Funding for Higher Education (Part IV)
7/19/2004
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4. Education Expense Deduction
Starting from 2002, tuition and fees paid to credited educational institutions can enjoy an “above-line” deduction up to $4,000. That is, the qualified expenses could be one of a few deductions from gross income to arrive at adjusted gross income (AGI is the bottom line amount in page 1 of your Form 1040).
To qualify for the deduction, the expenses must be for tuition and fees at eligible colleges or other post-secondary educational institutions including vocational schools and graduate schools. The deduction is a dollar-for-dollar amount but can only be claimed by taxpayers with AGIs below a certain amount.
For qualified expenses incurred in 2004, a single taxpayer with an AGI of $65,000 or less and a joint filing couple with an AGI of $130,000 or less will be able to deduct up to $4,000.
The available deduction decreases to $2,000 for a single filer with an AGI greater than $65,000 but less than or equal to $80,000 and ditto for a married couple with an AGI greater than $130,000 but less than or equal to $160,000. There is no deduction allowed with an AGI above the limits.
The very new education expense deduction will sunset quickly unless the Congress acts to extend it. The current tax law only allows such deductions up to 2005.
As you may know, tax credit is more powerful than an income deduction under most circumstances. So, since we already have Hope and Lifetime credits, why bother with deductions?
First, if you recall from our prior weeks’ tips, both Hope and Lifetime credits are totally unavailable for single taxpayers with AGI above $51,000 and a couple with AGI above $103,000. Comparing them with the above stated $80,000 and $160,000 AGI limits, you get the picture.
Secondly, depending on one’s marginal tax rate (that’s a taxpayer’s highest tax bracket), sometimes the deduction beats the credit. For example, assume John is at a combined Federal and State marginal tax rate of 30% with $3,500 tuition that is eligible for Lifetime credit in 2004. If John takes the credit, he would only save $700 in Federal taxes ($3,500*20% and keep in mind the credit is only available for Federal tax). But if John chooses to take deduction, he would save $1,050 in combined Federal and state taxes ($3,500*30%).
Yet several “hidden” benefits of taking above-line deduction: lowering a taxpayer’s AGI could offer many more tax saving opportunities such as making one eligible to make IRA or Roth contributions, getting more medical or unreimbursed employee expenses deductions, avoiding or reducing alternative minimum tax (AMT), reduce itemized deduction phase-out (which is a notorious hidden tax hitting many taxpayers), and many more.
When educational expenses are incurred, be on the lookout for the optimal strategy based on your particular circumstance. That’s what we do when preparing a client’s tax returns or conducting financial planning when education expenses are in the equation. Since the tax law concerning educational expenses has such an interlinking relationship, we always run such a tax return multiple times to search for the best answer.
Next time, we will discuss how to utilize 529 Plan to help fund your children's education.
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