Washington’s Tax Break for Upper-Income Graduate Students

Mixed in with the expiring tax benefits that lawmakers are debating to extend before the end of the year is something called the above-the-line tuition and fees deduction. Lawmakers should let this $300 million annual benefit expire and put the money to better use.

Because lawmakers changed other tax benefits for higher education in recent years, the deduction isn’t really for “college” tuition as most think of it. There is almost no reason why an undergraduate student (or his parent) would claim this benefit. The deduction is almost always less generous than other tuition tax benefits that are available to undergraduates and their parents, such as the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Credit. More on that calculation in a minute.

Who does that leave to claim the deduction? Graduate students. But not lower income graduate students. Graduate students with incomes below $63,000 ($127,000 for joint filers) will generally benefit more from the Lifetime Learning Credit than the deduction. That means only graduate students with incomes above those limits earn net benefits from the deduction (although those with incomes above $80,000 and $160,000 for joint filers are ineligible for even the deduction). In a world where many lower and even middle income families struggle to finance a two-year or four-year degree, one has to wonder why scarce federal aid goes to people who by definition already have an undergraduate degree and now are part of a household with a six-figure income.

Here is a little more on why the deduction ends up targeting upper-income graduate students. First, remember that tax credits generally provide larger benefits than deductions. If you deduct $1,000 in tuition you can only collect a benefit equal to the tax you would have paid on that $1,000, which is probably $250 or less. But a $1,000 tax credit is worth exactly that amount because it is $1,000 you don’t send to the IRS. That is one reason why both the American Opportunity Tax Credit and the Lifetime Learning Credit are usually (there are exceptions) worth more than the tuition and fees deduction. The AOTC provides a credit worth up to $2,500 for undergraduate tuition and the Lifetime Learning Credit up to $2,000 for tuition at any level of education.

Would a higher-income family that paid undergraduate tuition fail to qualify for the AOTC due to income cuttoffs but qualify for the deduction? No. The income cutoff for the AOTC is $180,000 (half that for individual filers), which is higher than the income cutoff for the deduction. The only reason why a higher income family might benefit from the deduction over the AOTC is if the student incurred a fifth year of undergraduate tuition expenses, thereby bumping up against the AOTC’s four-year limit. They would then claim the Lifetime Learning Credit, which has no time limit and provides the next-largest benefit, provided that they earn less than $127,000. Only families earning above that amount would claim the deduction, which also has no limit on the number of years it can be claimed. That is why nearly everyone getting a tax break for undergraduate expenses would claim the AOTC or the Lifetime Learning Credit, not the deduction.

Even though the AOTC is off-limits to graduate students, that does not mean they automatically claim the deduction instead. The Lifetime Learning Credit -- which can be applied to graduate school tuition -- will almost always provide them with the larger benefit: a $2,000 credit is worth more than a $4,000 deduction, though there are rare and minor exceptions.

So why would a graduate student claim the deduction over the Lifetime Learning Credit? Those earning more than $127,000 (half for individual filers) are ineligible for the Lifetime Learning Credit, leaving the deduction as the only tuition tax break that they can claim. Put it all together and you can see that the deduction targets families who paid graduate school tuition and earn too much to qualify for the more generous Lifetime Learning Credit.

This was surely not the intent of the benefit. Lawmakers likely had undergraduates in mind when they created it. Even so, Congress and the president may decide yet again to extend this de facto tax break for individuals who hold advanced degrees and earn high incomes. But they should remember that Income-Based Repayment for federal student loans and the Public Service Loan Forgiveness benefit are already set to heap plenty of subsidies on exactly that group of “needy” individuals.

Alas, if Congress and the president won’t let the deduction expire and redirect the $300 million annual cost to something more worthy, like helping lower income families pay for an undergraduate education, at least rename it. After all, other higher education benefits, like the American Opportunity Tax Credit, have patriotic and inspiring names.

Given that the beneficiaries in this case must hold advanced degrees and belong to households earning between $127,000 and $160,000, how about the “Americans Who Need No More Opportunity Tax Deduction.”