by Ann Garcia
Currently two tax credits exist to help defray higher education expenses, the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit. Each is slightly different but for most families, the AOTC is the most beneficial.
The maximum annual AOTC credit is $2,500 per student. Eligibility is limited to undergraduates who are enrolled at least half time for at least one academic period beginning in the tax year. It’s also limited to four years. The credit is 100% of the first $2,000 of qualified educational expenses and 25% of the next $2,000 of qualified expenses. It’s 40% refundable, meaning that if the credit reduces your tax liability below $0, you can still be refunded 40% of the remaining credit.
Only taxpayers with AGI below $80,000 (single/head of household)/$160,000 (married filing joint) are eligible for the full AOTC (there is a phaseout up to $90,000/$180,000).
Families who are eligible for the AOTC should be aware of a few nuances in claiming it:
Qualified expenses for the AOTC are more limited than for 529s: Only tuition, required fees, books and required supplies are eligible; room and board are not.
You must pay the expense in the calendar year in which you’re claiming it, regardless of what academic period the expense is for. That means that if your spring tuition is due by 12/31, you won’t be able to claim the AOTC for that tuition payment. However, if the college offers a payment plan for some of the tuition and you make payments after 1/1, the portion paid after 1/1 is eligible for the AOTC, which might justify paying a finance charge for a payment plan. This is different from your 529, where you can take a distribution in December to pay January’s tuition bill.
In order to claim the AOTC you cannot have paid the qualified expenses with a distribution from your 529 plan. That means that if you’re eligible for the AOTC, you need to spend $4,000 out of pocket (or by taking out loans) in order to claim it. Families with fully funded or overfunded 529s who are eligible for the AOTC might consider having the student take out $2,000 in direct student loans each year to get the AOTC, then, based on the SECURE Act now allowing 529 distributions to repay loans, use the 529 to repay the loan. (Hey, I just found an actual use of this provision of the SECURE Act!)
You can only claim the AOTC if you claim the student as a dependent on your tax return. This comes into play most often with divorced parents who might want to consider—given the lower dependent tax credit; for college-aged dependents under the 2018 TCJA—whether both spouses are eligible for the AOTC and if not, if it’s more beneficial for the lower-earning spouse to claim the student in order to claim the AOTC. This is different from being the custodial parent on the FAFSA, which is determined by which household the student spends the most time in.
The AOTC is not indexed for inflation. That means that families who are close to the income limit at the start of college may exceed it in later years. Increasing pre-tax retirement contributions can help get under the threshold, but it may take some planning to remain eligible for all four years.
Families above the income limit can let the student claim the AOTC on their own return, but the parents cannot claim the student as a dependent on their tax return if they go this route. Note that only $1,000 of the credit is refundable, so for a student without tax liability, this nets out to only $500 after the parents forgo the dependent tax credit. However, one might assume that a student who is graduating from college in May or June will earn enough from working after graduation to claim the full credit.
The final important point about the AOTC: It’s not automatic. You need to file IRS Form 8863 with your tax return to claim it.
This article originally appeared on https://thecollegefinanciallady.com
Ann Garcia is the owner of Independent Progressive Advisors, a fee-only financial advisory firm in Portland, OR, and author of The College Financial Lady blog. A CERTIFIED FINANCIAL PLANNER(TM) (CFP(R)) specializing in helping families plan for affordable education and mom of college-aged twins, Ann has been featured in the New York Times, CNN/Money and more. Please visit ipawealthmanagement.com or thecollegefinanciallady.com