If you have a child attending a college or university this fall, you may be eligible for a tax credit called the American Opportunity Tax Credit (AOTC). Below are some of the key facts to know so that you are paying expenses with the right dollars to get as much of a tax credit as possible.
The AOTC is a tax credit offered for qualified education expenses for students in the first four years of higher education. This credit could save a qualifying household as much as $2,500 in taxes. Here’s how it works: 100 percent of the first $2,000 you spend on education expenses (such as tuition, books, school supplies, etc.) and 25 percent of the next $2,000 of education expenses can translate to tax credit. The following expenses would not qualify as education expenses: room and board, insurance, medical expenses and transportation. The student must be pursuing a degree or other recognized education credential and enrolled at least half time for at least one period (semester, quarter, etc) in that tax year.
It is important to note that to claim the full credit, your modified adjusted gross income (MAGI) must be $80,000 or less ($160,000 or less if married filing jointly). A reduced credit can be claimed if your MAGI is between $80,000 and $90,000 ($160,000 and $180,000 if filing jointly). No credit may be claimed if MAGI is over $90,000 ($180,000 if filing jointly). Another important issue is that the credit cannot be claimed if all the qualified education expenses were paid for with a 529 account. If you have enough funds in your 529 account to pay the entire bill, you will still need to pay $4,000 of the expenses directly (with non-529 money) in order to receive the maximum credit.
Consider two families with college students, the Smith’s and the Johnson’s. Joe Smith’s parents spend $7,500 on qualified education expenses while Mary Johnson’s parents spend $2,500. In these scenarios, they both meet the requirements set forth by the IRS for the AOTC. Joe’s parents can claim the maximum credit of $2,500 because $7,500 exceeds $4,000, reducing their tax liability by $2,500. On the other hand, Mary’s parents can claim a tax credit of $2,125 (100% x $2,000 + 25% x $500) on their tax returns and have their tax bill reduced by $2,125.
As you can see from the example, if you will qualify for the tax credit, it is important to make sure you are using the correct strategy to maximize the tax credit. This is an important step in an education plan and something we review with all of our clients with children in college.
Other key facts:
- The AOTC is refundable. A tax credit is a dollar for dollar offset of your income tax liability. The refundable portion allows you to get money back from the IRS even if you don’t owe any taxes. This tax credit allows 40 percent of the credit to be refundable after your tax liabilities have been met.
- You will need a Form 1098-T Tuition Statement from your child’s school. Then you must complete the IRS’s Form 8863 and attach the completed form to your Form 1040
- The MAGI (from the third paragraph) is calculated by using your AGI from your 1040 and adding foreign earned income exclusion, foreign housing exclusion, foreign housing deduction, exclusion of income by bona fide residents of American Samoa or Puerto Rico. There is a worksheet in IRS Publication 970 to help as well.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.