FORBES. JANUARY 16, 2013. Now that the fiscal cliff tax deal has given the American Opportunity Tax Credit (AOTC) an additional five years of life, it’s time for parents of both college students and high school juniors and seniors, to learn about how this valuable tax break works. The credit reduces your federal tax bill dollar-for-dollar by up to $2,500 per year for each eligible college student for whom you pay qualified tuition expenses. It can be claimed on behalf of an undergraduate for four years—that’s a $10,000 tax subsidy, over four years. And if you have more than one child in college at the same time, you can claim more than one credit. This break had been set to expire at the end of 2012, but the fiscal cliff deal extended it for tax years 2013-2017.
The American Opportunity Tax Credit is worth more than the older college-related tax credits you might have heard of: the Hope Scholarship and Lifetime Learning Credits. It’s also more valuable than another tax break, the tuition and fees deduction. But understandably, having all of those credits creates a lot of confused taxpayers and leads some to miss out.
Clearing Up The College Credit Confusion
As Ronald Reagan said, “The nine most terrifying words in the English language are, `I’m from the government and I’m here to help.’” A tax credit for paying college tuition expenses is a big help to families, but in trying to help the government has made claiming the credit confusing, and that’s because there are actually three college tax credits and a tuition and fees deduction to choose from. According to the IRS, a lot of people are still confused because 3.1 million families claimed college tax credits improperly in 2010.
So first, let’s clear up all of this college tax credit confusion.
Which College Credit Should You Claim?
There are three college-related tax credits, the American Opportunity Tax Credit, Lifetime Learning Credit and the Hope Scholarship Tax Credit, as well as one deduction, the tuition and fees deduction. You may only claim one credit or deduction per child in any given year. The American Opportunity Tax Credit (AOTC) is the logical choice for full-time undergraduates because it is by far the richest at up to $2,500 per eligible child, versus $2,000 and $1,800 for the Lifetime and Hope credits. Think of the AOTC as a super Hope Credit. The AOTC was originally pushed through by President Barack Obama as part of the big 2009 economic stimulus package. Essentially, the stimulus took the Hope Credit and made it worth more, made it available to more families and gave it a new name. So there is no reason anyone should be claiming the Hope Credit now. There is, however, still reason to use the Lifetime Learning Credit, since it is available for part-time and graduate study.
American Opportunity Tax Credit Is Worth $2,500
The AOTC is worth up to $2,500 per student each year for four academic years (extended through the 2017 tax year). But families who earn too much can’t claim the credit. The income phase-out for claiming the AOTC is $160,000 – $180,000 of modified adjusted gross income on joint tax returns ($80,000 – $90,000 for single tax filers and head of household). The amount of the credit is calculated as 100% of the first $2,000 in qualified tuition and fees costs paid, plus 25% of the next $2,000 paid for such fees. For lower income taxpayers who don’t owe $2,500 in tax, up to $1,000 of the credit is refundable. (The credit is not refundable on a dependent child’s return.)
Which College Expenses Count?
You use IRS form 8863 (get the form and instructions here) to claim the American Opportunity Tax Credit, which is based on qualified college expenses that you pay for yourself, your spouse or a dependent for whom you claim an exemption on your tax return.
According to IRS Publication 970, qualified education expenses are tuition and related expenses required for enrollment or attendance at an eligible educational institution.
An eligible educational institution is any college, university, vocational school, or other post-secondary educational institution eligible to participate in a student aid program administered by the Department of Education. It includes virtually all accredited public, non-profit, and proprietary (privately owned profit-making) post-secondary institutions. The credit cannot be claimed for college credits taken under dual enrollment programs, where high school students are simultaneously enrolled in college courses. The reason for this is because, according to the Department of Education, high school students are not technically enrolled in a degree-granting program because they do not yet have a college diploma, even though they are earning college credits. It doesn’t make any sense, but that is the rule.
Related expenses are student-activity fees and expenses for course-related books, supplies, and equipment that are required as a condition of enrollment or attendance. The amount of qualified educational expenses that can be used in calculating these tax credits is reduced if you pay for the qualified expenses with certain tax-free funds. They include:
- Tax-free portions of scholarships and fellowships
- Pell grants
- Employer-provided educational assistance (section 127 tuition reimbursement plan)
- Veterans’ educational assistance
- Any other tax-free payments received as educational assistance
Claiming The AOTC Takes Coordination
It is very important to remember that you cannot claim any of the college tax credits, including the AOTC, based on expenses that were used to calculate the tax-free portion of a distribution from a 529 college savings or prepaid plan, or a Coverdell Education Savings Account (ESA). The AOTC may be claimed in the same year that a tax-free distribution is made as long as the same expenses are not used to calculate the tax-free distribution AND the American Opportunity Tax Credit.
For example, if you take $12,000 out of a 529 college savings plan to pay for tuition you cannot use that $12,000 of tuition expenses to claim the American Opportunity Tax Credit also. This coordination of benefits provision is exactly why it helps to have a tax preparer who understands education funding so that you can make the most of the benefits that you qualify for. Even more important, however, is to discuss how you will pay for college ahead of time with a financial planning or tax professional so that you can coordinate how to best pay for college using the income and assets that you have, and still be eligible to claim the full amount of college tax credit that you are eligible for.
If You Make Too Much Money To Qualify For The Credit, Try This
If you are not able to claim the AOTC because your income exceeds the $180,000 (MAGI) phase-out threshold, maybe your child can claim the credit on his or her tax return. If you cannot, or do not claim the AOTC (or any other tax credit or the tuition and fees deduction), and you also do not claim that child as a personal exemption on your tax return, your child can claim the American Opportunity Tax Credit on his or her tax return. For more on how to use the AOTC, standard deduction and personal exemption on your child’s tax return, to minimize or eliminate thousands of dollars of earned and unearned income, please see my post, 2011 Tax-Saving Strategies For College Funding. Yes, it is from 2011, but it is the tax-saving concept that is important.
The American Opportunity Tax Credit Does Not Impact College Financial Aid
When calculating a student’s expected family contribution (EFC) toward the cost of college, the federal, state and withholding taxes that parents and students pay reduce the amount of their incomes that counts against them in the aid calculation. Since the AOTC reduces the federal income tax paid by parents (or whomever the taxpayer is), and therefore reduces the amount of tax allowances they have against their income in the aid formula, the credit would normally increase the student’s expected family contribution and decrease the student’s aid eligibility. However, the financial aid forms, theFAFSA and the CSS Profile, effectively “add back” the amount of the credit that parents claim on their tax return, thereby eliminating any negative impact on the student’s potential need-based aid eligibility.