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Tax Deduction and Credits for College Expenses

The following is an excerpt from my book Taxes Made Simple: Income Taxes Explained in 100 Pages or Less.

Given that the tax law is (usually) set up to reward things that Congress has decided are beneficial to our country, it’s no surprise that there are tax breaks available to people paying for higher education expenses.

Education Credits

If you pay higher education expenses for yourself, your spouse, or your dependent, you may be entitled to one (or both) of two credits: the Lifetime Learning Credit or the American Opportunity Credit.

Lifetime Learning Credit

The Lifetime Learning Credit may be available to you if you pay postsecondary education expenses for a student. The credit is calculated as 20% of the first $10,000 of qualified education expenses that you pay in a given year. (Note that this means that the maximum credit per tax return is $2,000.)

Your eligibility to claim the Lifetime Learning Credit begins to decrease as your modified adjusted gross income exceeds $80,000 ($160,000 if married filing jointly). Once your MAGI reaches $90,000 ($180,000 if married filing jointly), you’ll no longer be eligible to use the credit.

There is no limit to the number of years that the Lifetime Learning Credit can be used for a given student.

In order to qualify for the Lifetime Learning Credit, the expenses must be paid to a university, college, vocational school, or other postsecondary educational institution. Eligible expenses include tuition, fees, and other course-related expenses that are required to be paid to the institution as a condition for enrollment or attendance. The course must be part of a postsecondary degree program or taken by the student to acquire or improve job skills.

EXAMPLE: Jack is attending school to be a filmmaker. In addition to his tuition, he’s required to pay $500 per semester for use of the school’s film studio. Because he is required to pay the $500 to the school in order to attend classes, the expense can be included as a qualifying education expense.

EXAMPLE: Lee is attending school for a degree in Spanish. Each semester, he is required to buy several textbooks to use for his courses. However, because his school doesn’t require him to buy the materials from the school — he could buy them online on Amazon, for instance — the cost does not count as a qualifying education expense.

Two more points of note about qualifying expenses:

  1. Room and board does not count as a qualifying education expense.
  2. It doesn’t matter whether or not the money used to pay the expenses was obtained with a loan.

American Opportunity Credit

The American Opportunity Credit is available for students who are in their first four years of postsecondary education and who are enrolled at least “half-time.” The amount of the credit is the sum of the first $2,000 of qualified education expenses paid for the student, plus 25% of the next $2,000 of qualified expenses. (Note that this means that the maximum credit per student is $2,500.)

Your eligibility to claim the American Opportunity Credit begins to decrease as your modified adjusted gross income exceeds $80,000 ($160,000 if married filing jointly). Once your MAGI reaches $90,000 ($180,000 if married filing jointly), you’ll no longer be eligible to use the credit.

In addition to the expenses that can be used when calculating the Lifetime Learning Credit, expenditures for “course materials” can be used for purposes of calculating the American Opportunity Credit. “Course materials” includes books and supplies needed for a course, whether or not the materials are purchased from the educational institution as a condition of enrollment or attendance.

How the Credits Work Together

For a given student, you can claim either the Lifetime Learning Credit or the American Opportunity Credit in a given year, not both.

EXAMPLE: Katie and Alex are siblings. Alex is a freshman in college, and Katie is a senior (in her fifth year of college). With the help of some student loans, their family spends $20,000 for tuition for each of them for the year.

The family should probably claim the American Opportunity Credit for Alex, because it will allow for a credit of $2,500, as opposed to the $2,000 that would be allowed via the Lifetime Learning Credit. Also, by not using the Lifetime Learning Credit for Alex, the family can still use the Lifetime Learning Credit for Katie. (Katie is ineligible for the American Opportunity Credit, because she is in her fifth year of college.) In total, the family will be able to claim $4,500 of education-related credits.

Student Loan Interest Deduction

If you pay interest on student loans, you may be able to deduct that interest (up to $2,500 per year) as an “adjustment to income” (sometimes referred to as an “above the line” deduction). In order to qualify:

  1. The loan must be taken out solely to pay for qualified higher education expenses,
  2. You (and your spouse, if you’re married) must not be claimed as a dependent on another person’s return, and
  3. If married, you must file jointly.

The $2,500 limit for the deduction is reduced as your modified adjusted gross income exceeds (for 2023) $75,000 ($155,000 if married filing jointly). Once your modified adjusted gross income reaches $90,000 ($185,000 if married filing jointly), you will no longer be eligible for the deduction.

Simple Summary

  • If you pay postsecondary education expenses for yourself, your spouse, or your dependent, you may be eligible for the Lifetime Learning Credit (of up to $2,000). Only one Lifetime Learning Credit can be claimed per tax return per year.
  • If you pay higher education expenses for yourself, your spouse, or your dependent, you may be eligible to claim the American Opportunity Credit (of up to $2,500 per student).
  • For a given student’s expenses each year, you can use either the American Opportunity Credit or the Lifetime Learning Credit, not both.
  • If you pay student loan interest, you may qualify for a deduction for the amount of interest paid, up to $2,500.

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

The Difference Between Exemptions, Deductions, and Credits

The following is an excerpt from my book Taxes Made Simple: Income Taxes Explained in 100 Pages or Less.

In short, the difference between deductions, exemptions, and credits is that deductions and exemptions both reduce your taxable income, while credits reduce your tax.

Exemptions

Important note: for 2018-2025, exemptions will no longer exist. (This is one of the big changes from the tax law that took effect in 2018.)

For 2017, you were entitled to an exemption of $4,050 for yourself, one for your spouse, and one for each of your dependents.

EXAMPLE: Kevin and Jennifer are married, with a combined income of $80,000 in 2017. They have four children, whom they claimed as dependents. They were allowed six exemptions of $4,050 each. As a result, their 2017 taxable income was reduced by $24,300.

Deductions

Deductions generally arise from your expenses. For example, a deduction is allowed for interest paid on student loans.

EXAMPLE: Carlos is in the 12% tax bracket. Over the course of the year, he paid $2,000 in student loan interest. This $2,000 decrease in his taxable income will save him $240 in taxes ($2,000 x 12%).

Types of Deductions

Deductions are often grouped into two categories:

  1. “Adjustments to income” and
  2. “Itemized” deductions.

Every year, you can claim all of the adjustments to income for which you qualify, as well as:

  1. The itemized deductions for which you qualify, or
  2. A fixed amount known as the “standard deduction.” (In 2023, the standard deduction is $13,850 for a single taxpayer or $27,700 for a married couple filing jointly.)

Here’s how it looks mathematically:

Total income (sum of all your income)
“Adjustment to income” deductions
=  Adjusted gross income
Standard deduction or itemized deductions
=  Taxable income

A key point here is that adjustments to income are always valuable, whereas itemized deductions are only valuable if and to the extent that they (in total) exceed your standard deduction amount. That is, if your itemized deductions in a given year are less than the standard deduction you’ll simply claim the standard deduction in that year rather than using your itemized deductions. And your itemized deductions will therefore not provide you with any tax savings.

Some common adjustments to income include contributions to a traditional IRA, contributions to a Health Savings Account (HSA), and interest paid on student loans.

Common itemized deductions include charitable contributions, the interest on a home mortgage, and medical/dental expenses.

EXAMPLE: Eddie is a single taxpayer. During the year he contributes $3,000 to a traditional IRA, and he makes a charitable contribution of $1,000 to the Red Cross. He has no other deductions, and his income (before deductions) is $50,000.

The IRA contribution is an above the line deduction, and the charitable donation is an itemized deduction. Using our equation from above, we get this:

$50,000 Total income
$3,000 Adjustments to income
= $47,000 Adjusted gross income
$13,850 Standard deduction
= $33,150 Taxable income

Important observations:

  1. Eddie’s itemized deductions ($1,000) are less in total than his standard deduction ($13,850). As such, Eddie’s charitable contribution doesn’t provide him with any tax benefit, because he’ll elect to use his standard deduction instead of his itemized deductions.
  2. Eddie’s adjustment to income provides a tax benefit even though he’s using the standard deduction.

Again, itemized/below the line deductions only help when they add up to an amount greater than your standard deduction. Adjustments to income, on the other hand, are always beneficial.

Credits

Unlike deductions, credits reduce your taxes directly, dollar for dollar. After determining the total amount of tax you owe, you then subtract the dollar value of the credits for which you are eligible. This makes credits particularly valuable.

Credits arise from a number of things. Most often, they are the result of the taxpayer doing something that Congress has decided is beneficial for the community. For example, you are allowed a credit of up to $2,500 for paying “qualified education expenses” for one of your dependents. If you meet the requirements to claim the maximum credit, your tax (not taxable income) will be reduced by $2,500.

“Pre-Tax Money”

You’ll often hear the term “pre-tax money,” generally used in a context along the lines of, “You can pay for [something] with pre-tax money.” This means one of two things:

  1. The item is deductible, or
  2. The item can be paid for automatically in the form of a payroll deduction.

The reason these situations are sometimes referred to as “pre-tax” is that you get to spend this money before the government takes its cut. This makes it more cost-effective for you.

You may, from time to time, run across people who are under the impression that something is free simply because it’s deductible or because they were allowed to spend pre-tax money on it. This is a severe misunderstanding. Being able to spend pre-tax money on something is more akin to getting a discount on it than it is to getting the item for free.

Simple Summary

  • Deductions reduce your taxable income. Aside from the standard deduction, deductions generally arise from your expenses.
  • Each year, you can use either your standard deduction or the sum of all your itemized deductions.
  • “Adjustment to income” deductions are particularly valuable because you can use them regardless of whether you use your standard deduction or itemized deductions.
  • Credits, unlike deductions, reduce your tax directly (as opposed to reducing your taxable income). Therefore, a credit is more valuable than a deduction of the same amount.

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

Capital Gains and Losses: Short-Term and Long-Term

The following is an excerpt from my book Taxes Made Simple: Income Taxes Explained in 100 Pages or Less.

When you sell something (such as a share of stock) for more than you paid for it, you’re generally going to be taxed on the increase in value. This increase in value is known as a “capital gain.”

The amount of gain is calculated as the proceeds received from the sale, minus your “cost basis” in the asset.

What is “Cost Basis”?

In most cases, your cost basis in an asset is simply the amount that you paid for that asset, including any brokerage commissions that you paid on the transaction.

EXAMPLE: Lauren buys a share of stock for $250, including brokerage commissions. She owns it for two years and then sells it for $400. Her cost basis is the amount she paid for it: $250. Her gain will be calculated as follows:

$400 (proceeds from sale)
$250 (adjusted cost basis)
= $150 (capital gain)

Long-Term Capital Gains vs. Short-Term Capital Gains

The rate of tax charged on a capital gain depends upon whether it was a long-term capital gain (LTCG) or a short-term capital gain (STCG). If the asset in question was held for one year or less, it’s a short-term capital gain. If the asset was held for greater than one year, it’s a long-term capital gain.

STCGs are taxed at normal income tax rates. In contrast, LTCGs, are taxed at the same rates as qualified dividend income.

That is, for 2023, LTCGs are taxed at a 0% rate if they fall below $44,625 of taxable income ($89,250 if you’re married filing jointly). They are taxed at a 15% rate if they fall above the 0% threshold but below $492,300 ($553,850 if married filing jointly). And they are taxed at a 20% rate if they fall above the 15% threshold.

An important takeaway here is that if you’re ever considering selling an investment that has increased in value, it might be a good idea to think about holding the asset long enough for the capital gain to be considered long-term.

Note that a capital gain occurs only when the asset is sold. This is important because it means that fluctuations in the value of the asset are not considered taxable events.

EXAMPLE: Beth buys ten shares of a company at $25 each. Five years later, Beth still owns the shares, and the price per share has risen to $45. Over the five years, Beth isn’t required to pay any tax on the increase in value. She will only have to pay a tax on the LTCG if/when she chooses to sell the shares.

Taxation of Mutual Funds

Mutual funds are collections of a large quantity of other investments. For instance, a mutual fund may own thousands of different stocks as well as any number of other investments like bonds or options contracts.

Each year, each mutual fund shareholder is responsible for income tax on her share of the net capital gains realized by the fund over the course of the year. (Each shareholder’s portion of the gains will be reported to her annually on Form 1099-DIV sent by the brokerage firm or fund company.)

What makes the situation counterintuitive is that, in any given year, the capital gains realized by the fund could vary significantly from the actual change in value of the shares of the fund.

EXAMPLE: Deborah buys a share of Mutual Fund XYZ on January 1 for $100. By the end of the year, the investments that the fund owns have (on average) decreased in value, and Deborah’s share of the mutual fund is now worth $95.

However, during the course of the year, the mutual fund sold only one stock from the portfolio. That stock was sold for a short-term capital gain. Deborah is going to be responsible for paying tax on her share of the capital gain, despite the fact that her share in the mutual fund has decreased in value.

Note how even in years when the value decreases, it’s possible that the investors will be responsible for paying taxes on a gain. Of course, the opposite is also true. There can be years when the fund increases in value, but the sales of investments within the fund’s portfolio result in a net capital loss. And thus the investors have an increase in the value of their holdings, but they don’t have to pay any taxes for the time being.

Capital Gains from Selling Your Home

Selling a home that you’ve owned for many years can result in a very large long-term capital gain. Fortunately, it’s likely that you can exclude (that is, not pay tax on) a large portion — or even all — of that gain.

If you meet three requirements, you’re allowed to exclude up to $250,000 of gain. The three requirements are as follows:

  1. For the two years prior to the date of sale, you did not exclude gain from the sale of another home.
  2. During the five years prior to the date of sale, you owned the home for at least two years.
  3. During the five years prior to the date of sale, you lived in the home as your main home for at least two years.

To meet the second and third requirements, the two-year time periods do not necessarily have to be made up of 24 consecutive months.

For married couples filing jointly, a $500,000 maximum exclusion is available if both spouses meet the first and third requirements and at least one spouse meets the second requirement.

EXAMPLE: Jason purchased a home on January 1, 2021. He lived there until May 1, 2022 (16 months). He then moved to another city (without selling his original home) and lived there until January 1, 2023. On January 1, 2023 Jason moved back into his original home and lived there until October 1, 2023 (9 months) when he sold the house for a $200,000 gain.

Jason can exclude the gain because he meets all three requirements. The fact that Jason does not have 24 consecutive months of using the home as his main home does not prevent him from excluding the gain.

Capital Losses

Of course, things don’t always go exactly as planned. When you sell something for less than you paid for it, you incur what is known as a capital loss. Like capital gains, capital losses are characterized as either short-term or long-term, based on whether the holding period of the asset was greater than or less than one year.

Each year, you add up all of your short-term capital losses, and deduct them from your short-term capital gains. Then you add up all of your long-term capital losses and deduct them from your long-term capital gains. If the end result is a positive LTCG and a positive STCG, the LTCG will be taxed at a maximum rate of 20%, and the STCG will be taxed at ordinary income tax rates. If the end result is a net capital loss, you can deduct up to $3,000 of it from your ordinary income. The remainder of the capital loss can be carried forward to deduct in future years.

EXAMPLE 1: In a given year, Aaron has:
$5,000 in short-term capital gains,
$3,000 in short-term capital losses,
$4,000 in long-term capital gains, and
$2,500 in long-term capital losses.

For the year, Aaron will have a net STCG of $2,000 ($5,000-$3,000) and a net LTCG of $1,500 ($4,000-$2,500). His STCG will be taxed at his ordinary income tax rate, and his LTCG will be taxed at a maximum rate of 20%.

EXAMPLE 2: In a given year, Sandra has:
$2,000 in short-term capital gains,
$3,500 in short-term capital losses,
$3,000 in long-term capital gains, and
$5,000 in long-term capital losses.

Sandra has a net short-term capital loss of $1,500 and a net long-term capital loss of $2,000. So her total capital loss is $3,500. For this capital loss, she can take a $3,000 deduction against her other income, and she can use the remaining $500 to offset her capital gains next year.

So what happens when you have a net gain in the short-term category and a net loss in the long-term category, or vice versa? In short, you net the two against each other, and the remaining gain or loss is taxed according to its character (that is, short-term or long-term).

EXAMPLE 1: In a given year, Kyle has:
$5,000 net short-term capital gain and
$4,000 net long-term capital loss.

Kyle will subtract his LTCL from his STCG, leaving him with a STCG of $1,000. This will be taxed according to his ordinary income tax bracket.

EXAMPLE 2: In a given year, Christopher has:
$3,000 net short-term capital loss and
$6,000 net long-term capital gain.

Christopher will subtract his STCL from his LTCG, leaving him with a LTCG of $3,000. This will be taxed at a maximum of 20%.

EXAMPLE 3: In a given year, Jeremy has:
$2,000 net short-term capital gain and
$3,000 net long-term capital loss.

Jeremy will subtract his LTCL from his STCG, leaving him with a $1,000 LTCL. Because this is below the $3,000 threshold, he can deduct the entire $1,000 loss from his ordinary income.

EXAMPLE 4: In a given year, Jessica has:
$2,000 net long-term capital gain and
$4,000 net short-term capital loss.

Jessica will subtract her STCL from her LTCG, leaving her with a $2,000 STCL. Because this is below the $3,000 threshold, she can deduct the entire $2,000 loss from her ordinary income.

Simple Summary

  • If an asset is held for one year or less, then sold for a gain, the short-term capital gain will be taxed at ordinary income tax rates.
  • If an asset is held for more than one year, then sold for a gain, the long-term capital gain will be taxed at a maximum rate of 20%.
  • If you have a net capital loss for the year, you can subtract up to $3,000 of that loss from your ordinary income. The remainder of the loss can be carried forward to offset income in future years.
  • Mutual fund shareholders have to pay taxes each year as a result of the net gains incurred by the fund. This is unique in that taxes have to be paid before the asset (i.e., the mutual fund) is sold.
  • If you sell your home for a gain, and you meet certain requirements, you may be eligible to exclude up to $250,000 of the gain ($500,000 if married filing jointly).

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"
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