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| The Basics | Tax lessons for college students
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Attention, students (and parents): Uncle Sam wants to help with that degree. Here's how the tax code both hits and helps college students.
By Jeff Schnepper
Congratulations! Your high school career is winding down. And you're starting to focus on the next phase in your life: College.
Part of your learning experience will be an introduction into the mystery world of finance -- and taxes. Yes, college is expensive. It can cost up to $60,000 or so to go to a state school and upwards of $150,000 if you go to a private school like Yale.
That's before taxes. The tax code can ease the pain. In fact, there's an intense interrelationship between college and taxes that you need to know about. You or your parents should be able to harvest a host of special deductions or credits. Your parents get the breaks if they claim you as a dependent.
Here's Schnepper's Tax 101 class for students and their parents.
When you get a job, get real about taxes
Unless you are really lucky, Mom and Dad are going to want you to contribute to your expenses. And, despite what my kid Allison insists, "daughter" is not a job title. So, do yourself a favor: Get a job for the summer. When you get to school, start looking for another job.
At the same time, a job means taxes. So let's kill a big rumor now. You get no special deduction or tax exclusion just because you're in college. There are tax breaks you may qualify for, and I'll discuss them later. But your wages are not exempt from income taxes or from Social Security and Medicare taxes just because you're a college student. If you're earning, say, $100 per week, don't expect a check for $100. My son Josh morphed from an economic liberal into a fiscal conservative when he saw his first paycheck.
Related news and commentary on MSN Money
When you get a job, your new employer will ask you to complete a Form W-4. This is the form you use to tell your employer how many "allowances" you're claiming. Each allowance claimed will reduce the amount of tax withheld from your paycheck. The more allowances claimed, the more of your wages you'll get in each check.
If you have never paid taxes before and expect to earn $5,150 or less in 2006, you can put exempt" on your W-4 and no income tax will be withheld. That's because, for 2006, the first $5,150 you earn is sheltered from income tax by your standard deduction. Your employer will still deduct 7.65% of your gross wages for Social Security and Medicare. There's no way around that.
If you're making more than $5,150, you may be liable for federal and state income taxes. Normally, you'll want to pay them through withholding as you go. However, there won't be any interest or penalty if the tax that you owe in April 2007 is not more than $1,000. That means, in round numbers, you can earn as much as $14,323 (or $17,633 if your parents don't claim you as a dependent) in 2006 and not have anything withheld. But on April 17, 2007, you're gonna have to come up with the $1,000.
It would be nice if you could pay your taxes with a smile, but they'll want a check. Personally, I'd go the withholding route.
Employee benefits may be a tax-smart alternative to traditional compensation. Propose that your employer provide you with tax-free hospitalization, accident and health coverage. Employer-provided educational assistance up to $5,250 per person each calendar year is also tax-exempt. This provision applies to both undergraduate and graduate courses.
If your employer provides a retirement plan, say a 401(k) plan, it's never too early to start contributing. There's no tax on what you put into your plan (you'll be taxed when you take the money out in retirement). And many employers match as much as 3% of your wages. It would be financially foolish not to contribute, at least up to the amount of the match.
Scholarships and fellowships
Let's get to the breaks Uncle Sam provides to help you get an education.
If you're a candidate for a degree at a qualified educational institution (meaning, a real college), any scholarships you receive are tax free. Scholarships include fellowship grants as long as the money is used for tuition or related expenses, such as fees, books, supplies and equipment required by your coursework. Doesn't matter if it's Yale or San Diego State.
If your parent works for the college and you get a tuition reduction because of that relationship, there's no tax on that, either.
But exclusions for scholarships and tuition reduction will not apply to pay for teaching, research or other services performed that are required as a condition of receiving the scholarship dollars. Athletic scholarships still qualify for the exclusion because you'd only be expected, but not "required," to participate in sports activities. Even though they contain a service obligation, scholarships from the National Health Service Corps Scholarship Program or the Armed Forces Scholarship Program are specifically exempt from taxation.
Deductions for higher education expenses
Student-loan interest. Any student-loan interest you pay may potentially be an above-the-line deduction. That means you can deduct the interest plus take the standard deduction. You don't have to itemize to get this.
The maximum deduction is $2,500 per year.
To qualify for 2006, your adjusted income must not exceed $50,000 ($105,000 on a joint return). The deduction is phased out as your income reaches $65,000 ($135,000 on a joint return).
There is a downside to watch for. Congress recently changed the terms of the Stafford student-loan program, and now you can't take advantage of low-interest rates. Starting July 1, the rate jumps from 4.7% to 6.8%. Potentially, that means more interest on any Stafford loans -- the most-common college loans -- you take out. Now, you see how important jobs become.
Educational expenses as business expenses. Let's say you're working while you attend college. You may deduct your educational expenses as a business expense if the education maintains or improves a skill required in your current employment or trade or business. Even if it does, you won't qualify if the education is to meet the minimum educational requirements for your current job or business, or if it qualifies you for a new trade or business. You must be upgrading skills in your current line of work.
Qualified education-expense deduction. This is a deduction you and your parents need to fight for. For 2005, you could deduct as much as $4,000, also above the line, for qualified educational expenses. This deduction phases down as your adjusted income exceeds $65,000 ($130,000 on a joint return) to $2,000 once you hit $80,000 ($160,000 on a joint return). No deduction is allowed if your income exceeds these numbers.
Here's where the fight comes in: This deduction is not available after the 2005 tax year. If you want it to continue, start writing letters to your senator or House member, demanding it be reinstated.
Love those education credits
A credit is a dollar-for-dollar reduction of your taxes. It is always better than a deduction. In the 28% tax bracket, a $100 deduction saves $28 off your tax. A $100 credit would cut your taxes by $100.
There are two kinds of credits available for students or their parents:
The Hope Scholarship credit. This is a per-person credit for tuition and fees paid during the first two years of post-secondary education.
The credit is equal to:- 100% of the first $1,000 in tuition and fees;
- 50% of the next $1,000 in tuition and fees, or $500;
- for a maximum Hope Credit of $1,500.
The credit is phased out for 2006 between adjusted gross incomes of $45,000 and $55,000 ($90,000 and $110,000 for joint returns).
This is a great tax break. So is the Lifetime Learning credit. But if your income exceeds the threshold amounts, you're out of luck. That's why the Education Expense Deduction is worth fighting for.
The Lifetime Learning credit. This is a per-family credit for tuition and fees up to $10,000 for undergraduate (after the first two years), graduate and professional-degree courses.
The maximum credit is 20% of $10,000, or $2,000. The phase-out is the same as the Hope credit above.
So, if you're headed to college, good for you. It's your first step into the real world. So, think of today as the first day of the rest of your taxable year.
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