The first three methods describe how you can save tax $$ when you contribute your own funds to a college education and at the time you incur these expenses. The last method explains a tax deduction you can benefit from when you repay a loan you took for funding the college education.
1. American Opportunity Tax Credit (a.k.a. AOTC) offers the most generous tax credits for funding undergraduate education. In fact, this credit has been in place since 2009 and was set to expire by the end of 2017. However, the new tax deal reached in the last two weeks made the credit a permanent one. Thank you, Congress! This is indeed great news for parents who like to fund their children’s undergrad education with their own funds. So, let us do a deep dive and see how AOTC works.
First of all, the credit is offered only to those within some pre-defined AGI (Adjusted Gross Income) limits. This is important to note. For example, in the year 2015, a married couple filing taxes jointly are eligible as follows: full credit if AGI is less than $160,000, NO credit if AGI is above $180,000, and partial credit for AGI between $160,000 and $180,000. For single filers, the AGI range is $80,000-$90,000 for 2015.
Secondly, AOTC offers a tax credit, not a tax deduction. That is, indeed, a great incentive from a tax saving perspective. To understand the difference, let us say you have a taxable income of $100,000, 25% marginal tax bracket, and owe $12,000 final tax liability. A tax credit of $5,000 will reduce your final tax liability to $7,000 (reduced from $12,000). On the other hand, a tax deduction of $5,000 will reduce your taxable income to $95,000 and perhaps will reduce your tax liability to $10,750 (a reduction of 25% of $5,000 assuming all else is same). No, I am definitely not trying to perform an actual tax calculation here, but merely trying to show you the difference between a credit and deduction.
Third, this credit is offered per child and not per tax return. This is crucial for families who fund college education for multiple children in the same tax year. In other words, if you have four kids going to undergrad in a particular year, you are eligible up to $10,000 (4 X $2,500) during the year. Isn’t that great?
Fourth, this credit is offered each of the four years of under graduation. So, if your child attends four years of undergrad, you have a potential to save up to $10,000 towards the funding for that child.
Fifth, the maximum of $2,500 per child per year is calculated as follows: 100% of the first $2,000 qualified expenses + 25% of the next $2,000 qualified expenses. In other words, to get the maximum, you need to have at least $4,000 qualified expenses.
Finally, no you cannot combine this credit with the benefit 529 plans offer. No double-dipping please. In other words, if your qualified expenses for a child in a year are $10,000, you may use $6,000 of 529 distribution + $4,000 of your other funds to get the AOTC credit. You WILL NOT be able to use $10,000 from your 529 distribution and also claim AOTC credit.
2. Lifetime learning credits offer next best tax reprieve if you are funding college education with your own funds. Here is how Lifetime learning credit compares itself with AOTC:
First, the notable difference between Lifetime learning and AOTC is that while AOTC is limited to undergrad four years, lifetime learning benefit has no number of years limitation and could be used for education other than undergrad. i.e. for graduation or other lifetime learning. Once again, detailed rules in IRS Publication 970.
Secondly, just like AOTC, lifetime learning offers tax credit as opposed to a tax deduction. Remember, credits reduce your tax liability dollar-for-dollar.
Third, just like AOTC, has AGI limits. However, these limits are lower than for AOTC. For example, in 2015, these limits are: for married filing jointly $110,000-$130,000 and single filers $55,000-$65,000.
Fourth, lifetime learning credit is per tax return and not per student. The maximum qualified expenses per year are $10,000, and you can claim a credit of 20% of that. In other words, you can take a maximum of $2,000 per tax return in lifetime learning credit irrespective of the number of students in the household that used lifetime learning during the year.
Lastly, just like AOTC, you cannot combine this with the distribution amounts of 529 funds.
3. Tuition and Fees deduction is used in situations when you cannot use AOTC or lifetime learning credits. That said, this deduction is offered as an adjustment to your income, thus reducing your taxable income even when you do not itemize. So, let us see how this compares with the previous two credit offers.
First, this is a tax deduction as opposed to a tax credit. So, as explained in the AOTC section, your final tax savings is your tax bracket % of how much you deducted. Not a dollar-for-dollar as offered in AOTC or lifetime credits.
Secondly, maximum deduction amount is $4,000 per year per tax return.
Third, just like the credits, has AGI limits. For example, in 2015, if you are married filing jointly and modified AGI is over $160,000, you cannot take a deduction. Similarly, single filers above MAGI of $80,000 cannot take this deduction.
Fourth, if you are tax filing under married filing separately or if someone else can claim you as a dependent on their return, you WILL NOT be able to take this deduction.
Lastly, just like other credits, you cannot combine this with the distribution amounts of 529 funds.
4. Student Loan Interest deduction is offered when you are paying back a loan you have taken for financing your education. Similar to Tuition and Fees deduction, this deduction is offered as an adjustment to your income, thus reducing your taxable income even when you do not itemize. That said, let us see how this works.
First, this is a tax deduction as opposed to a tax credit. In other words, it is not a dollar-for-dollar as offered in AOTC or lifetime credits.
Secondly, maximum deduction amount is $2,500 per year per tax return.
Third, just like the credits, has AGI limits. For example, in 2015, if you are married filing jointly and modified AGI is over $160,000, you cannot take this deduction. Similarly, single filers above MAGI of $80,000 cannot take this deduction.
Finally, nope – You cannot take this from a family member or related members. IRS Publication 970 provides all the fine print.
If you are married filing jointly and making an AGI of more than $180,000 in the year 2015, you will not be able to benefit with any of these choices.
On the other hand, if you are within the stipulated AGI limits, and funding either your own or your dependent’s college education, perhaps you are eligible for some tax reprieve.
So, what do you think? Do you have college going children and feel the pain of high costs? Looking ways to cut costs? Make sure you analyze carefully and save as much as you can. If you need additional help or guidance, please feel free to Schedule an appointment with me. I will be more than glad to advise.
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