications or advance their career. Employer-provided assistance is tax-exempt up to $5,250 each year; any amount over the threshold is taxable and can be used as a basis to claim either the AOC or the LLC.
Maria attends a university this year and receives $8,250 of educational support from her employer. The support covers her tuition and books and supplies, which Maria pays to the university directly. Maria files as a single taxpayer. While $5,250 of the support is tax-free, the remaining $3,000 is taxable and can be used to calculate any education credit. If Maria is eligible to claim the AOC, she can receive a tax credit of $2,250 [$2,000 + ($1,000 × 25%)]. If Maria is not eligible to claim the AOC, she can take a LLC of $600 ($3,000 x 20%).
Tax Planning for Veterans
Veterans constitute another group of nontraditional students and are eligible to receive tax-exempt educational benefits from the Department of Veterans Affairs (VA). Veterans are also eligible to claim the AOC or the LLC; to do so, however, they may have to subtract some of their VA benefits from their qualified education expenses. Whether a benefit affects a taxpayer’s qualified education expense depends on the type of benefit. If the benefit is given strictly to pay for tuition and fees, then the taxpayer must reduce qualified education expense by the same amount; however, if the benefit can be used to pay for any expense, such as housing expenses, the taxpayer does not need to adjust the qualified education expense.
Mike is a veteran and an undergraduate student at a university. He pays $5,200 for tuition and receives $4,200 of educational benefit from the VA. Out of the total benefit, $3,200 is designated specifically for tuition and fees, and the other $1,000 is for a housing allowance. Mike does not need to report any of his benefit of $4,200 on his tax return; however, if Mike wants to claim the AOC or the LLC, he must reduce his qualified education expense by $3,200, since this portion of his benefit is specifically given for education expenses. His qualified education expense is thus $2,000 ($5,200 – $3,200), and, if eligible, he can claim $2,000 of the AOC. If Mike is not eligible to claim the AOC, he can claim $400 ($2,000 × 20%) of the LLC.
Being a nontraditional student presents both opportunities and potential tax consequences that the average taxpayer may not be aware of.
Tax Planning for Investments
Attending school may also offer tax benefits for nontraditional students from an investment perspective. Students who have a job already lined up prior to graduation will likely see an increase in their income in the near future. This situation is especially pertinent to nontraditional students, who are likely to file tax returns themselves and attend school to acquire additional knowledge to advance their careers. Expecting a higher income upon completing her studies, a taxpayer should consider selling long-term investments at the preferential long-term capital gains rates during the course of an educational program in order to save taxes, particularly if she anticipates selling the investment in the near future anyway.
John and Ashley are married and file a joint return. Ashley goes back to school to obtain her therapy license in 2018 and receives a job offer with a starting date of January 1, 2019. John and Ashley’s taxable income will increase from $60,000 in 2018 to $110,000 in 2019, and as a result, the couple’s tax rate on long-term capital gains will increase from 0 to 15%. The couple purchased stock of MM Corporation in 2010 for $5,000, and the investment is worth $9,000 on both December 27, 2018 and January 4, 2019. If they sell the stock on December 27, 2018, they do not have to pay any tax on the long-term capital gain of $4,000. In contrast, if they sell the stock on January 4, 2019, they must pay 15% on the gain and have additional tax of $600 ($4,000 × 15%).
Impact of the Tax Cuts and Jobs Act
The TCJA retained most of the educational tax benefits discussed above; for example, it did not change the AOC or the LLC. The TCJA also did not change the rules regarding the student loan interest deduction, the exclusion of employer-provided education assistance, or whether scholarships, grants, or educational assistance are taxable. The TCJA did, however, make two major changes. First, it did not extend the tuition and fees deduction. Second, it eliminated the ability for taxpayers to deduct unreimbursed work-related expenses as an itemized deduction on Schedule A.
How CPAs Can Help
Being a nontraditional student presents both opportunities and potential tax consequences that the average taxpayer may not be aware of, and electronic tax preparation programs will not necessarily catch all opportunities to minimize taxation. Therefore, these taxpayers may very well benefit from the advice of a CPA in wading through the waters to determine what strategy is best in a given situation. Such advice may be useful in assessing the best approach for the current year and for the future.
First, CPAs should point out to non-traditional students that educational assistance is only tax-free when used to pay for qualified education expenses, as well as explain what constitutes a qualified education expense for each type of assistance. Second, nontraditional students should claim both the refundable and nonrefundable portion of the AOC, where applicable. Third, if a taxpayer’s education expense is paid by her employer, a CPA should help the taxpayer decide how much education expense she can use to claim any tax credit. Fourth, CPAs should help these students understand how to handle their educational benefits from the VA, if applicable, and whether such benefits affect their application for other non-VA educational benefits. Finally, CPAs may recommend that students sell their long-term investments during their pursuit of further education in the likely event that they expect to experience significant increases in income, and thus their marginal tax rate, upon graduation.