Tax Planning

Someone recently had a question regarding going back to college to finish up their degree that they started more than a few years ago. When they attended school before, the current tax credits weren’t available, which is important to this story.

Currently, there are two key tax laws that relate to higher education tax savings. The first is called the American Opportunity Tax Credit (AOTC) and the second is the Lifetime Learning Credit (LLC).

For those who already have a four-year bachelor’s degree from a QUALIFIED INSTITUTION (generally, any US college that is accredited and students are able to receive federal student loans etc, however, if the school isn’t on the list of educational institutions, a bachelor’s degree from the school may not disqualify you from the AOTC tax credits- Some on-line (and physical) schools fall into this category).

Also, generally if your degree is from another country (and you weren’t an exchange student for example), you may still qualify. More on the eligibility criteria to follow. For a list of Postsecondary Education Schools, see this list https://ope.ed.gov/dapip/#/home  and this list https://studentaid.gov/understand-aid/types/international#participating-schools

The American Opportunity Tax Credit (AOTC) is a crucial element in the financial support system for students pursuing higher education in the United States. This tax credit, established to help offset the costs of post-secondary education, provides tangible financial relief for students and families contending with the escalating costs of college and university education.

Understanding the AOTC, its eligibility requirements, and the benefits it provides can lead to significant tax savings and reduce the financial burden of obtaining a higher education.

Understanding the American Opportunity Tax Credit

The American Opportunity Tax Credit was introduced in the American Recovery and Reinvestment Act of 2009 as an expansion of the Hope Credit, and it’s currently available to individuals for four tax years per eligible student.

This tax credit was designed to help students and parents mitigate the rising costs of college fees by providing a tax credit for qualified education expenses.

The AOTC allows taxpayers to reduce their federal tax liability by up to $2,500 per eligible student. To break it down, 100% of the first $2,000 spent on qualifying education expenses and 25% of the next $2,000 can be claimed as a credit. This structure means that to receive the full credit, a taxpayer must have at least $4,000 in qualified expenses in a given tax year.

One of the standout features of the AOTC, compared to other education tax benefits, is its refundability. Typically, tax credits offset the amount of tax you owe to the IRS. However, the AOTC is 40% refundable up to $1,000, which means that you can still receive a refund even if you don’t owe any tax. For struggling students and families, this refund can provide essential financial support.

Eligibility Criteria

Understanding eligibility requirements is crucial to fully leverage the benefits of the AOTC. The primary criteria include:

Educational phase: As stated above, the credit is available for the first four years of a student’s post-secondary education. The student must be pursuing an undergraduate degree, certificate, or other recognized educational credentials. For a list of schools

Number of Tax Years AOTC Has Been Claimed: Again, the AOTC can only be claimed for four tax years per eligible student. If the student has not claimed the AOTC in any prior year (including years they were pursuing an undergraduate degree in a non-U.S. institution), theoretically, they might be eligible if all other criteria are met.

However, this is subject to the stipulation about the credit being intended for the first four years of higher education, which would generally, albeit not necessarily exclude graduate-level studies.

Enrollment status: The student must be enrolled at least half-time for at least one academic period that began in the tax year at an eligible educational institution. The institution must be eligible to participate in the federal student aid program administered by the Department of Education.

Qualified expenses: These are costs required for enrollment or attendance at the educational institution. They include tuition, fees, and course materials needed for a course of study. Note that expenses for room and board, medical expenses, transportation, and similar personal, living, or family expenses are not qualified. The expenses MUST be required for all students.

For example, if you want to buy a computer, albeit one isn’t required, it likely doesn’t qualify without justification of why it’s a needed purchase. Given the amount of tuition at most colleges, by the time you pay for half-time status and books, you’ve likely used up the full amount of credit anyway.

Furthermore the expenses must be out of pocket. You can’t “double dip” for example and use the GI Bill or some other alternative government money to pay for school, and still claim the credit if you didn’t actually pay for the expenses.

Income limits: To receive the full amount of the credit, your modified adjusted gross income (MAGI) must be $80,000 or less ($160,000 or less for married filing jointly). You receive a reduced amount if your MAGI is over $80,000 but less than $90,000 (over $160,000 but less than $180,000 for married filing jointly). You’re not eligible for the credit if your MAGI is over $90,000 ($180,000 for married filing jointly).

Dependent status: If parents claim the student as a dependent, they claim the credit. If another individual claims the student as a dependent, neither the student nor the other individual can take it.

Calculating the Credit

When preparing to utilize the AOTC, taxpayers must keep meticulous records of their education-related expenses. Only qualified education expenses are eligible for the credit, and these expenses must be reduced by any scholarships, grants, or other tax-free educational assistance received.

The process of calculating the credit can be summarized as follows:

1. Calculate total qualified education expenses.
2. Subtract tax-free educational assistance received (e.g., tax-free scholarships and grants).
3. Subtract expenses used for any other tax benefit (e.g., distributions from 529 plans or Coverdell Education Savings Accounts used tax-free).
4. Apply the credit rate (100% of the first $2,000 and 25% of the next $2,000).

Remember, the AOTC is claimed per student, not per tax return, so if you have multiple eligible students in your family, you could potentially claim multiple credits.

Tax Savings Potential

The AOTC’s potential for tax savings is significant, especially for households with multiple college-going individuals. For instance, a family with an annual income below the phase-out limit, incurring $4,000 or more of qualified educational expenses for two children, could see a tax credit of up to $5,000 (or $2,500 per student).

For families or individuals hovering near the federal poverty line, the refundable portion of the AOTC can provide direct financial assistance, up to $1,000 per eligible student, even if they owe no tax.

Interaction with Other Educational Benefits

When planning for the utilization of educational tax benefits, it’s important to consider that one student’s qualified education expenses cannot be used for multiple tax benefits in the same year. For example, if you choose to claim the AOTC for your child in a given year, you cannot use that same child’s qualified education expenses to justify tax-free withdrawals from a 529 plan.

However, families with multiple students can strategize their tax savings by assigning different benefits to different children if it results in greater savings. For instance, parents might claim the AOTC for one child and use tax-free distributions from a 529 plan for another child’s expenses.

Application Process

To claim the AOTC, you must complete IRS Form 8863 and attach it to your Form 1040. Part I of Form 8863 requires basic information about each student for whom you’re claiming the credit. In Part II, you calculate the allowable credit amount.

Moreover, educational institutions should provide Form 1098-T, which includes information about tuition paid or billed along with other educational information. However, amounts on Form 1098-T might differ from what you actually paid. Always rely on your own financial records when calculating the credit.

Complexities and Common Misunderstandings

Despite its apparent benefits, the AOTC isn’t without its complexities and common areas of misunderstanding. One area that often causes confusion is the issue of what constitutes qualified education expenses.

For the purposes of the AOTC, it’s important to understand that expenses beyond tuition, mandatory enrollment fees, and course materials required for study (such as books, supplies, and equipment) generally do not qualify.

This means that payments for room and board, insurance, medical expenses (including student health fees), transportation, and similar personal, living, or family expenses cannot be counted.

Another common area of confusion is the claim process for the credit, particularly for those students who are claimed as dependents on someone else’s tax return.

The rule here is straightforward but crucial: if a student is claimed as a dependent on another person’s tax return, all scholarships, grants, and tuition reductions for the student are treated as having been paid by that person. Consequently, the student cannot claim the AOTC for that tax year.

Also, the issue of refundability is often misunderstood. While it’s true that up to 40% of the AOTC is refundable, this doesn’t mean that 40% of your education expenses are refundable. It means you may be able to get back 40% of the credit amount (up to $1,000) even if you owe no tax.

This aspect of the AOTC is particularly valuable for lower-income individuals or families who might not owe enough tax to benefit from a non-refundable credit.

Looking Ahead

The American Opportunity Tax Credit is currently set to expire at the end of 2025, which obviously raises questions about the future of education tax credits. While it’s possible that Congress could extend or even expand the AOTC, there’s also a chance that it could be replaced or undergo significant changes.

Given the amount of inflation recently (as of the end of 2023), it’s possible Congress could increase the amount of the credit when the current credit expires in a couple of years. Will Congress act beforehand, it doesn’t look likely, however, once the end is near, it’s more likely it will actually gain greater attention to avoid have AOTC disappearing altogether.

Given the current landscape of rising higher education costs, the continuation of some form of education tax credit seems likely. However, what form that will take remains uncertain. Families and students should keep informed about potential changes to the tax code and be prepared to adapt their financial strategies accordingly.

Furthermore, there is ongoing discussion about the expansion of education credits to foster greater inclusivity, potentially widening the scope of qualifying expenses or increasing the income thresholds to allow more middle-class families to qualify.

The AOTC and the Lifetime Learning Credit (LLC)

When discussing the AOTC, it’s also important to mention the other key tax law regarding higher education.

Lifetime Learning Credit (LLC), another education tax credit available to U.S. taxpayers. Unlike the AOTC, the LLC is not limited to the first four years of post-secondary education, and there is no requirement for the student to be pursuing a program leading to a degree or other recognized education credential. This makes the LLC applicable to a broader range of educational activities, including graduate and professional courses, continuing education, and even classes taken to acquire or improve job skills.

However, the LLC has its limitations. The maximum credit is limited to $2,000 per return (not per student), and it’s calculated as 20% of the first $10,000 of qualified education expenses. Also, the LLC is not refundable, which means it can reduce your tax to zero but can’t result in a refund.

When deciding between the AOTC and the LLC, taxpayers need to consider their specific circumstances — the type of degree program, the number of courses, income level, and more. In many cases, the AOTC may offer greater tax savings for those who are eligible, but for many lifelong learners and non-traditional students, the LLC can also provide valuable tax savings.

For graduate students, or students that have exhausted the AOTC, the Lifetime Learning Credit (LLC) is often more applicable. The LLC is not limited in the same way as the AOTC, including the first four years of post-secondary education and applies to all years of post-secondary education and for courses to acquire or improve job skills.

Unlike the AOTC, the Lifetime Learning Credit is available for an unlimited number of tax years and could apply to graduate, professional degree courses, and other courses that may have a certificate instead of a degree.

Understanding the Lifetime Learning Credit:

At its core, the Lifetime Learning Credit is a tax credit that allows eligible students or their parents to reduce the amount of federal tax owed by up to $2,000 per year based on qualified education expenses. It’s calculated as 20% of the first $10,000 of qualified education expenses paid for all eligible students on the taxpayer’s return. The Lifetime Learning Credit is non-refundable, which means it can reduce your tax to zero, but the remaining credit does not result in a refund.

Key Attributes of the Lifetime Learning Credit:

Broad Applicability: One of the Lifetime Learning Credit’s most significant advantages is its wide applicability. It’s available for all years of post-secondary education, including graduate and professional degree courses, and courses taken to acquire or improve job skills, with no limit on the number of years you can claim it.

This stands in contrast to the AOTC, which is available only for the first four years of post-secondary education.

No Degree Requirement: The Lifetime Learning Credit does not require the student to pursue a degree or other recognized education credential, which is particularly beneficial for students taking courses to acquire or improve job skills, including those enrolled in continuing education programs.

Income Limitations: To receive the full Lifetime Learning Credit, your Modified Adjusted Gross Income (MAGI) must be below a certain level. The amount of your LLC is gradually reduced if your MAGI is within a specific range, known as the phase-out range. You cannot claim the credit if your MAGI is above this range.

Eligibility Requirements: To qualify for the Lifetime Learning Credit, the student must:

Be enrolled or taking courses at an eligible educational institution. The school must be eligible to participate in a student aid program administered by the U.S. Department of Education, which covers virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) post-secondary institutions. A link to the list of schools is provided above.

Be taking higher education courses or courses to acquire or improve job skills.

Be yourself, your spouse, or a dependent listed on your federal tax return.

Qualified Expenses:

The LLC allows for a more narrow range of qualified education expenses than some other educational benefits. Qualified expenses include tuition and fees required for enrollment or attendance at the eligible educational institution, as well as fees for books, supplies, and equipment needed for a course of study.

Unlike the AOTC, the cost of books and equipment are not considered qualified expenses unless they must be paid to the institution as a condition of enrollment or attendance. Notably, the cost of room and board, insurance, medical expenses, transportation, and similar personal, living, or family expenses are not considered qualified expenses for the LLC.

Claiming the Credit:

To claim the LLC, you must complete Form 8863 and attach it to your Form 1040 or 1040A. You cannot claim the LLC if your filing status is married filing separately. You must also provide the Employer Identification Number (EIN) of the educational institution to which you paid qualified expenses, and you cannot claim the LLC for expenses paid with tax-free funds.

Strategic Considerations for the LLC:

Coordination with Other Educational Tax Benefits: You cannot double-dip by using the same expenses to qualify for several tax benefits. For instance, if you use qualified expenses to figure the LLC, you cannot use the same expenses to figure the tax-free portion of a distribution from a Coverdelle Education Savings Account or Qualified Tuition Program. However, if you have additional expenses, they can be used to qualify for multiple benefits.

Effect of Scholarships and Fellowships: Scholarships and fellowships may reduce the amount of expenses that can be used to calculate the LLC. If your scholarship or fellowship is tax-free, you must subtract that amount from your qualified expenses. However, if it is taxable, you do not need to subtract it from your expenses.

Impact on State Taxes: While the LLC is a federal tax credit, it’s important to understand that it may also affect your state taxes. Some states have their own educational tax benefits, and claiming the LLC could potentially impact these benefits.

Case Studies: Let’s consider a few scenarios where the LLC can be beneficial:

Graduate Students: A student is pursuing her master’s degree in environmental science. Even though she’s beyond her first four years of college, she can still claim the LLC for her graduate degree expenses.

Continuing Education: John, a professional with a decade of work experience, decides to take courses related to his field to improve his job skills. He can use the LLC to claim these expenses, even though they aren’t part of a degree program.

Non-traditional Students: Sarah, a part-time student and single mother, returns to college to finish her bachelor’s degree. The LLC provides her with the flexibility to claim the credit even though she’s not attending full-time and it’s not her first four years of college.

Conclusion

The American Opportunity Tax Credit and the Lifetime Learning Credit serves as a significant tax relief for families managing the financial challenges of their own and their dependent’s higher education costs. Its capacity to reduce tax liability and, in some cases, provide refundable benefits, makes it an invaluable resource for eligible students.

Understanding the AOTC’s requirements and strategically applying it while considering other educational tax benefits can lead to substantial tax savings. Keeping detailed records of educational expenses and being mindful of the income thresholds will ensure you leverage the full potential of this credit.

However, the complexities of educational tax benefits necessitate thorough planning and, often, consultation with a tax professional to ensure optimal benefits. Always consult with a tax professional if you’re unsure about your eligibility or the application process to maximize your benefits from this opportunity.