The tax law will subsidize your pursuit of knowledge, if the schooling passes several tests.
Just as the cost of hunting for your first job or a career switch is nondeductible, neither is the cost of education that prepares you for your first job or for a position in a different business or profession. To qualify for education deductions. you must already be working—either as an employee or self-employed—and the training must either be designed to maintain or improve the skills needed for your present job or be required by your employer or the law to keep that job.
You can't deduct the cost of courses taken to meet the minimum requirements of a job, and even if you could argue that a class improves the skills used on your present job, you can flunk the deductibility test if the education is also a step toward entering a new trade or profession.
What constitutes a new occupation? Clearly, if you are a secretary and sign up for night law-school classes, you're preparing for a new profession and the costs would not be deductible. But if you're an attorney, the cost of continuing-education courses could be written off.
What if you're a real estate agent who takes courses necessary to get a real estate broker's license? The Tax Court rejected such a deduction on the grounds that the broker's job was significantly different than the agent's. The IRS also says "no" to deductions for bar-review courses, even if you're already an attorney preparing for admission to the bar in an additional state.
In general, to qualify to write off education expenses you need to mix work with schooling. But if you go to school during your vacation or during a temporary absence from your work, you can still qualify. The IRS will consider up to one year off the job temporary for these purposes, and in some cases the courts have permitted even longer absences. You don't have to go back to the same job to qualify for the educational expenses deduction, just to the same line of work.
If you have to go out of town for the course and you're away overnight, you can deduct travel expenses as long as the primary purpose of the trip is the educational activity. Basically, that means you write off the cost of getting to and from the site of the course or seminar, including 50% of what you pay for meals and entertainment en route and while there.
Say you're a tax practitioner who travels 1,000 miles for a five-day course on the ramifications of yet another new tax law. After the seminar you stick around for a couple of days of sight-seeing. Your travel costs as well as tuition and any other fees connected with the course are deductible as job-related educational expenses. If you spend three weeks on vacation instead of just a couple of days, though, the primary purpose of the trip would be considered personal, and you would get no deduction for travel expenses.
What you deduct for transportation to and from your classes depends in part on where the courses are held vis-à-vis where you work. If you have to travel beyond the general area where you work, you can deduct the full cost. When the schooling is within that general work area (the IRS offers no specific distance) you write off only the cost of going from your workplace to the school and back to the workplace. If you drive your own car, you can deduct either the standard rate (44.5 cents a mile) or your actual expenses. The cost of getting to and from classes on a nonworking day is not deductible.
Congress keeps adding tax incentives to help families pay for higher education. The Hope credit is worth up to $1650 per eligible student — including yourself, your spouse or your dependent — for the first two years of post-secondary education. The credit refunds 100% of the first $1,100 per student paid for tuition and fees and 50% of the next $1,100. Thus, if qualifying expenses are at least $2,200, you get the full $1,650 credit. And, if your triplets started freshman year in 2006, you can qualify for three $1,650 credits. That's $4,950 right off the top of your tax bill.
The right to this credit is phased out as 2006 adjusted gross income rises between $45,000 and $55,000 on an individual return and between $90,000 and $110,000 on a joint return. (You can't claim the credit at all if you are married filing separately.) If your AGI on your joint return is $100,000 (halfway between $90,000 and $110,000), for example, the top credit you could claim per qualifying student would be $825 (half of the maximum $1,650). To qualify for the Hope credit, the student must be at least a half-time student.
After the student completes two years of college, the Hope credit is replaced by the "lifetime learning" credit, which, again, is based on tuition and fees paid for yourself, your spouse or your dependents. For 2006, the lifetime learning credit can be as much as $2,000, based on 20% of up to $10,000 of qualifying expenses. And, unlike the Hope credit—which can be claimed for any number of qualifying students each year—only one lifetime learning credit can be claimed each year, for a maximum tax savings of $2,000 each year. You can, however, claim a Hope credit for one or more students and a lifetime learning credit for another one in the same year. The student does not have to be a half-time student to qualify for the lifetime learning credit. If you take a single course, for example, you could qualify.
Students who attend colleges in New Orleans and other areas of the Gulf Coast hit by Hurricanes Katrina, Rita, and Wilma are eligible for Hope and Lifetime Learning credits double the normal size — $3,300 for Hope credits and $4,000 for Lifetime Leaning credits. The higher amounts apply for the 2006 tax year.
Neither credit can be used by someone who is claimed as a dependent on someone else's return. Even if a child pays his or her own way, for example, he or she can't claim either credit if Mom and Dad are claiming the student as a dependent. In that case, the parents get the credit, even if the child is paying the bills.
The same income phase-out zones apply to the lifetime learning credit as to the Hope credit. If parents' income is too high to claim the credit, in some cases it will pay off for the parents to skip claiming the child as a dependent so that the child might qualify for the credit. You must weigh the loss of a tax-saving exemption against the benefit of the credit. Of course, the student would have to have a tax bill to offset for the credit to have any value to him or her.
You may also be able to deduct interest on loans used to pay for education—even if you don't itemize deductions. On 2006 returns, you can deduct up to $2,500 of interest you pay on loans for which you are responsible. (In a recent change of heart, the IRS decided that if a third party--such as a generous Mom or Dad--repays a loan for which the child along is obligated, the child can claim the interest deduction. The IRS will treat it as though the parent gave the money to the child, who then paid the interest. Parents still can't deduct interest they pay on a loan taken out by their sons and daughters, unless the parents co-signed the note, but at least now the deduction is not lost completely in these circumstances.)
This write off applies to interest on loans used to pay for college or vocational schools for yourself, your spouse or someone who was our dependent with the money was borrowed. (A silly restriction that used to permit the deduction only for interest paid in the first five years after repayment began has been eliminated.) The right to this tax break disappears as 2006 income rises between $50,000 and $65,000 on a single return and between $105,000 and $135,000 on a joint return.
In 2001, Congress also decided to rename the education IRA with a moniker that makes a lot more sense. It's now called the Coverdell education savings account (ESA), honoring the late Georgia Senator Paul Coverdell who pushed for its creation. It was misleading to call this an IRA because it has nothing to do with retirement. Here's how the new, improved version works: Up to $2,000 can be contributed to an ESA for a child. The contributor (and anyone can contribute; it's not restricted to parents and grandparents) doesn't get a deduction but all earnings accumulate tax-free and payouts are tax free if the money is used to pay qualifying education expenses—basically college tuition and fees. (Until 2002, the limit was a paltry $500.) The $2,000 per year limit is for each beneficiary, not for each contributor, so no more than $2,000 can be set aside each year for each child. Money that's not used for college costs will be taxed to the beneficiary (to the extent it represents earnings rather than non-deductible contributions) and hit with a 10% penalty. And, if the account hasn't been used up by the time the beneficiary is age 30, it will be paid out, taxed and penalized at that time. If the child for whom the account was set up decides not to go to college, however, the ESA can be rolled over tax-free to pay college bills for another member of the family.
As with the credits, the right to use the ESA is phased out as the contributor's income rises. This break is phased out as adjusted gross income rises from $190,000 to $220,000 on a joint return and from $95,000 to $110,000 on an individual return. Prior to 2002, no contributions could be made to an ESA for an individual if, during the same year, money is being contributed to a qualified state tuition program on behalf of the same beneficiary. That restriction has been abolished.
Congress has also greatly expanded the tax breaks for state sponsored prepaid tuition plans and state college savings plans. The tuition plans basically allow parents (or grandparents or other generous souls) to set aside money in a special account for a young person in exchange for tuition when the child is ready to go to college. The idea is to lock in a return on the investment that keeps up with rising college costs. The college savings plans invest contributions with the same goal: to be used to pay the student's college costs. Through 2001, the earnings in such an account were not taxed until the money was withdrawn and, if it was used to pay college costs, earnings were taxed to the student, presumably in a low tax bracket. That was a good deal. Now it's even better: when the money is withdrawn — or the tuition credits cashed in — the earnings are completely tax-free as long as the money is used to pay college bills.
In the past, it was possible for a French teacher to deduct the cost of a trip to France to maintain general familiarity with the language and culture, for example. The law now bars the deduction for the cost of travel when the travel itself is the educational activity.
Self-employed taxpayers deduct qualifying educational expenses in full on Schedule C. Employees have to struggle past the 2% threshold for miscellaneous deductions on Schedule A to win their deductions.