In my last article, I focused on the IRS rules related to distributions from Qualified Tuition Programs (such as 529 and prepaid tuition accounts), so this article will address two of the best tax breaks available to most families who are currently paying college costs—the American Opportunity credit and the Lifetime Learning credit. More importantly, I’ll discuss the importance of coordinating your college savings distributions with these credits to maximize the tax benefits each year.
As a CPA, nothing is more frustrating than seeing people miss out on legitimate tax breaks due to poor planning or advice. Here’s a scenario that actually happened to some friends of mine (the names have been changed to protect the unfortunate):
Jim and Sue have two children pursuing their undergraduate degrees at State University and both children are claimed as dependents on their tax return. When the kids were much younger, Jim and Sue diligently saved for their education by opening and annually funding two 529 accounts. In December, Jim and Sue talk to their investment manager about withdrawing funds from the 529 plan, and the investment manager withdraws the maximum amount of funds allowable for the year based on their qualified expenses. Unfortunately, by covering all qualified expenses with 529 plan distributions, Jim and Sue missed out on $5,000 of tax savings (assuming their Adjusted Gross Income is below the phase out limits) because they would have qualified for the American Opportunity credit on each child. Alternatively, if Jim and Sue had paid for $8,000 of tuition for the year ($4,000 per child) out-of-pocket rather than with 529 distributions, they would have received $5,000 of that cost back in tax credits ($2,500 per student). To make matters worse, since the American Opportunity credit is only available for the first four years of undergraduate schooling, those credits are lost forever. It’s like asking Jim and Sue to write an extra $5,000 check to the IRS for taxes they don’t owe.
Here’s the key to maximizing your tax credits in a calendar year when you’re also paying for college expenses with Qualified Tuition Program (QTP) distributions: Pay for some of the tuition with out-of-pocket money first to maximize your tax credit, and then pay for the rest of the qualified expenses with QTP distributions. Why pay the tuition out-of-pocket versus some other college related cost? Because tuition counts toward the tax credit, unlike some of the other qualified expenses (room and board, etc.) that can be paid for with QTP funds but can’t be considered when calculating the credit. Here’s an example of how this works:
Harvey’s daughter is a sophomore at State University and he claims her as a dependent on his tax return. Based on Harvey’s income level, he will able to claim the American Opportunity credit on qualified education expenses he pays that year. Harvey has $50,000 in a 529 plan and he would like to use as much of those funds as possible this year without limiting his potential tax credit. His daughter’s expenses for the calendar year are $12,000 for tuition and $10,000 for room & board ($22,000 total). Harvey should maximize his use of 529 funds and his tax credit by only withdrawing $18,000 from the 529 plan to pay for the total cost of room and board, but only $8,000 of tuition in this case. By paying for the other $4,000 of tuition with out-of-pocket funds, he will be able to recover $2,500 of that cost as a credit on his tax return. So, it turns out that by paying $1,500 of tuition without using QTP funds ($4,000 paid, less the $2,500 tax credit received), Henry has effectively added another $2,500 of Uncle Sam’s money to his daughter’s 529 plan balance for use in a future year.
If you aren’t familiar with the characteristics and rules for two of the most popular tax credits available, I’ve included some of the highlights below.
NOTE: Both of the tax credits discussed below are addressed extensively in IRS publication 970, and the instructions for IRS form 8863. The information presented in this article does not address specific circumstances, such as coordination with scholarships, rules for claiming dependents, etc. Make sure to discuss your specific circumstances with a knowledgeable financial advisor or CPA.
American Opportunity Credit – This is the most generous education credit for those who qualify to claim it. Here are some of the guidelines:
- Up to $2,500 credit per student per year on up to $4,000 of qualified out-of-pocket expenses (100% on the first $2,000 and then 25% on the next $2,000)
- Qualified Student
- Student is a dependent claimed on your tax return
- Student is enrolled at least half time in a program leading toward an undergraduate degree or recognized education credential
- Student has not completed the first 4 years of post-secondary education at the beginning of the calendar year
- Taxpayer is not claiming another tax credit or tuition and fees deduction on their tax return
- Qualified Expenses
- Tuition and required fees
- Required course materials
- Does not include expenses paid for with tax advantaged funds (college savings plans, scholarships, etc.)
- Other Important Information
- Tax credit is reduced or eliminated if your Adjusted Gross Income (AGI) is above certain amounts (for 2020 the phase out begins at $160,000 for married couples and $80,000 for single filers)
- 40% of the credit (up to $1,000) is refundable, which means you can still get some of the credit even if you don’t have other taxable income to offset
Lifetime Learning Credit – While not as generous as the American Opportunity Credit, this credit is available under an expanded set of circumstances. Here are some guidelines:
- 20% credit on up to $10,000 of qualified out-of-pocket expenses per tax return per year ($2,000 maximum credit)
- Qualified Student
- Student is a dependent claimed on your tax return
- Student does not have to be pursuing a degree
- Student does not have to be enrolled half time or more
- Taxpayer is not claiming another tax credit or tuition and fees deduction on the tax return
- Qualified Expenses
- Tuition and required fees. These apply to courses that help you acquire or improve job skills, as well as to graduate school
- Required course materials purchased from the institution
- Does not include expenses paid for with tax advantaged funds (college savings plans, scholarships, etc.)
- Other Important Information
- Available for an unlimited number of years
- Tax credit is reduced or eliminated if your Adjusted Gross Income (AGI) is above certain amounts (for 2020 the phase out begins at $118,000 for married couples and $59,000 for single filers)
Key takeaway: With a little extra planning and record keeping, you might qualify for thousands of dollars in education tax credits, even when you have distributions from a Qualified Tuition Plan during the same calendar year.
Paul Hansen, CPA, CFP®
