With the tax season upon us, many families are gathering and organizing their tax information.  What is often overlooked are the dollars that can be saved by the various education tax credits.  This article is a guide to the educational tax credits which can you save money.  We often refer to them as tax scholarships since it is free money.

A tax credit is much more valuable than a tax deduction.  Tax credits are a dollar-for-dollar reduction of a person’s actual tax amount due.  A tax deduction is a reduction of a person’s income before that tax percent is applied.

This guide to the educational tax credits is focusing on paying for college tax incentives.  This includes the American Opportunity Credit, Lifetime Learning Credit, and proper use of 529 Plans.  There are other tax deductions related to student loan interest that are described in other PayForED articles.

Each year, I write an article on year-end planning for college funding.  That article identifies the steps you should take in planning to maximize these tax incentives before the end of the year.  This can be a good reference point along with IRS Publication 970 to explain the steps needed to receive these education tax items.

Qualified Educational Expenses

To determine if you are eligible for any of the educational tax credits you need to understand the term of qualified expenses.  This could be different depending on the tax credit that you are considering or eligible for.  One important fact is you cannot reuse the same qualified expenses for multiple tax credits.

As an example, a student has tuition fees of $4,000 and it is paid with 529 money.  The same $4,000 of tuition expense could not be reused for the American Opportunity Credit since it was already used for the 529 tax advantage.

Below is the list of qualified expenses and what is allowed by each tax credit.

Educational Tax Credit Chart

Educational institutions are required to issue each student’s qualified expense information on a Form 1098T.  These are often inaccurate since they do not include all the qualified expenses.  It is important to review that form to confirm the direct expenses paid to the institution are correct.  This would include tuition, fees, room, and board if paid to the institution.  Items often not include are books, off-campus living, and off-campus board.

American Opportunity Credit (AOC)

The American Opportunity was originally called the Hope Credit.  It was a temporary education tax credit that was renewed for years starting in 2009.  It was made permanent in 2015 under the PATH Act.  In addition to the qualified expense and income limits, it has a few other rules for a person to qualify.;

• Must be enrolled in a recognized education program
• Need to have a registered social security number
• Be enrolled in an academic period at least half time within the tax year
• Not have finished the first four years on higher education
• Not claimed the tax credit more than four times
• Not have a felony drug conviction at the end of the year

An important difference between this and the lifetime learning credit is that this credit is per student.  Another advantage is that student loans used to pay for the required qualified expenses count toward the credit.

This $2,500 educational tax credit has two specific parts of the calculation.  The first part of the credit is calculated by taking 100% of the first $2,000 of qualified expenses.  The next $2,000 of qualified expenses are calculated at 25%.  These two numbers add up to the total of $4,000 of qualified expenses needed to maximize the $2,500 credit.

There is another benefit that only the American Opportunity Credit offers.  As a tax credit, it is a direct offset of the actual tax due.  If the credit exceeds the tax due a person could get up to $1,000 as a refund depending on the remaining credit amount.

Lifetime Learning Credit (LLC)

The Lifetime Learning Credit is less attractive than the American Opportunity Credit.  The typical process would be to use the American Opportunity Credit first.  It is still a tax credit but is normally used when an undergraduate has exceeded the four-year rule or used for graduate school.

The Lifetime Learning Credit has some other differences:

• It is a household credit vs a per student credit
• If you receive the AOC you cannot qualify for the Lifetime Learning Credit
• LLC is a $2,000 tax credit and requires $10,000 of qualified expenses to maximize the credit

The credit calculation is also a little different.  LLC is prorated at 20% of the qualified expense amount.  There is also no refund available.  It can only offset an actual tax amount.

Proper 529 Plan Distribution 

Even though 529 plans are not a tax credit, many times they impact a family’s ability to maximize these tax credits or tax scholarships.  The biggest mistake is the improper use of qualified expenses.  Using the chart above you can see that qualified expenses for 529 plans include room and board.  As more students start to live off-campus proper payment strategies need to be considered.  This would also need to include a proper student debt structure.

Most people do not realize that 529 plan money can be used for off-campus living expenses.  It needs to be within the college’s off-campus cost of attendance guidelines and be documented.  The error here is the family uses the 529 money to pay for tuition and fees and cash to pay for the off-campus living resulting in a limited amount of qualified expenses for the educational credits.

Other Tax Incentives Strategies

There are more advanced educational tax strategies available to families.  These advanced strategies are a combination of other tax rules in combination with the educational tax credits.  In most cases, these will help the business owners and people with larger taxable investment portfolios.

For this reason, we call them tax scholarships since it is free money.  They can be worth thousands of dollars a year if utilized correctly. The financial advisors with the College Funding and Student Loan Advisor (CFSLA) designation have the expertise to implement these strategies.  They are listed on the PayForED website.

Educational Tax Credit Summary

As college costs continue to rise, finding alternative ways to save money is critical.  College expenses are paid with after-tax dollars.  Families need to look beyond the financial aid and the traditional scholarship search process to lower their college costs.  Education is an investment and we need to find all the resources we need to improve the outcomes.  By properly using these educational tax credit savings, families and students are lowering their student loan borrowing needs resulting in a better financial future.