American Opp Tax Credit: Affordable college

The American Opportunity Tax Credit (AOTC) can make college more affordable for many families. This article summarizes the credit and offers planning strategies.

The AOTC allows for a maximum annual credit of $2,500 for qualified education expenses paid per eligible student for the first four years of higher education. The amount of the credit is 100% of the first $2,000 of qualified education expenses paid for each eligible student, and 25% of the next $2,000 of qualified education expenses paid for that student. The credit is partially refundable. If the credit brings the amount of tax to zero, 40% of any remaining credit up to $1,000 is refundable.

Qualifying for the AOTC

Several criteria must be met to qualify for the AOTC:

1. Student eligibility

• The student must be enrolled at least half time in a program leading toward a degree, certificate, or other recognized educational credential for at least one academic period beginning in the tax year.
• They must not have finished the first four years of higher education at the beginning of the tax year.
• They must not have claimed (or someone else has not claimed) the AOTC or the former Hope Credit (for years prior to 2009) for more than four tax years for the student.
• They must not have a felony drug conviction at the end of the tax year.

2. Qualified expenses

• Tuition and fees required for enrollment or attendance.
• Course-related books, supplies, and equipment that are required for the course of study.
• Costs for room and board, transportation, and medical insurance are not qualified expenses for purposes of the AOTC.
• Qualified education expenses can be paid with borrowed funds, such as student loans, credit cards, gifts, or inheritances. Many taxpayers that receive financial aid fail to claim the credit for expenses covered by student loans.
• Qualifying expenses paid with tax free scholarships, federal Pell grants, employer or Veterans’ provided assistance, 529 plans, and Coverdell Education Savings Accounts (ESAs) do not qualify unless the scholarships, grants, or assistance are treated as taxable income.

 3. Income limits

• To claim the full credit, the taxpayers’ modified adjusted gross income (MAGI) must be $80,000 or less [$160,000 or less for married filing jointly (MFJ)].
• The credit is gradually reduced if the taxpayer’s MAGI is between $80,000 and $90,000 ($160,000 and $180,000 for MFJ).
• Taxpayers with MAGI above $90,000 ($180,000 MFJ) are not eligible for the credit.

Filing the forms

The student should receive  Form 1098-T, Tuition Statement, from the eligible education institution they attended. Generally, Form 1098-T is required and provides information needed to determine the amount of qualified expenses paid during the year. Form 8863, Education Credits, must be completed to calculate the credit. Paid preparers are required to fulfill due diligence requirements when they prepare a return containing the AOTC. Due diligence includes asking the taxpayer relevant questions and completing Form 8867, Paid Preparer’s Due Diligence Checklist. Note that if a taxpayers’ AOTC claim has been denied in a prior year, Form 8862, Information to Claim Certain Credits After Disallowance, may need to be completed.

Tax planning with your clients

There are a number of tax planning opportunities for families with college-bound students. When implementing any of these strategies, you must look at the big picture to determine the actual, potential benefit. For example, there may be state tax implications, while including or reducing income may affect need-based education assistance and the Earned Income Credit.

By strategically timing the payment of qualified education expenses, the benefits of the AOTC can be maximized. Taxpayers can bunch expenses into one tax year to take full advantage of the credit. This could be particularly helpful for the first and last of the four years because  these are typically shorter school years. Taxpayers can pre-pay tuition for the next academic period to help them reach the $4,000 threshold needed to claim the full $2,500 credit.

By strategically timing the payment of qualified education expenses, the benefits of the AOTC can be maximized.

Scholarships and grants can reduce the amount of qualified expenses eligible for the AOTC. Taxpayers can apply these funds to non-qualified expenses, such as room and board, if the terms of the scholarship or grant permit this.

Another strategy for tax free scholarships and grants is to include them in gross income. In some cases, the tax on the included income will be significantly less than the credit received for including the income. You must be sure the scholarship or grant you include in income can only be used for qualified education expenses.

Taxpayers near the phase-out threshold may benefit from strategies to reduce their MAGI. Contributions to retirement accounts such as IRAs or 401(k)s, health savings accounts, or other tax-advantaged accounts can lower MAGI, making the client eligible for a larger portion of the AOTC.

Clients with more control over their income, such as business owners, can consider income-shifting strategies. Deferring income or accelerating deductions can help keep MAGI within the eligible range for the AOTC.

If the credit is phased out on the parent return, parents could forgo claiming the student as a dependent to allow the student to claim the education credit. You must keep in mind that the student can only claim the credit if they provide more than half of their own support. Student loans can be considered in determining support.

The AOTC offers substantial benefits for reducing the cost of higher education. By employing strategic tax planning techniques, accounting professionals can help clients maximize the AOTC for their clients. From timing expenses and coordinating with other benefits to managing income, there are numerous ways to maximize  the value of this credit.