An Important Learning Curve
Educational Tax Credits Help Defray the Costs of Higher Education
Sean Wandrei
This article will provide an overview of the higher-education credits available and how they may be used in tax planning and financing your student’s education.
The credit that most taxpayers take advantage of is the American Opportunity Tax Credit (AOTC), which modified and replaced the Hope Credit through 2012. The AOTC was created by the American Recovery and Reinvestment Act of 2009 and was originally available for 2009 and 2010. The recent tax-relief package, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, extended the AOTC for two years, through Dec. 31, 2012. The second credit, the Lifetime Learning Credit, has been around for many years but, as discussed below, is less advantageous than the AOTC.
Each credit is based on the amount of qualified tuition and related expenses paid for an eligible student at an eligible education institution, and is subject to income limits of the taxpayer. Qualified tuition and related expenses are defined as out-of-pocket cost for tuition and fees required for enrollment or attendance at an eligible educational institution. For the AOTC, expenses for qualified course materials may also be used to compute the credit. Cost for room and board, insurance, medical expenses, and transportation do not qualify for the credit.
There are some common elements of these education credits — a joint return must be filed by married taxpayers claiming either credit (no married-filing-separately returns), a taxpayer cannot claim a credit and also claim a deduction for those same higher-education expenses, there is no carry-forward of an unused credit, and each credit is claimed in the year the expenses are paid if the education commences during that year or during the first three months of the next year.
As stated before, the ATOC is a modification of the Hope Credit and basically replaces the Hope Credit through 2012. The credit amount is the sum of 100% of the first $2,000 of qualified tuition and related expenses plus 25% of the next $2,000 of qualified tuition and related expenses, for a total maximum credit of $2,500 per eligible student per year. The credit is available for the first four years of a student’s post-secondary education (college). Up to 40% of the credit amount (max of $1,000) is refundable should the taxpayers’ tax liability be insufficient to offset the non-refundable credit amount (max of $1,500). The credit starts to phase out ratably for taxpayers with a modified adjusted gross income (AGI) of $80,000 through $90,000 ($160,000 through $180,000 for joint filers).
The Lifetime Learning Credit is equal to 20% of the amount of qualified tuition expenses paid on the first $10,000 of tuition. The maximum credit available to the taxpayer is $2,000 per return. The Lifetime Learning Credit maximum is calculated per taxpayer and does not vary based on the number of eligible students in the taxpayer’s family, unlike the AOTC, which is per student. A student is eligible for the Lifetime Learning Credit if enrolled in one or more courses at a qualified education institution.
The Lifetime Learning Credit is phased out ratably when the taxpayer’s modified AGI reaches $50,000 through $60,000 ($100,000 through $120,000 for joint filers). The credit can be used on courses that enable the taxpayer to acquire or improve job skills rather than obtain a degree.
Taxpayers with children in college going for their undergraduate degree will most likely use the AOTC, and taxpayers going to school for their graduate degree or to acquire or improve job skills will only be able to use the Lifetime Learning Credit.
If a student is a claimed dependent of another taxpayer (mostly likely the parent), only that taxpayer (the parent and not the student) can claim an education credit for that tax year for the student’s qualified tuition and related expenses. Any qualified tuition and related expenses paid by the student who is a claimed dependent of the taxpayer can be treated as paid by that taxpayer (the parent and not the student) for the tax year in which the expenses are paid. In some cases, the cost paid by the parent is treated as paid by the student.
If parents decide to not claim the student as a dependent, the student may claim the education credit for the student’s qualified tuition and related expenses. In this situation, the student cannot claim a dependency-exemption deduction for himself, but can claim an education credit on his return. The exemption is basically forfeited by the family.
There is some tax planning that can be done through the ability to shift the education credit. The greatest tax savings are going to be seen by taxpayers with income greater than the phaseout limits mentioned above. This allows parents who cannot benefit from the education credit because their AGI is too high to shift the credit to the student (child), regardless of whether the child or parents paid the education cost. The student does need taxable income to generate enough tax liability to be able to use the education credit.
With the new ‘kiddie-tax’ provisions from 2008, the number of students subject to parents’ tax rates will likely increase. The thing to remember is that the parents will lose the dependency exemption (which does not have a phaseout through 2012) if the child claims the credit. An analysis of total tax savings will have to be done to see which route is most beneficial. Also, there is a risk that, if the student is not claimed as a dependent of the parent, then the parents’ health insurance may drop coverage of the student. Taxpayers should review their health insurance policies to make sure that this does not happen.
As you can see, there are several opportunities for families to benefit from the educational credits that are available.
Sean Wandrei is manager of the Tax Department at Meyers Brothers Kalicka, P.C. His technical concentrations are in multi-state taxation as well as real-estate entities; (413) 536-8510.
