Tax credit and retirement saving

sue is working at a sports bar waiting on tables while attending college.  She is currently enrolled as a sophomore in the school of business at State University majoring in human resource management.  What are the possible tax credits or deductions that she can take for her tuition, books, supplies, transportation to classes and fees associated with her education? 

This is an excellent question because there are several different tax benefits available to Sue.  As we learned a few weeks ago there are several for AGI deductions available for people like Sue that are interested in higher learning.  These deductions work to lower Sue’s taxable income dollar for dollar whereas any education credit she is eligible for lowers her overall tax dollar for dollar.

According to Spilker et al. (2015) Sue is eligible to deduct up to $4,000 in tuition and fees from her college education if she earns $65,000 AGI or less.  Since she is a part time bartender I assume she is likely eligible for this deduction.  Of note, this deduction is only for tuition and fees and does not include any tax benefits for the funds she spends on books, supplies, transportation, or room and board.  Sue could apply for a student loan that would help her pay for costs as transportation or room and board and the interest on that loan would also qualify as a for AGI deduction if she earns $65,000 or less (Spilker et al., 2015).   The educational loan interest deduction is really the only way to get any tax benefit that is associated with transportation or room and board.

In my opinion Sue should take advantage of the American Opportunity Credit (AOC) which is a tax credit that can only be used during the individual’s first four years of post-secondary education (Spilker et al., 2015).  This tax credit is more advantageous than the deductions mentioned above because it decreases her overall tax dollar for dollar and is even refundable up to 40% of the value of the credit (Spilker et al., 2015).  The credit is limited to tuition, fees, and course materials and pays 100% for the first $2,000 of eligible expenses and then 25% for the next $2,000 of eligible expenses (Spilker et al, 2015).  If she earns $80,000 or less in AGI she is eligible to claim this tax credit (Spilker et al, 2015).  Unfortunately, the credit cannot be combined with the deductions mentioned above (Spilker et al., 2015).

Sue also needs your advice about finding a retirement plan or saving plan to start putting some money away for retirement.  What advice do you have for her?

There are several different avenues Sue could take concerning beginning to save for retirement.  Since she is a part time bartender I assume she is not eligible for an employer sponsored retirement plan and will likely have to do something on her own to start saving.  I am a big fan of the Roth Individual Retirement Account (IRA) since it allows both the principal and earnings to grow tax free (Kofsky, 2016).  Any type of deferred tax retirement plan is less advantageous for Sue since she is currently in low earning years and will not receive much tax benefit from lowering her taxable income.  I think the benefit of the Roth IRA is best summed up by saying you are “paying a little tax now in return for a larger tax-free account in the future” (Kofsky, 2016, p. 163).  Sue can set up a Roth IRA online using any of the big retirement brokerages such as Schwab, Vanguard, or another.  Once she establishes her account she can seek out advice from them on what investment vehicles she should invest her IRA in based on the risk she is interested in taking on.

References

Kofsky, A. M. B. (2016). Rehabilitating frankenstein’s monster: Repairing the public policy of

the roth IRA. Albany Law Review, 80(1), 161.

Spilker, B.C., Ayers, B.C., Outslay, E, Weaver, C. D., Barrick, J. A., Robinson, J. R., &   Worsham,

R. (2015). Taxation of individuals and business  entities. New York, NY:  McGraw Hill                    Education.

Brett,

You made a good point with “In my opinion Sue should take advantage of the American Opportunity Credit (AOC) which is a tax credit that can only be used during the individual’s first four years of post-secondary education (Spilker et al., 2015).  This tax credit is more advantageous than the deductions mentioned above because it decreases her overall tax dollar for dollar and is even refundable up to 40% of the value of the credit (Spilker et al., 2015).  The credit is limited to tuition, fees, and course materials and pays 100% for the first $2,000 of eligible expenses and then 25% for the next $2,000 of eligible expenses (Spilker et al, 2015).  If she earns $80,000 or less in AGI she is eligible to claim this tax credit (Spilker et al, 2015).  Unfortunately, the credit cannot be combined with the deductions mentioned above (Spilker et al., 2015). “.

Tax credits always seem like a better deal than a deduction on Schedule A.

Dr. Whitley,

I totally agree, whenever I see that I am eligible for a tax credit I get a smile.  I was excited to see that the new tax law allows for a child tax credit of $2,000 per child.  I have three children so that put a smile on my face!

Brett

Diego,

I thought your point about using a traditional IRA was an important one because as you said it is a for AGI deduction which allows someone to lower their AGI and hence their tax.  The flip side to using a traditional IRA is that both the contribution and earnings are still taxed, they are just deferred and taxed at a later time.  Upon withdrawal the earnings and contribution are taxed as regular income.  This means we get into a debate of whether it is better to defer income via a traditional IRA to lower your AGI now at the expense of potentially having a higher AGI later.  Many people go with this strategy because they argue that you are likely earning more money now then you will be earning when you retire.  This means that you are essentially in a higher tax bracket now so any income you can defer is a good strategy because you may be able to defer it to a point later in life when you are not in as high of a tax bracket.  If, however, you are like Sue and really in  early earning years and likely not in a high tax bracket it is probably better to go with a Roth IRA versus a traditional.  The Roth IRA receives its contributions from after tax dollars and this contribution as well as the earnings are not taxed when withdrawn as long as they are withdrawn after age 59 1/2.  Many people recommend a Roth IRA in this situation because it allows you to take care of the taxes up front and not worry about the impact of your AGI and associated tax bracket when you make your withdrawals.  In addition, the earnings grow tax free, with a traditional IRA you must be tax on the earnings as ordinary income when you withdraw them.

Thanks,

Brett

Hello Diego,

I found it interesting this week that the scenario did not tell us if Sue was Single, Married, or even if she had any kids.  It always fascinates me how many exemptions there are when it comes to taxes. The lifetime learning credit was one that I had never heard of before.  I tend to use the AOC also known as Hope credit.  The lifetime learning credit would only apply to the cost of tuition and fees.  It would also help professional or graduate tuition as well.   For Sue to save for retirement, she could cut back on frivolous spending.  Cook dinner at home instead of eating Fast food.  The same could be said for lunch and buying expensive overpriced coffee all the time. Sue would only need roughly $25 to start a savings plan or a retirement plan.  There are many options available to Sue when it comes to choosing the right plan for her.  Her best option would probably be to go talk to a Financial Planner and see what advice they could give her.  Since we don’t know her marital status or how much income she has, it would be difficult to suggest how much she should put away.   You did a great job on this week’s forum post, but I would elaborate a little bit more on everything Sue could deduct.

Reference:

Spilker, B. (2015). Taxation of Individuals and Business Entities Edition 6e.  McGraw-Hill, Inc.