Navigating Education Tax Credits
Each January or February, we all receive various tax documents needed to complete our personal taxes. Some of us receive W-2s. Still others received 1099s or K-1s. But for those lucky individuals who’ve attended some sort of post-secondary school (college, trade school, etc.), you will be presented with a Form 1098-T. This form can be quite the godsend, especially after shelling out thousands of dollars towards the betterment of yourself, your spouse or your children.
But let’s be honest, the biggest question a person asks when they get this form is, “How much more of a refund will I get?” To answer that question, we need to dive a little deeper into the benefits that Uncle Sam has graciously provided us with.
One of the larger changes since the passing of the Tax Cut and Jobs Act (TCJA), is that effective January 1, 2018, the Tuition and Fees Deduction is no longer an option. This was an above-the-line deduction which was available in the event a taxpayer did not meet the eligibility requirements for the education credits, which typically carried a larger tax benefit to the taxpayer.
Starting in 2018, two different education credits are available to a taxpayer who has qualified education expenses. The American Opportunity Credit (AOC) and the Lifetime Learning Credit (LLC). At first glance, it appears they are similar in nature, but upon further scrutiny, the differences are quite vast.
American Opportunity Credit
This is the credit most people hear about and want to take on their tax return. It’s up to $2,500 per student, and potentially $1,000 of it (40%) is refundable. To qualify for this credit, a student must meet the following criteria:
- Is pursuing a program leading to a degree or other recognized education credential
- Must be enrolled at least half-time
- Has not completed the first 4 years of postsecondary education
- Has not already claimed the AOC or Hope Credit 4 times
- Has not been convicted of a felony for possessing or distributing a controlled substance
Lifetime Learning Credit
While this credit is only up to $2,000 per student and none of it is refundable, it is available to a larger range of students. Here are some highlights:
- There is no limit in the number of years you can claim it
- The student does not have to be pursuing a program leading to a degree or education credential
- There is no minimum enrollment – a single class can qualify
As with most credits and deductions, there are income limitations. If your Modified Adjusted Gross Income (MAGI) exceeds certain amounts, you are ineligible to take either credit. The income thresholds are driven by your filing status and which credit you are attempting to take. The chart below shows the income phaseouts for each credit and filing status. If your income is below these amounts, you’re able to take the credit in full. If your income exceeds these amounts, you get nothing.
Married Filing Joint
$160,000 - $180,000
$114,000 - $134,000
Single, Head of Household or Qualifying Widow
$80,000 - $90,000
$57,000 - $67,000
In case you don’t have the Internal Revenue Code memorized, MAGI for this situation is:
+ Adjusted gross income
+ Foreign earned income exclusion
+ Foreign housing exclusion
+ Foreign housing deduction
+ Excluded income by bona fide residents of American Samoa or Puerto Rico
Missing from the above chart is the filing status of Married Filing Separately. This was not a mistake. According to the IRS, if you choose this filing status, you are ineligible to take any education credit.
What’s just as important as receiving the credit, is ensuring you’re reporting the correct qualified expenses. Just because you spent $127 on a jewel-crusted pencil sharpener, doesn’t necessarily mean it counts towards your education credit. The IRS says the following expenses qualify towards your credit:
- Student activity fees that are paid as a condition of enrollment
- Books, supplies and equipment required for a course of study
It’s worth noting that books, supplies and equipment do not have to be purchased at the college bookstore. (Thank you, Amazon). So, while your 1098-T may show the tuition and fees you’ve paid, it does not include the books, lab coats or canvases you bought for your English, Chemistry and Art class. Make sure to factor those expenses in to maximize your credit.
Remember that room and board are not part of the qualified expenses for either credit.
No Double Dipping
As in most cases, the IRS typically frowns on taking advantage of their generosity. The education credits are no exception. You cannot do any of the following:
- Deduct higher education expenses against your income (as a business expense) and also take an education credit on the same qualified expenses
- Claim the AOC and the LLC for the same student in the same tax year
- Claim the credit when the expenses were paid with tax-free assistance such as a grant, scholarship or employer-provided assistance
One of the larger issues you may encounter is if you take distributions from a Qualified Tuition Program (like a 529 plan) or a Coverdell education savings account to pay for qualified expenses. The rules state that you are not permitted to take a tax-free distribution from a QTP or Coverdell and claim an education credit using the same expenses. For example, if Johnny has $5,000 of qualified education expenses and takes a distribution of $5,000 from a 529 plan, but mom and dad also claim the AOC on those same expenses, then a portion of his distribution should be treated as taxable income since mom and dad are already receiving a tax benefit from the education credit. If you receive both a 1098-T and 1099-Q in the same tax year for the same student, expect follow-up questions from your tax professional to see how much, if any, of your distributions are taxable.
Claiming the Credit
The biggest decision to make is who gets to claim the credit. In most cases, the parent receives the largest tax benefit from the credit, so they are the ones who claim it. The IRS says if you claim the child/student as a dependent, you treat any expenses paid by your dependent as if you paid them yourself. So even if Johnny pays for his tuition himself through a 529 plan distribution, but mom and dad claim him, they get to treat the payments he made as if they made it directly and take the credit (sorry, Johnny).
What about the tuition that grandma paid directly to Johnny’s college? Well, mom and dad win again! If a payment is made by a third party (i.e. grandma) directly to an eligible educational institution, the student is treated as receiving the payment from grandma and in turn, paying the tuition themselves. And since Johnny is claimed as a dependent by mom and dad, they get to claim the payment made by grandma as their own and claim the credit.
But what if mom and dad have a MAGI of $275,000? Obviously, they’re phased out of the education credit entirely. If they claim Johnny as a dependent, the only tax benefit they may end up receiving is the new Credit for Other Dependents in the amount of $500 since the personal exemption (and its related tax benefit) have been eliminated as of 1/1/2018. Is there another option? If certain circumstances exist, the credit can be utilized by Johnny himself.
In most cases, college students are broke. The stereotype of Raman noodles is closer to the truth than many realize. Claiming an education credit for those students will prove to be fruitless. Even though a portion of the AOC is refundable, most college-aged students are disqualified from receiving the refundable portion. However, let’s say Johnny works full-time in the summer and has a small investment portfolio that does well each year. If he’s faced with a tax liability, there may be an opportunity to utilize the education credit on his return. But, this would involve mom and dad not claiming Johnny on their return for that tax year.
Just because mom and dad don’t claim him, doesn’t give Johnny the right to claim himself. At the very top of page 1 of the 1040 there is a section that requires you to check a box if, ‘Someone can claim you as a dependent’. Notice how it doesn’t say ‘Someone HAS claimed you as a dependent’. In our scenario, Johnny still meets the criteria for being a Qualifying Child and therefore is a dependent to mom and dad. They simply don’t claim him on their return for that tax year. Because of this, Johnny does not claim himself, yet is allowed to take the educational credit.
In order to maximize the education credits offered by the IRS, a bit of planning is required. Questions need asked and answered. In our example, if Johnny only gets $425 in an education credit, then there’s a bigger advantage for mom and dad to claim him and take the Credit for Other Dependent of $500. However, if mom and dad’s AGI is above $400,000 then they lose out on that credit too, bringing us back to letting Johnny take it. These are the type of situations and scenarios that need to be researched and discussed with your tax professional. At Herbein + Company, we stand ready to assist you through the various complexities of your situation.
For more information, please contact a member of the Herbein tax team, or email us at firstname.lastname@example.org.
Article prepared by William J. Hall.