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Tax Strategies & Credits

Using the Tax Code to Help Pay for Your Education

by
Steward Financial
on
12/14/2017
Using the Tax Code to Help Pay for Your Education

When it comes to accessing the federal gove­­­­rnment's higher education tax credits, what you don't know can definitely hurt you. There are two different education tax credits available, and they each have their own advantages and rules. Let's take a closer look at the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC) to see what each one offers, and how best to use both of them.

Two Different Opportunities for Higher Education Tax Credits

  • Where the American Opportunity Tax Credit applies only to the first four years of post-secondary education, the Lifetime Learning Credit does not have the same limitation. It can be used at any point.
  • The American Opportunity Tax Credit offers taxpayers a maximum of $2,500 of credit, where the maximum for the Lifetime Learning Credit is $2,000.
  • Up to 40 percent of the American Opportunity Tax Credit is refundable, where the credit for the Lifetime Learning Credit can only be used to reduce the amount of tax that is owed by the taxpayer. If a taxpayer's tax liability is less than the $2,000 LLC credit, the credit cannot be used.

When calculating the credit to be received using the American Opportunity Tax Credit, the taxpayer is able to write off all of the first $2,000 that is spent on either qualified expenses or college tuition. They can also take 25% of the next $2,000 on those same expenses.  The Lifetime Learning Credit allows the taxpayer to write off 20 percent of the first $10,000 of those same qualifying expenses.

Making the Most of the Education Tax Credits

Though the credits seem fairly straightforward, it is important to understand each one's limitations in order to make sure you're getting the greatest benefit possible. For example:

  • Because the American Opportunity Tax Credit can only be applied to the first four years of post-secondary education, taxpayers should always take that credit first, before turning to the Lifelong Learning Credit. Otherwise, the opportunity may be lost. This is particularly true in cases where a student transfers from one college to another, resulting in their education taking more than four years. If the family makes the mistake of using the LLC first, they will not be able to use the AOTC in the student's fifth year of schooling.
  • You can increase the amount of your write-off by taking advantage of a rule that allows you to prepay the first three months of the following year's tuition in advance. This is particularly helpful in the first year of the student's post-secondary education when the year's tuition is generally only incurred in the fall. By prepaying the tuition owed for January, February and March of the following academic year, you are able to maximize your benefit.

Example: To understand how this would work, imagine a student has completed their high school education and plans to attend college in the fall. The fall semester's tuition is $1,500, and their college has already published the rates for the following year's tuition, which is also $1,500. By paying for both the fall semester and the tuition for the following year's first three months, the family can write-off a total of $3,000 in qualifying tuition and expenses. Using the AOTC credits this would mean that all of the tuition paid for the fall semester would be credited at 100%, plus the next $500 that was paid for the following semester would also receive the same 100%. The remaining $1000 paid would be credited at 25%, giving the family a $2,250 credit for the year despite the fact that actual tuition for the year was only $1,000. The family would also be able to maximize the available tax credit by spending the remaining $1,000 of the annual $4,000 limit on supplies that fall under the category of being needed for “meaningful attendance or enrollment.”

  • While on the topic of supplies, it is important to remember that higher education credits are not limited to the cost of tuition. The tax laws allow course materials needed for “meaningful attendance or enrollment” to be used as qualifying expenses. In fact, the definition of qualified expenses under the AOTC has expanded to include items purchased from a source other than the school itself. For the Lifetime Learning Credit, the tax rules still indicate that in order to fall under the category of a qualified expense, the items must be purchased from the school rather than from another source.
  • The education credit is available for tuition payments and qualified expenses having to do with any post-secondary institution that is able to take part in the Department of Education's student aid programs. Though this would preclude any foreign institution, it makes way for any accredited schools, whether for profit or nonprofit, privately owned or technical in the United States.

Tax Rules and Restrictions on Taking the Higher Education Credits

In addition to the nuances of the write-offs themselves, the tax laws can be complicated as to who has the right to claim the deduction. For example:

  • Only the person that is claiming the student as an exemption on their annual taxes is able to claim the education credit. It does not matter who actually pays the tuition. This means that if a couple is divorced and the wife is claiming their child on her tax return, the father cannot qualify for the education credit, even if he is the one paying the bills for college.
  • There are thresholds for taking the credit for both the AOTC and the LLC. In 2017, the threshold for the LLC is slightly lower than for the AOTC, starting to phase out at $112,000 and ending at $132,000 for married couples filing jointly and between $56,000 and $66,000 for all others: by contrast the AOTC's levels are between $160,000 and $180,000 for married couples filing jointly and between $80,000 and $90,000 for others.
  • Couples that file their taxes married but filing separately are prohibited from taking advantage of either the AOTC or the LLC higher education credit.

Because of the phase-out rules, as well as the requirement that the person that claims the student as an exemption being the only one able to take the credit, couples that are divorced are encouraged to coordinate with each other in order to make sure that they get the greatest tax advantage. If there is a way to arrange it, it makes more sense for the person who has the lowest income to take the exemption and to pay the tuition.

Gift Tax Questions

Frequently, a relative will want to help pay for a student's college tuition but will be concerned about the tax ramifications, and particularly about going over the gift tax limitations. Though this would be a concern if tuition money is given directly to the person who is paying the tuition bills or to the student themselves, the gift tax requirements do not apply when the payments are made directly to the academic institution.

The U.S. tax code's rules for higher education tax credits are written to encourage people to attend and benefit from furthering their education, but the restrictions and application of the rules can be hard to understand. In order to make sure you are getting the greatest benefit possible from these credits, contact a tax professional to get all your questions answered.

Jon Osborn, EA writes for TaxBuzz, a tax news and advice website. Reach his office at [email protected].

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Steward Financial

Steward Financial

Jon Osborn is a tax preparer based in San Dimas, California. His company, Steward Financial Services, offers a broad range of tax preparation, accounting and business consulting for small businesses. He loves to work with clients who are looking for answers to complex tax and business planning issues. He has owned several small businesses and worked with over one hundred small business owners. He helps his individual and business tax clients find the best ways to spend their money in order to minimize IRS tax. Small businesses looking to grow, sell or just increase cash flow are one of Jon's specialties.

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