March 5, 2007

Educational Tax Breaks for 2006 Tax Returns

Posted in Misc, Saving for College at 8:29 AM by Joe From Boston

The website has a great article on the crazy tax breaks for higher education – thanks to Congress re-approving them after they’d already expired and hence after the 2006 tax forms had been printed!!

Anyone paying higher-education expenses might want to study his or her tax return. Both the 1040 and 1040A contain a valuable lesson on how to write off up to $4,000 of college costs without having to itemize.

The tuition-and-fees deduction’s immediate attraction is that it doesn’t require you to fill out Schedule A. Other appealing features: You can count undergraduate and graduate expenses for yourself, your spouse or dependents — and you (or your dependents) don’t have to be full-time students to deduct the costs.

Students got a bit of a scare last year when this tax break expired. Congress finally re-enacted it, but not until late December 2006. That meant tax forms were printed without including this and a couple of other tax breaks.

Even though the adjustment is nowhere to be found on Form 1040, don’t worry. You can still claim eligible tuition and fees on your 2006 return. It will just take a bit more tax homework on your part.

Applies only to specific expenses
The deduction, however, is not without limits.

Note the name. Only payments for tuition and fees count. No room, board or book costs are eligible.

Also, be sure your courses pass Internal Revenue Service inspection. In addition to being college-level, they must be for legitimate educational reasons. Sport, hobby or noncredit courses don’t qualify unless the class is required as part of a degree program, for example, an archery class necessary to earn your B.S. in physical education.

Did you use other tax-advantaged education funds to pay your schooling costs? Those distributions could reduce, or possibly eliminate, this tuition-and-fees tax deduction. If you used money from a state tuition plan, a Coverdell educational savings account or interest on savings bonds you cashed to pay for class, you have to subtract those amounts from your expenses to arrive at the allowable deductible amount.

And some filing-status issues need to be considered. Married couples, for example, must file a joint return to take this deduction. And if you’re a college student who is claimed as a dependent on your parents’ return, you can’t take the deduction yourself even if you paid your tuition with your own money. In fact, in that case no one gets the deduction.

$$$ limits
Then there are the money limits.

On 2006 returns, the tuition-and-fees deduction could be as much as $4,000. This amount, however, applies to all qualified expenses paid last year, not paid per student.

So you can’t claim the $4,000 spent toward your M.B.A. course work and another $4,000 you paid for your daughter’s freshman year at State U. (However, if your course work is employment-related, you might be able to claim it as a miscellaneous expense on Schedule A. Remember, though, you’ll have to meet the 2 percent of adjusted gross income threshold for the schooling costs to be of any itemized tax benefit.)

There also are income limits. Single filers who make less than $65,000 or married joint filers earning less than than $130,000 can take the full four-grand deduction. If you make more than those amounts, but less than $80,000 as a single filer or $160,000 when married filing jointly, you can deduct up to $2,000 in tuition and fees.

Earn more than the top limits for your filing status and you’re out of deduction luck.

Only one tax break per filer
The IRS also frowns on double dipping in the tax break pool. You can’t claim the tuition-and-fees deduction if you also take the Hope Scholarship or Lifetime Learning credit for the same student in the same tax year.

In deciding which tax break to use, some taxpayers who qualify for all of the education-assistance options might be tempted to go for the tuition-and-fees deduction. After all, it’s worth $4,000 and easy to claim. There’s no form to send along with your return, although you’ll need to complete the short work sheet in the 1040 or 1040A instruction book to determine just how much you can deduct.

The credit amounts, meanwhile, are less: a maximum of $1,650 for the Hope and $2,000 for the Lifetime Learning. And both require you to fill out Form 8863 and attach it to your return.

Those numbers and slightly less paperwork means the larger tuition and fees deduction is the way to go, right? Not so fast. You’re comparing an apple (a tax deduction) to oranges (tax credits).

A tax deduction reduces your taxable income, while a credit reduces your actual tax bill. In almost every instance, a credit is preferable.

For a quick comparison of the educational tax breaks, multiply your deductible schooling costs by your tax rate to see how it matches up with the credits. For example, a $4,000 deduction for a taxpayer in the 25-percent tax bracket comes to an actual tax break of only $1,000.

So, if you have a choice of how to take your education tax break, run the numbers both ways to make sure you take the one that saves you more.

Additional tax-filing homework
Now it’s time for the 2006 tax-year lesson on taking the deduction directly on your 1040. Here’s where the delay in reauthorizing this tax break complicates claims.

To claim the higher education tuition and fees adjustment, enter the eligible amount (up to $4,000) on line 35. That line is officially labeled “domestic production activities deduction,” a tax break for U.S.-based businesses that manufacture products domestically instead of sending the work overseas.

If you use it, however, for tuition and fees, write “T” on the corresponding dotted line. Taxpayers who also take the domestic production deduction, will put the combined amount on line 35, write “B” on the dotted line and attach a paper showing the breakdown of the amounts claimed for each deduction.

The IRS has provided an example of what a correct tuition and fees annotation looks like on its Web site.

If you claimed these expenses last year on 1040A, you’ll have to use the long Form 1040 this filing season. Since the tax break didn’t make it onto forms, the IRS decided to limit the annotated claims to just one form in order to streamline the makeshift process.

The good news, though, is that the tuition and fees adjustment was approved for 2007, too. So the IRS has plenty of time to get the tax break back on the forms for next filing season.