Article | November 11, 2022 | Authored by KDP LLP
College is a significant investment, whether you’re paying for your own education or a dependent’s. Thankfully, there are tax credits to help defray the costs.
In the United States, there are two specific tax credits for education: The American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC).
Each credit has its own advantages for taxpayers, and there are certain requirements to claim each credit. In this article, we will cover everything you need to know about these two educational tax credits.
First, it’s important to clear up some confusion regarding tax credits and tax deductions. Credits and deductions are two separate things, though they both save you money on taxes.
A tax credit can be used to pay a tax liability. For example, if a taxpayer has a federal tax bill of $5,500 and a tax credit of $2,500, the taxpayer may use the credit to pay $2,500 of the liability. Some tax credits are refundable, meaning that a taxpayer may receive a refund if the tax credit exceeds their tax liability.
A tax deduction on the other hand is an amount deducted from your taxable income. For example, if a taxpayer earned $100,000 and had a deduction of $10,000, then they would owe taxes on the net of $90,000.
Even though each tax credit has its own guidelines and limitations, a taxpayer must meet the following requirements to be eligible for either one:
A taxpayer is not eligible for either of the tax credits if:
The American Opportunity Tax Credit (AOTC) AOTC is available for the first four years of higher education and provides a maximum of $2,500 per student per year.
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 – for a total of $2,500. Qualified expenses include tuition, required enrollment fees, student activity fees, books, and supplies.
To qualify for the American Opportunity Tax Credit (AOTC), the student must:
There are income limitations for the AOTC:
The full AOTC credit is worth $2,500 per student annually. Taxpayers may use it for the first four years of enrollment at an eligible college or vocational school, and it’s partially refundable. If the credit reduces a taxpayer’s tax liability to $0, then the taxpayer may receive a refund of 40% of the remaining credit amount (up to $1,000).
Students who aren’t eligible for the AOTC may still qualify for the Lifetime Learning Credit (LLC). The AOTC helps taxpayers claim a tax credit of up to $2,000 per tax return to cover the costs of college and continuing education for themselves, a spouse or dependent children. This credit is often used to help pay for professional degree courses as well as graduate courses, though you may use it for undergraduate courses too. Unlike the AOTC, a taxpayer may claim the LLC for any number of tax years as long as the qualifications are met.
The amount of the credit is 20% of the first $10,000 of qualified education expenses for a maximum of $2,000 per return. Qualified expenses include tuition, fees, books, supplies and equipment.
To qualify for the Lifetime Learning Credit, the taxpayer must:
Unlike the American Opportunity Tax Credit, the student doesn’t need to pursue a degree to qualify for the LLC. Also, the Lifetime Learning Credit doesn’t have any requirements regarding felony drug convictions.
However, there are income limitations for the LLC:
The LLC provides a maximum credit of $2,000 per tax return no matter how many students qualify for the credit in a single tax year. The credit is not refundable.
The American Opportunity Tax Credit is almost always the better option for undergraduate expenses. It provides the most value dollar-for-dollar, and it’s up to 40 percent refundable. The maximum credit is $2,500 per year.
However, some students don’t qualify for the AOTC. If your situation doesn’t meet the qualifications listed above, take advantage of the LLC. If you qualify for this credit, you may still see significant savings on your tax return.
After 2020, there aren’t any deductions for tuition and fees, which are usually the bulk of educational expenses, but there are other tax savings available.
The student loan interest deduction is a popular tax benefit. It reduces your taxable income according to the interest you paid throughout the year on your student loans. If you paid more than $600 in interest on a student loan, you should receive a 1098-E tax form that displays that amount of student loan interest you can claim on your tax return.
You may deduct up to $2,500 in student loan interest per student, and you don’t need to itemize your deductions to claim it. However, there are other requirements for tax year 2021:
You must also use your student loan for qualified education expenses, which include tuition, fees, books, supplies, transportation, and room and board.
You may also take advantage of an education savings plan. An education savings plan lets the owner open an investment account to save for a beneficiary’s educational expenses. These accounts provide tax benefits, though they aren’t federally tax-deductible. Instead, your earnings grow tax-free, and you won’t owe taxes when you use the funds to pay for the beneficiary’s qualified education expenses.
There are three options available through state or federal plans:
The qualifications and guidelines vary for each plan, so you’ll need to do a bit of research to find the best option for your situation.
If you qualify for a scholarship or fellowship, you may not owe taxes on the amount you receive. However, some scholarships and fellowships are considered taxable income, so check with a CPA for guidance. Usually, these resources are only tax-free if you are a candidate for a degree at an eligible educational institution and you use the scholarship or fellowship to pay qualified education expenses.
Educational expenses can quickly add up, especially when you’re paying for undergraduate or post-graduate programs. With a little planning, you can take advantage of these tax credits and savings to reduce your expenses. While this article provides an overview of tax credits and savings, it is not a substitute for speaking with one of our expert advisors. If you would like to discuss tax credits and savings for education, please contact our office.
Call us at (541) 773-6633 (Oregon), (208) 313-7890 (Idaho) or fill out the form below and we’ll contact you to discuss your specific situation.