The costs of higher education may be offset with two credits: the American Opportunity tax credit and the Lifetime Learning credit.
The American Opportunity tax credit (previously known as the HOPE Scholarship credit, which was more limited than this new credit) is available for a student’s first four years of postsecondary education. Either the student or the parents may claim the credit. The maximum credit allowed for any year is 100% of the first $2,000 of qualified expenses plus 25% of the second $2,000 of qualified expenses. In other words, the maximum annual credit is $2,500 per student, and the maximum overall credit is $10,000 per student. The credit may be adjusted annually for inflation.
40% of the American Opportunity tax credit may be refundable. This means that if the nonrefundable part of your credit is more than your tax, you can get the excess back as a refund. However, if you are under age 24, see IRS Publication 970 to determine if you can take advantage of the refundable portion of the credit.
To qualify for the American Opportunity tax credit, the student must be carrying at least one-half of the normal workload for the student’s course of study. Individuals convicted of a Federal or state felony offense related to a controlled substance cannot claim the American Opportunity tax credit.
The American Opportunity tax credit:
- Only applies to qualified expenses, including tuition and fees necessary for the enrollment or attendance of you, your spouse, or any of your dependents at a higher education institution. For the American Opportunity tax credit, expenses include books and course materials. However, books and course materials are not included for the Lifetime Learning credit. Expenses do not include sports fees (unless they are part of the degree program), activity fees, insurance expenses, transportation costs, or room and board. You must reduce your qualified expenses by scholarships, grants, and other tax-free educational benefits, but you do not need to reduce your qualified expenses by gifts, bequests, or inheritances. Higher education institutions include accredited postsecondary educational institutions that offer degree programs and are eligible to participate in student financial aid programs, i.e., colleges, community colleges, and many vocational schools.
- Is phased out if you are single with adjusted gross income (AGI) between $80,000 and $90,000 or married filing jointly with AGI between $160,000 and $180,000. Note that phase-out levels for the Lifetime Learning credit are lower, with AGI between $52,000 and $62,000 for 2012 if you are single or AGI between $104,000 and $124,000 for 2012 if you are married filing jointly. These amounts may be adjusted annually for inflation.
- Cannot be claimed if you are married filing separately.
Furthermore, you may elect either the American Opportunity tax credit or the Lifetime Learning credit with respect to one student. In other words, you cannot claim the American Opportunity tax credit if you use the Lifetime Learning credit to offset the expenses for the student’s education expenses. However, if you have more than one student at the same time, you can use the Lifetime Learning credit to offset the expenses for one student and the American Opportunity tax credit to offset the expenses of the other student.
You may claim the American Opportunity tax credit or the Lifetime Learning credit for some educational expenses and use tax-free Coverdell Education Savings Account earnings for educational expenses for which no credit is taken.
You and your wife have AGI of $70,000 and pay the expenses of your two children in college. Your son is ending his first year and starting his second year. Your daughter is starting graduate school in the fall. The tuition for your son for the year is $3,000. Your daughter’s graduate school tuition will be $2,500.
You may claim an American Opportunity tax credit for your son of $2,250 (100% of the first $2,000 plus 25% of the remaining $1,000). You may claim a Lifetime Learning credit of $500 ($2,500 x 20%) for your daughter’s first semester of graduate school. In other words, you can reduce your taxes by $2,750 of the $5,500 you pay in higher education expenses for the year.
If you and your husband/wife have AGI of $120,000, your American Opportunity Tax credit would not be reduced because of the phase-outs, but your Lifetime Learning credit would be reduced to $100 ($500 x ($124,000 - 120,000/$20,000)).
The planning strategies for the American Opportunity tax credit and the Lifetime Learning credit focus on timing your tuition payments so you receive the $10,000 maximum American Opportunity tax credit during your child’s first four years of school. Because most college students start in the fall following graduation from high school, the American Opportunity tax credit is usually available for four of the first five years following graduation. Generally, it is better to claim the American Opportunity tax credit first because the credit is larger ($2,500 compared to $2,000 for the Lifetime Learning credit) and the phase-out levels are higher. However, if tuition payments in the first semester are not at least $4,000, leading to a $2,500 credit, it may be advisable to claim the Lifetime Learning credit for the first semester and claim the American Opportunity tax credit for the second and third years.
For both the American Opportunity tax credit and the Lifetime Learning credit, it may make sense to pay spring semester tuition in the December before the semester begins. For the American Opportunity tax credit, this could bunch two semesters into the high school graduation year.
In the example above, you could claim a $500 Lifetime Learning credit for paying your daughter’s fall graduate school tuition. You could increase the Lifetime Learning credit to $1,000 ($5,000 x 20%) if you pay her spring tuition in December rather than in January.
NOTE: If available, you can use scholarships, Schedule C business education deductions, or Schedule A employee business expenses for amounts over $2,400.
NOTE: The American Opportunity Tax Credit expires on December 31, 2012, unless Congress enacts legislation to extend the credit to future years. The HOPE credit, which is more limited that the American Opportunity Tax Credit, would be available beginning January 1, 2013 in the event legislation is not enacted to extend the American Opportunity Tax Credit.