Once upon a time, the American Opportunity Tax Credit was a pretty simple proposition: Families could get a $2,500 annual tax credit for $4,000 of out-of-pocket college tuition expenses for their dependent student, as long as their income was below the IRS threshold for the credit. However, tax law changes over the past few years have created some opportunities for creative claiming strategies, opening the tax credit up to a larger population.
First, let’s review the AOTC:
The $2,500 tax credit has two parts: the first $2,000 in expenses get a 100% credit, and the next $2,000 in expenses get a 25% credit. So your first $2,000 spent gets you $2,000 back in tax credit, while your next $2,000 spent only gets you $500. (A tax credit is a reduction in the amount of taxes you owe.)
The credit is also 40% refundable, meaning that you can get up to 40% of the available credit ($1,000) even if you don’t owe any taxes.
The income threshold for the AOTC is MAGI* of $80,000 ($160,000 for married filing joint) with a phaseout up to $90,000/$180,000. This amount is not adjusted for inflation so effectively it goes down every year.
You cannot claim the AOTC for an expense that was paid by either a 529 or Coverdell ESA withdrawal—only one tax benefit per dollar. But you can claim it for expenses paid by a student loan.
Finally, the AOTC has a more limited list of qualified expenses: tuition, required fees, and required books and supplies—not room and board—and can only be claimed by the taxpayer claiming the student on their tax return. And it’s only good for four tax years.
The AOTC is free money, so it’s worth figuring out how to get it. Simple strategies include increasing 401k contributions to bring your income below the threshold or timing your out-of-pocket spending vs 529 spending to ensure that you have $4,000 of non-529 spending annually.
First, the TCJA replaced dependent exemptions (which reduced taxable income by $4,050 per dependent) with a dependent tax credit which makes it possible for families with incomes above the AOTC threshold to benefit from the AOTC. A family in the 24% tax bracket would have saved $972 on their 2018 taxes through the dependent exemption. However, a dependent college student age 17 or over only gets a family a $500 tax credit under TCJA rules. This means that a family that is over the AOTC income threshold whose student has sufficient earned income would now benefit from not claiming the student on their tax return and letting the student take at least the refundable portion of the AOTC by filing their own tax return (note that the student must have earned income equal to at least half of their support to do this). This would save at least $500 a year ($1,000 refundable credit – $500 dependent credit), for a total of up to $2,000 if the student is eligible for four years. However, assuming the student graduates in May or June and then gets a job for at least some portion of the tax year in which they graduate, they may be able to claim the full $2,500 in that year, for a total savings of up to $4,000.
Second, by allowing 529 funds to repay up to $10,000 in student loans, the SECURE Act opened up a nifty little loophole for families who have fully funded their 529s– enough in the 529 to cover all college expenses– and are eligible for the AOTC. Fully funded 529s happen more frequently than one might think, due to scholarships, planning for private school but attending public, etc. In this case, the family might be tempted to forego the AOTC because they have to spend the 529. Instead, thanks to the SECURE Act, they can borrow $2,000 annually through a direct student loan, have it disbursed directly to the school to pay tuition, and claim the first $2,000 of the AOTC, netting $8,000 in tax credit. Upon graduation, the family can use $8,000 (plus loan interest) from the 529 to repay the loans. Assuming the current 4.59% interest rate for the federal student loan, the loan balance would be $8,961 upon graduation; the 529 might grow by 2% annually so the $8,000 in the account at the beginning of the college years would now be $8,659, meaning that $8,000 in tax credits cost the family approximately $300. And they may have received a state tax credit for the contribution too.
If that seems too complicated, a family with an overfunded 529 can also consider whether claiming the AOTC is more valuable than a non-qualified 529 distribution. Let’s say you claimed the first $2,000 of the AOTC and then had $2,000 left in your 529. Of course you could choose one of the options for keeping the money in the 529—naming a new beneficiary, saving it for grad school, etc. But if you just wanted your money back, you’d simply take a nonqualified distribution. In this case you would pay income tax and a 10% penalty on the gain (many states also impose state penalties on nonqualified distributions; check your plan info if this might pertain to you). If the $2,000 were 50% growth, then $1,000 would be subject to taxes and penalties. In the 22% federal tax bracket, that would cost $320 (22% + 10% of $1,000) in taxes and penalties, plus state taxes. While you’ve still come out ahead– $320 in taxes/penalties for $2,000 int ax credit—repeat four times and that’s almost $1,300 in taxes and penalties, compared with $300 in student loan interest. Add in state taxes and the loan strategy is much better.
Here’s something that hasn’t changed: Divorced parents should be cognizant of the income thresholds. If one parent is eligible for the AOTC and the other is not, it’s much more beneficial to allow the eligible parent to claim the student during four college tax years. Only the person claiming the student on their tax return can claim the AOTC.
And finally, to claim the AOTC you need to file Form 8863. Tax prep software should prompt you, and your CPA should ask– and you should ask your CPA about the benefits and drawbacks to your own situation of using any of these claiming strategies.
* For AOTC purposes, MAGI is AGI plus:
- Foreign earned income exclusion,
- Foreign housing exclusion,
- Foreign housing deduction,
- Exclusion of income by bona fide residents of American Samoa, or of Puerto Rico.