Besides financial aid, specific tax benefits can reduce the net cost of sending a child to college. Among the three major tax breaks—American Opportunity Tax Credit, Lifetime Learning Credit, tuition and fees deduction—you can claim only one on your tax return.
American Opportunity Tax Credit (AOTC)
This credit, which recently was extended through 2017, typically will be the best choice for parents of collegians. The AOTC can produce the biggest tax saving: as much as $2,500 per student per year. In addition, the AOTC has the most generous income limits.
The maximum tax credit is available with modified adjusted gross income (MAGI) up to $80,000 for single filers, partial credits with MAGI up to $90,000. For married couples filing joint tax returns, the comparable income limits are $160,000 and $180,000. Typically, MAGI for this credit is the same as your AGI, reported on the bottom of page 1 of your return.
To get the full $2,500 in tax savings, your spending must be at least $4,000 of qualified expenses for each college student. Qualified expenses include tuition and required fees but not room and board, transportation, insurance, or medical expenses. Unlike other education tax breaks, the costs of course-related books, supplies, and equipment that are not necessarily paid to the school can be qualified expenses.
You can take the AOTC for each of the first four years of a student’s higher education but not for subsequent years. Each year that you claim the AOTC, you must claim the student as a dependent on your tax return. (You also can claim the AOTC for yourself and your spouse, if the other conditions are met.)
The AOTC is also refundable: If the AOTC reduces the tax you owe to zero before the full credit is used, 40% of the remaining credit amount (up to $1,000) can be paid to you in cash.
Lifetime Learning Credit
For the Lifetime Learning Credit, the income limits are lower than for the AOTC: for single filers, the MAGI phaseout range is $55,000-$65,000; for joint filers, the range is $110,000-$130,000 of MAGI. In addition, the tax savings can’t be more than $2,000 per return, not per student. The Lifetime Learning Credit is set at 20% of the first $10,000 you spend on higher education. Otherwise, the rules for the Lifetime Learning Credit are similar to those for the AOTC.
If the AOTC is far more appealing, why use the Lifetime Learning Credit? Because the Lifetime Learning Credit might work when the rules for the AOTC can’t be met. As mentioned, the AOTC only covers a student’s first four years of higher education. Students for whom the credit is claimed must be enrolled in college at least half-time for one academic period during the tax year. The Lifetime Learning Credit, on the other hand, is available for all years of higher education as well as for courses taken to acquire or improve job skills. You can claim the Lifetime Learning Credit for an unlimited number of years, so it can be useful once you’ve claimed the AOTC for four years.
Tuition and fees deduction
A tax credit is generally better than a tax deduction, so either the AOTC or the Lifetime Learning Credit usually will save more tax than the tuition and fees deduction. You can deduct up to $4,000 of tuition and required college costs with MAGI up to $65,000 (single) or $130,000 (joint). With larger MAGI, up to $80,000 or $160,000, you can deduct up to $2,000 of those expenses. With even greater MAGI, no deduction is allowed.
Taxpayers with qualifying MAGI usually will be in the 15% or 25% federal tax bracket, so the tax savings may be modest.
Example: Ken and Kathy Long are in the 25% tax bracket. Taking a $4,000 tuition and fees deduction reduces their tax bill by $1,000: 25% times $4,000. Thus, their tax saving is less than the $2,000 possible from the Lifetime Learning Credit or the $2,500 per student from the AOTC.
If that’s the case, why would anyone choose this deduction, instead of one of the tax credits? Note that the income limits for the Lifetime Learning Credit are lower than the limits for the deduction. Thus, if the Longs can’t qualify for the AOTC (say, they’ve already used it for their child for four years) or for the Lifetime Learning Credit (their income is just over the Lifetime Learning Credit threshold), they may be able to benefit from the tuition and fees deduction.Also, this deduction is taken as an adjustment to income, reducing your AGI. (A tax credit reduces your tax obligation, not your AGI.) A lower AGI, in turn, may offer benefits throughout your tax return. Our office can make sure you use the most effective education benefit on your tax return.