Thursday, February 3, 2011

Higher Education Expenses and Your Taxes - Which Choice is Best for Me?

Exciting New Build by Caryl Sumner,
picturing Walsall College (U.K.)

If you, your spouse, or your qualifying child attend an eligible post-secondary school, you could be eligible for up to $2,500 per student in tax savings this year.  There are three main options, with complex questionnaires to determine what you qualify for.  Your tax software will guide you through these questions and generally will pick the best option -- but you need a human to see if state tax makes a difference.

The options for 2010 tax returns are the American Opportunity Tax Credit, the Lifetime Learning Credit, and the Tuition and Fees Deduction.  We'll discuss each of them, and also give an example of how state tax can change which choice will save you the most money.

The American Opportunity Tax Credit

This credit is an expansion of the old Hope Credit, which it replaces for 2010.  It is the most generous of the three options but has the most restrictive requirements.  You claim it by completing IRS Form 8863 and attaching it to your tax return.  On this form, you report your payments for tuition and fees, course-related books, supplies, and equipment needed by a student.  You are not required to buy the books, supplies, or equipment from the school.  You need to be an undergraduate student meeting the following criteria:
  • Attend a post-secondary school that is eligible to participate in a U. S. Department of Education student aid program.
  • Pursue a degree or a training program that prepares students "for gainful employment in a recognized occupation".
  • Be enrolled for at least a half-time course of study, as determined by the school.
  • Have no felony drug convictions.
The American Opportunity Tax Credit can be claimed a maximum of 4 times in a student's lifetime.  If the previous Hope Credit was claimed in past years, that counts towards the 4 time maximum.  The credit is a dollar for dollar reduction in taxes for the first $2,000 in qualifying expenses, and a 25% reduction on the next $2,000 -- making the maximum credit $2,500 on out-of-pocket expenses of $4,000 or more. 

Another unique feature is that 40% of the credit is refundable, meaning you can receive up to $1,000 even if no tax is owed.  The other two options do not allow this.

Payments for room, board, medical (including student health fees billed by the school), transportation, and other personal living expenses do not qualify, even if they are required by the school as a condition of enrollment.

Not only is this credit the largest of the three options, but it also is available at the highest income levels:  phase-out begins at $80,000 of modified adjusted gross income ($160,000 for married taxpayers filing a joint return).

The Lifetime Learning Credit

This credit has the advantage of applying to more people.  It is available for an unlimited number of years.  Graduate school and continuing professional education both qualify.  The student does not have to be working on a degree or other certificate.  Felony drug convictions do not matter for this credit.  You claim it by filing IRS Form 8863 with your tax return.  (This is the same form used for the American Opportunity credit)

It is a 20% credit on the first $10,000 of tuition, fees, and course-related materials purchased from the school as a condition of enrollment -- only.  This makes the maximum credit $2,000.  Phase-out begins at a modified adjusted gross income of $50,000 (or $100,000 for married taxpayers filing a joint return)

The Tuition and Fees Deduction

This is a deduction rather than a credit, and is limited to the first $4,000 of qualifying expenses.  It was slated to end with the 2009 tax year, but was reinstated in the tax law passed December 17, 2010.  Because of this, the IRS is reprogramming its computers to allow for it and you will have to wait until February 14, 2011 to file your 2010 tax return if you want to claim it.

The income phase-out begins at $65,000 ($130,000 for married filing a joint return).  For taxpayers in the 25% tax bracket, this is a better option than the lifetime learning credit.  You claim it by attaching IRS Form 8917 to your tax return.

Where Human Intervention Is Needed On Tax Software for Education Credits/Deductions

Most software will only "optimize" between these options for federal tax.  The credits only help the federal tax anyway, so for them it doesn't matter.  However, there are some states that allow the education deduction, and others that do not.  This means you need to know if your state allows it, and what your state tax bracket is.  If you are in the 15% federal tax bracket and your state bracket is higher than 5%, you will do better with the deduction than with the lifetime learning credit when state tax is also considered, but the computer will tell you to go with the credit.  Be sure to figure it both ways in this case to be sure.  (If you qualify for the American Opportunity credit, go for it and don't worry about this calculation)

If you are not confident doing this, this is one of the reasons you would want to consult with a tax pro and not rely solely on tax software.

If you have questions or comments, I'd love to hear from you -- either in the comment box bleow or through e-mail at if you have a personal question or would like to set up a free 30 minute initial consultation.  I also thank you in advance for sharing this with your friends!

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