Creating a strategy to help send your kids off to college is not only necessary, considering the high tuition costs, but it will also make the process more gratifying. Nothing is more fulfilling than giving your child the opportunity to experience higher education. So, what does saving for college have to do with taxes, and what exactly is the American Opportunity Tax Credit?
While many dread the inevitable arrival of tax season, it can actually be a good thing if you incorporate tax planning into your college-planning strategy. One of the best ways to do this is to utilize the American Opportunity Tax Credit (AOTC).
“You can get up to $2,500 each year for every student that is enrolled at least as a half-time student,” Tony Matheson, a certified financial planner (CFP) and founder of Matheson Financial Planners.
“It’s important to note the AOTC is a college tax credit, not a tax deduction. So up to the eligible limit, it is a dollar for dollar credit,” Matheson continues.
Do you qualify? Let’s take a closer look and find out.
The Basics of the College Tax Credit
The AOTC is a tax planning strategy that can help defray the cost of college. It can be claimed for every child attending college, even if you have multiple children in college at the same time.
- The student has not completed four years of post-secondary education as of the beginning of the tax year.
- The student has been enrolled at least half time for at least one academic period that began during the tax year.
- Income phaseout for claiming the AOTC is $160,000 to $180,000 of modified adjusted gross income on joint tax returns ($80,000 to $90,000 for single tax filers and heads of household). You cannot claim any education credits if you file as married filing separately.
- Credit is calculated on 100 percent of the first $2,000 in qualified expenses, plus 25 percent of the next $2,000.
- Qualified expenses include tuition and related expenses (not room and board) at college, vocational school, or other post-secondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education.
The amount of your qualified educational expenses will be reduced if you pay for any of those expenses with scholarships, grants, or other forms of tax-free assistance. So be careful and ensure that you have sufficient expenses to claim the credit.
For example, if tuition is $8,000 and the student receives a $5,000 scholarship, then that leaves only $3,000 of qualified expenses to claim the AOTC.
Along those same lines, you need to be careful when taking distributions from education savings accounts such as 529 plans and claiming the credit in the same year. Expenses paid for with tax-free 529 plan distributions cannot also be used to take the AOTC.
In other words, if you took $4,000 from your 529 account to pay for tuition expenses, you would be unable to use the same $4,000 in expenses to claim the AOTC.
How to Strategize
For starters, make sure that you have enough qualified expenses to claim the AOTC. If you plan on taking 529 distributions, then you will have to add up all of your expenses to determine eligibility for both the AOTC and tax-free 529 withdrawals.
Some expenses such as room and board are not considered qualified for AOTC purposes, so be sure to align expenses to the appropriate strategy. If you have a limited amount of qualified expenses, then focus on the AOTC first since that provides greater benefit.
If you make too much money to claim the credit on your return, then determine if your child can take the credit on theirs.
Children who pass the support test — meaning they use their own assets, income, and student loans to pay more than half the cost of college — can claim the personal exemption on their own tax return. This in turn allows them to claim the AOTC for themselves.
The increases in college tuition have made it more and more difficult for families to cover the cost. Most have resorted to loans and raiding their retirement assets to fill the gaps. But this doesn’t have to happen. Be proactive and understand what your options are. Ask yourself:
- Is a more reasonably priced college a better fit for my child?
- Where will my child qualify for the most financial aid?
- Will gifting appreciated assets to my child save us money and help pay for college? This strategy may work in situations where need-based aid is not an option.
Other Options for College Tax Credits
Though the AOTC is something to investigate, it isn’t flawless, so it’s a good idea to keep other college tax credit options in mind, such as the Lifetime Learning Credit (LLC).
“The LLC is a $2,000 nonrefundable credit widely used by students who have already maxed out their AOTC by claiming the credit during the first four years of undergraduate studies,” states Crystal Nickson, a certified financial social worker.
The LLC can also be used to pay for courses taken to improve job skills; the AOTC cannot be used for this.
The Bottom Line on College Tax Credits
These are just a few questions that can help shape your college planning strategy. A strategy that should not only cover tax aid, but also college selection, financial aid, and the best use of your personal resources. Doing so will go a long way toward helping your child receive a quality education, minimize their student loans, and protect your retirement.