IMPORTANT: The new tax law effective starting 2018 eliminated the tuition write-off, with limited exceptions for self-employed MBAs. The below article is still applicable, but only to amending past year tax returns within the statute of limitations (2015-2017). Updated 1/11/2019.
Attending business school can be a huge expense, many of us at Visor know from experience, so it is no surprise that many MBAs are interested in understanding the best ways to save on taxes during their time in school.
In particular, beyond the standard education credits, many MBAs have heard about the possibility of fully deducting all tuition expenses on their tax returns. Given that fully deducting tuition can often result in savings of around $15,000, the allure of this deduction is not surprising.
We at Visor have worked with MBA students from more than 50 universities, and put together this article to demystify the tax deduction. Read on for a comprehensive overview including eligibility rules and tax saving examples.
What standard education tax benefits are available.
There are two educational tax benefits available to graduate students, and then a student loan interest deduction that might be relevant after graduation for those paying off loans. The two standard benefits are the tuition and fees deduction and the lifetime learning credit.
The tuition and fees deduction is an above-the-line deduction of up to $4,000 for tuition, whether undergraduate or graduate. This would allow you to offset your income by up to $4,000 of tuition before then calculating your tax liability. To use an example, for a student that pays taxes at a marginal tax bracket of 25%, the most this deduction would save on taxes is $1,000 (=$4,000 * 25%). To make things even worse, the deduction phases out as your income exceeds certain levels, so you may not even be eligible for the full $4,000 deduction.
The lifetime learning credit, a tax credit of up to $2,000 for tuition, whether undergraduate or graduate, is slightly better. A credit is a one-for-one offset against your tax liability, so $2,000 of tax savings is not bad. But, just like the tuition and fees deduction, the credit phases out as your income increases, so not everyone is eligible for the full benefit.
For the student loan interest deduction, which is pretty well known, any student loan interest paid during the year is subtracted from taxable income. Once again though, there are limits. The maximum interest expenses that can be deducted are $2,500, and there are fairly low-income phase-outs here too (relative to typical post-MBA salaries). Not to mention, student loan interest only comes into play once you start paying back outstanding loans, so it is not helpful while enrolled in school.
What are the tax implications of deducting the full cost of the MBA tuition instead?
It is easy to see that the tax savings from fully deducting tuition expenses will be very beneficial. It is easiest to show this with a few examples.
First, let’s look at a student entering the first year of a full-time MBA program. Wages earned in the first half of the year before school started were $40,000. Then, tuition paid in that same year for fall quarter was $30,000. The tuition amount of $30,000 is subtracted from the wage income of $40,000, leaving a net taxable income of $10,000. Assuming an average tax rate of 20%, the tax savings in this is about $6,000 (20% x $30,000).
On top of that, many states also allow for similar educational expense deductions, adding to the tax savings at the state level.
The next year, that same student would have a full year’s tuition expense of $60,000, and likely about $20,000 of income from a summer internship. In this case, when you have more educational expenses than income, the tax liability goes to $0 and the unused expenses of $40,000 can be carried over to future years to help lower future tax burden (referred to as a net operating loss or “NOL”). That means the student saved $5,000 this tax year (=$20,000*20%) and might save another $10,000 the next year (=$40,000*20%).
The third year of school would look similar to the first year, but the tax savings would be even higher thanks to the NOL carryforward. Having run the numbers and filed the returns for thousands of MBA’s, we typically see just under $20,000 of total tax savings (federal and state) across 3 calendar years for most MBAs.
By the way, this works for full-time, part-time, and executive students as well as both US citizen taxpayers and any non-US citizens living and filing taxes in the USA.
Besides the eligibility requirements, which are detailed in the next section, the main caveat to these examples is the Alternative Minimum Tax (“AMT”). The AMT is a secondary tax system that all taxpayers must calculate, and then pay the higher of the two tax liabilities. The AMT does not allow as many itemized deductions, including this one, but has different rates and a higher standard deduction amount. For taxpayers that fall under AMT, the savings might not be as great as these examples would lead one to believe, so it is important to calculate your specific situation before assuming how big your tax savings might be.
What are the eligibility requirements for the MBA deduction?
The rules around the MBA tax deduction are admittedly less clear than the standard education credits. The deduction is technically taken as an unreimbursed business expense. IRS Publication 970 says you can write off qualifying work-related education expenses if:
- You are established in a trade or profession prior to starting your education
- Your education maintains or improves the skills you had prior to the education
- You continue to use these improved skills after your education
What this means is the IRS is looking for a thread of continuity in your job skills pre-MBA, during-MBA, and then post-MBA. The publications go on through to specify:
- The education can’t qualify you for a new trade or business
The MBA degree generally does not qualify you for a new profession (e.g. like a law degree would), so this last eligibility requirement is typically not a problem.
For MBAs then, the primary focus is whether there is continuity in your job skills. Given most programs only admit students with prior work experience, the degree (by definition) builds and enhances your business skills, and since most students return to a roughly similar business job after graduation, we have found that over 90% of MBAs qualify for the deduction.
This is true even for those changing jobs after graduation, although clearly this is where the tax code becomes particularly vague and open to interpretation. The IRS doesn’t specifically define being “established in a trade or profession”. And there is some subjectivity in determining if you’re using the same sets of skills pre-MBA and post-MBA.
Clearly, the rules disqualify those who are going through a dramatic career change, particularly those coming from a “non-traditional” business school background such as teaching. But for the vast majority of MBAs, you can think of it this way:
- Prior to getting an MBA, you were established as a business person. You likely used analytical skills, performed financial / marketing analyses, communicated with internal and external clients, etc.
- The MBA enhances all these sorts of skills (quantitative, qualitative, broad-based business skills).
- After graduating, you’re likely going to return to a job that uses these same sets of skills.
Changing jobs, even changing industries, is not a disqualification at all. And using that logic (a tried and tested logic that the IRS has supported), you are on your way to taking the MBA tuition deduction.
What are the chances of being audited?
To answer this question, it is helpful to first point out that, broadly speaking, the IRS “reviews” less than 0.5% of all tax returns each year. With about 150 million tax returns filed each year, it is simply a capacity issue for the IRS. A lot of these reviews aren’t even audits in the way you might be thinking, but instead are focused on errors caught by automated systems for obvious things like missing W2s, unreported stock sales, etc.
That being said, the IRS does look for deviations from the norm, and writing off upward of $60,000 of unreimbursed business expenses in one year will often stick out. In our experience, approximately 5% of MBA students who claim education expenses are asked for further information. For this reason, working with an accountant can help you determine if you meet the eligibility requirements.
What if I didn’t take the deduction on past year’s tax returns when I paid tuition?
The IRS allows all taxpayers to revise up to the past three tax filings. For instance, you have until April 15, 2020, to make any adjustments to your year 2016 tax return. This same process can be used by MBAs to claim a tax refund by retroactively applying the tuition expenses. These expenses must be deducted in the year they are paid, so most MBA students will have to amend up to three separate prior year tax returns to reclaim the full tuition write-off benefit.
Summary and Takeaway
Every situation is different, so each MBA should evaluate their own individual financial situation to determine the most financially rewarding outcome.
While this article attempts to spell things out as clearly as possible (with very simplified examples), the bottom line is that each taxpayer must analyze their specific circumstances in evaluating whether or not they qualify to take a business tax deduction for graduate school. We strongly recommended that you consult with a qualified tax professional with experience in exactly these matters for advice and guidance.
To discuss your specific circumstances with one of our tax advisors, register today and then either message us from inside the dashboard or use the schedule a call functionality for a live consultation. There is no obligation to pay unless you choose to file a tax return with us.
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