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How families can take advantage of tax credits when paying for college

As financial advisors, we want families to leave no stone unturned, no money left on the table when it comes to paying for college. Families need to be informed consumers of a college education. You need to be familiar with important college-related tax credits and how your clients can take advantage of them.

American Opportunity Tax Credit (AOTC)

In 2009, Congress replaced the well-known Hope Scholarship credit with the more generous American Opportunity Tax Credit. Senate Bill 699, American Opportunity Tax Credit Permanence and Consolidation Act of 2015, made this tax credit permanent. The American Opportunity credit covers up to $2,500 of undergraduate costs annually.

The American Opportunity credit equals 100% of the first $2,000 of a student’s qualified education expenses plus 25% of the next $2,000. The maximum annual credit is $2,500. Unlike the other education tax credits, the AOTC includes expenses for course-related books, supplies and equipment that are not necessarily paid to the educational institution. Room and board expenses are NOT qualifying expenses.

Who can claim the credit?

Families can claim the American Opportunity credit for qualified education expenses they pay for a dependent child as well as for expenses they pay for themselves or their spouse. Students must attend an eligible institution. You can visit www.fafsa.ed.gov if you want to verify that it has a Federal School Code. Almost all accredited public, nonprofit and for-profit postsecondary schools, including many trade schools, are eligible. If they have several students in their family, they can claim multiple credits based on the expenses of each student. If you have three kids in college, you can claim up to $7,500 ($2,500 x 3) in American Opportunity credits. The AOTC can be claimed in the same year that a parent takes a tax-exempt distribution from a section 529 plan or a Coverdell Education Savings Account, but the distribution may not be used for the same qualified higher education expenses. So, be sure to spend $4,000 of non-529 money to ensure they qualify for the maximum AOTC. Many families may be planning to use all 529 money for the first year or two and then tap other resources. To ensure a family gets the AOTC each year, they need to carefully coordinate a four-year funding plan.

The Credit is available to be claimed four times per eligible student. In other words, the credit is not allowed for a student who has more than four years’ worth of college credits as of the beginning of the year.

A family can only claim the credit for a year the student carries at least a half-time course load for a minimum of one semester beginning in that year. It is worth noting that the academic year and the tax year are not the same. The academic year is divided over 2 tax years. For instance the expenses from the 2020-21 academic year could potentially qualify for AOTC in both the 2020 and 2021 tax year. Additionally, the student must be enrolled in a program that leads to an associates or bachelors degree or some other recognized credential.

Which expenses are covered?

Expenses covered by the credit include tuition and mandatory enrollment fees and the cost of books and course materials. Room and board do not count as qualified expenses nor do optional fees to cover things like student health insurance, athletics and activities.

Income phase-out rule

The American Opportunity credit is phased out if the modified adjusted gross income (MAGI) exceeds certain levels. (MAGI is adjusted gross income plus certain tax-free income from sources outside the United States.)

Regardless of income, a parent is not eligible if they use the married filing separate status.

  • The MAGI phase-out range for unmarried individuals is $80,000 to $90,000.
  • The MAGI phase-out range for married couples filing jointly is $160,000 to $180,000.

What if You Make Too Much Money To Qualify For The Credit?

If you are not able to claim the AOTC because your income exceeds the $180,000 (MAGI) phase-out threshold, here are two ideas to consider:

First, the child can claim the credit on his or her tax return. If a parent cannot, or does not claim the AOTC (or any other tax credit or the tuition and fees deduction), and they also do not claim that child as a personal exemption on their tax return, a child can claim the American Opportunity Tax Credit on his or her tax return. This option should be explored by high income families that have students with earned income. Work closely with a tax professional to determine if a parent could achieve more tax savings by claiming their child or not claiming them given the AOTC and other considerations.

Or you might be able to drive the MAGI down below the phase out threshold by maximizing tax-deductible contributions to a qualified retirement plan (401(k), 403(b), 457, SEP IRA, etc.). Let’s say a parent is eligible to participate in the 401(k) plan at work. The elective deferral limit that they can deduct for 2019 is $19,000. If they are over the age of 50, they are eligible to contribute an additional catch up contribution of $6,000, for a total of $25,000.

For simplicity, let’s say the parents’ current MAGI is $180,000. If they contributed $20,000 more to their pretax 401(k) plan, they would reduce the MAGI dollar for dollar to $160,000.

In addition to boosting their retirement savings, which is always good, they also saved $7,000 on their current year’s taxes (assuming 28% federal, 5% state, 2% local tax brackets) as they maximize their current year’s contribution and reduce taxes. Assuming they spent $4,000 of non-529 dollars on qualified higher education expenses, they now qualify for the entire $2,500 tax credit. Over four years of college that results in significant tax savings and boosts the retirement nest egg for the future!

American Opportunity Credit is partially refundable. The credit is 40% refundable. A portion of the credit will be refunded even if a family doesn’t owe any federal income tax.

Here’s how it works…Say the family’s AOTC is $2,500. The refundable portion is $1,000 ($2,500 x 40%). That amount is treated as a payment on the tax return (as if you had the $1,000 withheld from your wages). The remaining $1,500 ($2,500 x 60%) is a nonrefundable credit that provides a benefit to a parent only if they owe federal income taxes. If they don’t owe any federal income tax because of deductions and other credits, the entire $1,000 refundable credit counts as a tax over-payment and is refunded.

Lifetime Learning Credit

The Lifetime Learning credit covers up to $2,000 of undergraduate and graduate school costs. For the traditional four-year college student enrolled full time, the AOTC almost always provides the most tax savings, but the Lifetime Learning Credit should not be overlooked.

The Lifetime Learning Credit equals 20% of up to $10,000 of qualified education expenses. The maximum credit is $2,000 before any phase-outs.

Eligibility rules and qualified expenses

The Lifetime Learning credit can help cover undergraduate costs for a student who is not eligible for the American Opportunity credit because he or she is carrying a limited course load or already has four years of college credit. Additionally, the Lifetime Learning credit can also help cover the cost of graduate school and of courses taken to maintain or improve job skills.

A parent can claim the Lifetime Learning credit for qualified education expenses paid for a dependent child as well as for themselves or their spouse. However, the maximum amount of covered expenses is $10,000 no matter how many students they have. This translates into a $2,000 maximum credit ($10,000 X 20%).

Qualified expenses include tuition and mandatory enrollment fees at an eligible institution. Books and course materials can also count, but only if you are required to purchase them directly from the school. Just like the AOTC, other expenses such as optional fees and room and board, do not qualify.

Logically, you can’t claim both the American Opportunity credit and the Lifetime Learning credit for the same student for the same year. However, you can potentially claim the American Opportunity credit for one or more students and the Lifetime credit for up to $10,000 of qualified expenses for other students in your family.

Income phase-out rule

Like the American Opportunity credit, the Lifetime Learning credit is phased out if your modified adjusted gross income (MAGI) exceeds certain (much lower) levels:

  • The MAGI phase-out range for unmarried individuals is $57,000 to $67,000.
  • The MAGI phase-out range for married couples filing jointly is $114,000 to $134,000.

Regardless of income, a parent is not eligible if they use the married filing separate status.

The rules for these credits can be tricky – coordinating 529 tax exempt distributions, handling a refundable portion of the American Opportunity credit, deciding if the Lifetime Learning Credit is applicable, retirement plan contributions, and the list goes on. Each situation is different, and there is no one size fits all approach.

To ensure an ideal outcome, create an integrated plan for college and retirement goals that incorporates smart investing and tax planning strategies. A tactical plan of exactly how to pay for all four years down to the penny is a central part of an overall course of action. Make sure to leave no stone unturned and take advantage of “free money.”