What to Know About Tax Breaks for College Students and Parents

• In 2021, total U.S. student debt hit a whopping $1.75 trillion — and it's only getting higher.
• Students and families can save money with college tax credits and deductions.
• Other education-related tax benefits include special savings accounts and savings bonds.

College in the U.S. can be incredibly expensive. According to the National Center for Education Statistics, tuition and fees cost an average of $8,620 at public in-state universities, $19,034 at public out-of-state universities, and $29,371 at private nonprofit universities during the 2019-20 academic year.

The rising cost of college has caused a massive spike in student debt, which sits at an all-time high of $1.75 trillion. What's more, student loan borrowers pay an average of $1,898 in interest each year.

Many parents, guardians, and students want a break from these expenses. Fortunately, the U.S. government offers a variety of tax breaks for college students in the form of tax credits, deductions, and tax-free savings accounts.

It's important for taxpayers to take advantage of these benefits. Whether you're a parent or guardian supporting your child's college education or a financially independent college student, these tax breaks could help you save thousands of dollars a year.

What Are College Tax Credits?

Tax credits are some of the best tax breaks for college students. These credits apply directly toward the amount of tax you owe rather than just reducing the amount of income subject to tax.

The two major education tax credits offered by the federal government are the American opportunity tax credit and the lifetime learning credit. Taxpayers may claim only one of these college student tax credits.

To claim either credit, you must use Form 8863. You'll also need Form 1098-T, which should be mailed to the student from the school and shows how much you paid in tuition and qualified expenses that year.

American Opportunity Tax Credit

The American opportunity tax credit (AOTC) provides a maximum annual credit of $2,500 per eligible student during the first four years of college. This credit may cover expenses associated with tuition, fees, and course materials. Note that expenses for room and board, transportation, medical care, insurance, and nonrequired fees are ineligible.

The amount of the credit is equal to 100% of the first $2,000 on qualified education expenses paid for each student and 25% of the next $2,000. In other words, if your qualifying educational expenses are $4,000 or more, you would be allowed the maximum credit of $2,500.

What's great about the AOTC is that it's refundable up to 40%. So even if the credit you receive brings your tax liability down to zero, you can still get up to 40% of what's left over, up to $1,000.

In order to qualify for the AOTC, students must be pursuing a postsecondary degree or other recognized education credential and be enrolled at least half time for one academic term beginning that tax year.

Be aware that the AOTC maintains income thresholds. In order to claim the full credit, your modified adjusted gross income must be $80,000 or less ($160,000 or less for married couples filing jointly). You can still receive a partial credit if your modified adjusted gross income is above $80,000 and below $90,000, or $180,000 if filing jointly.

Lifetime Learning Credit

The lifetime learning credit (LLC) is similar to the AOTC but less restrictive. This credit is for qualified tuition and related expenses paid for eligible students attending qualifying schools.

Unlike the AOTC, however, there's no limit on the number of years you can claim the credit. In addition, you don't have to be pursuing a degree or be enrolled at least half time.

These qualities make the LLC more appealing if you are not an undergraduate, attending college part time, or taking career development courses. Note that the student needs to be enrolled for at least one academic term beginning that tax year.

The LLC is slightly less valuable to taxpayers than the AOTC because it's nonrefundable, meaning you can't receive any of the credit back as a refund as you can with the AOTC. The amount of the credit provided by the LLC equals 20% of the first $10,000 of qualified education expenses, or a maximum of $2,000 per tax return.

Income thresholds for the LLC are somewhat restrictive. You can only claim the credit if your modified adjusted gross income is less than $69,000 ($138,000 for those filing jointly). The amount of the credit gradually drops if your modified adjusted gross income is between $59,000 and $69,000, or $118,000 and $138,000 for joint filers.

What Are Tax Deductions for College Students?

Tax deductions lower your tax liability by reducing the amount of income that's subject to tax.

While not as valuable as college tax credits, tax deductions for college students can be highly beneficial and significantly reduce the amount of tax you owe. A lower modified adjusted gross income can also help you qualify for other deductions and credits.

Student Loan Interest Deduction

The student loan interest deduction allows taxpayers to deduct any required or voluntary interest paid (up to $2,500) during the tax year on a qualified student loan used solely toward the payment of higher education costs for you, your spouse, or a dependent.

Private loans from family, friends, or employer plans do not count toward this deduction. The student must also be enrolled at least half time.

In order to qualify, your modified adjusted gross income must be less than a certain amount, which is set annually. For 2020, you needed to have a modified adjusted gross income of less than $85,000 a year ($170,000 for joint filers). Deductions are gradually reduced for incomes between $70,000 and $85,000 ($140,000 and $170,000 for joint filers).

Tuition and Fees Deduction

Originally scheduled to be discontinued after 2017, the tuition and fees deduction was extended through the 2020 tax year as part of the Further Consolidated Appropriations Act. As of 2021, however, the deduction has been officially repealed.

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Are There Any Other Tax Benefits for College?

In addition to college tax credits and deductions, there are other ways to help offset taxes when paying for higher education.

Education savings accounts like Coverdell and the 529 plan offer tax-free earnings growth and tax-free withdrawals when funds are used for qualified education expenses. The account holder does not have to pay tax on the annual growth on the original investment.

Additionally, no tax is paid on withdrawn funds, as long as this money is used to cover education expenses.

You can also invest in an education savings bond program. With this program, you may be able to exclude interest from income when the qualified savings bonds are redeemed to pay for higher education expenses.

In terms of IRA funds, while the IRS usually charges a 10% penalty if you withdraw funds early (before you reach age 59 and a half), if you use that money to pay for tuition and other qualified higher education expenses, it can be withdrawn without penalty. Note, however, that you may still have to pay income tax on the distribution.

Learn More About Tax Breaks for College Students

For a complete rundown on all education tax benefits, visit the IRS Tax Benefits for Education Information Center. You can also check with your state to see what benefits it offers. For example, New York offers a credit/deduction on qualifying college tuition.

As U.S. tax laws, rules, and regulations are constantly changing, it's important you consult with a tax professional such as an accountant, tax attorney, certified tax preparer, or IRS enrolled agent.

DISCLAIMER: The information provided on this website does not, and is not intended to, constitute professional financial advice; instead, all information, content, and materials available on this site are for general informational purposes only. Readers of this website should contact a professional advisor before making decisions about financial issues.

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