Tax time is as good a time as any to discuss education tax credits. The federal tax code provides two primary tax credits, the American Opportunity tax credit (formerly the Hope Scholarship) and the Lifetime Learning Credit. There are slight differences in each, and depending on a family’s circumstances, one or the other may be more beneficial. You can claim both credits on the same tax return, but not for the same student. And you can’t take a tax credit for expenses that were paid with qualified withdrawals from a 529 plan. I’ll get to that shortly.
The American Opportunity credit is for undergraduate studies only, for a maximum of 4 years per student. Up to $2,500 per student can be claimed on eligible returns (there is a phaseout for MAGI between $80,000 and $90,000 for single filers or $160,000 and $180,000 for joint returns). Let’s say you have two children: Roger, a college freshman, and Sharon, a college senior. If you are eligible for the AOTC based on MAGI, you can claim up to $5,000 in tax credit. If Sharon were in her first year of graduate school after completing a four-year undergraduate degree, however, you could only claim the credit for Roger, not for her.
The Lifetime Learning Credit, on the other hand, is available for all years of post-secondary education, including “courses to acquire or improve job skills.” (www.irs.gov) However, the credit is limited to $2,000 per return and it phases out at much lower income thresholds: between $53,000-$63,000 for single filers and between $107,000 and $127,000 for joint filers. In the same example above, in either case, Roger’s and Sharon’s parents could claim up to $2,000 on their return if they are eligible based on their MAGI. Or they could claim the AOTC for Roger and the LLC for Sharon in the graduate school case.
The LLC and AOTC can be combined with student loans and/or 529 plan funds, but you need to coordinate how you use them together. You cannot, for example, claim the AOTC or LLC for expenses that were paid with a tax-free distribution from your 529 plan. You can, however, claim the AOTC or LLC for expenses that were paid with a student loan. But you cannot claim your student loan interest for the AOTC.
Qualified expenses for the LLC and AOTC are also somewhat more limited than for 529 plans. The credits can only be used for tuition, fees, and some required books and supplies. 529 plans, in contrast, can also be used for room and board. Also, the credits only apply to the first $10,000 of tuition, fees, books and supplies. Here is a simplified example: Let’s say your total education expense for the year was $25,000, of which $18,000 was tuition and $7,000 room, board and supplies. You could claim the tax credit for the first $10,000 of tuition and then use 529 plan funds for the remaining $15,000.
And just to make sure: we are talking here about tax credits, not tax deductions. You know the difference, right? But someone else doesn’t, so here goes: a tax credit reduces amount of tax you owe. A tax deduction reduces your taxable income. The Dependent Care credit is a tax credit. The mortgage interest deduction is, as the name implies, a deduction. There are also some education tax deductions, which I’ll discuss in another post.