These Tax Credits Can Help Cut the Cost of College

Estimated tax savings: Your lawmakers might give you up to $2,500 in tax-credit cash if you or your child is in college or vocational school and you fixed your income to the right level.

In The Paradox of Choice, Barry Schwartz makes the point that too many choices make people do nothing or become dissatisfied with what they have chosen. Government help with higher education falls into “too many choices” and could make you say “Forget about it.”

Don’t kiss your tax benefits goodbye. This article simplifies the choice paradox by first addressing two of the 11 possibilities for education tax benefits and then taking the complexity out of them.

Once you see the rules simplified and the easy methods for planning your income so that you qualify for the tax benefits, you are going to smile. In fact, you may feel like you defeated those lawmakers who tried to paralyze you with choices.

Let’s get to the meat of the matter: will the government put some tax money in your pocket to help with your or your children’s education? Here’s our step-by-step approach.

Big Picture

To make this easy, we start with a snapshot of the basic rules that apply to the two tax credits discussed in this article. Please take a moment to examine the chart below, and then proceed to the easy explanations and step-by-step approach that follow.

Criteria

American Opportunity Tax Credit (AOTC)

Lifetime Learning Credit

Maximum cash benefit or tax deduction

Up to $2,500 tax credit per student, per year ($1,000 refundable if taxes are zero)
Up to $2,000 credit per year per return

Modified adjusted gross income limit (adjusted gross income for most people)

$180,000 joint;
$90,000 single
$128,000 joint;
$64,000 single

Type of qualifying education

First four years of undergraduate per student
Undergraduate, graduate, and courses to acquire or improve job skills

Number of years you can tap the benefits

Four tax years (includes use of Hope credit)
Unlimited

Type of education program required

Pursuit of an undergraduate degree
Any

Level of enrollment required

At least half-time enrollment
One or more courses

Required payment of qualified education expenses to receive full tax benefit

$4,000 (Credit is 100% of the first $2,000 in expenses, 25% of the next $2,000)
$10,000 (20% credit on up to $10,000 in expenses)

Student felony drug conviction allowed

Who can pay for qualified educational expenses

Anyone
Anyone

Required form

Form 8863
Form 8863

Weird but nice. Any qualified education expenses paid for you, your spouse, or your dependent qualify for the tax credits.1 Note that to qualify for the credit, you don’t personally have to pay the money (more on this later).

How the Money Works

This article discusses two tax credits. To put the credits in perspective, consider this: when you spend money for education that’s not deductible, you have to first earn the money and then pay the taxes.

When you qualify for the tax credits, the government pays you in after-tax dollars. If you are in the 50 percent tax bracket, a $2,500 tax credit is worth $5,000.

You have to smile when you make the government open up its wallet and pay you with a dollar-for-dollar reduction in your taxes. That’s what you get with the two tax credits in the chart.

And if you don’t owe any taxes, the government mails you a check for up to $1,000 of the AOTC per student per year (that’s what refundable means).2 The refundable tax credit is not available to any child to whom the kiddie tax applies.3

On the maximum tax credits, either you earn them or you don’t. You may not carry forward any unused credits to the next tax year.

Happy Days

Here’s a rule that’s hard to believe and that you have to love: you don’t personally have to pay the money to qualify for the tax credits. Here is how you qualify for the credits when a third party pays the money:

Part 1. IRS regulations state that solely for purposes of section 25A, if a third party (someone other than the taxpayer, the taxpayer’s spouse, or a claimed dependent) makes a payment directly to an eligible educational institution to pay for a student’s qualified tuition and related expenses, the law treats the third-party payment as first paid to the student, who in turn pays the qualified tuition and related expenses to the institution.4

Part 2. If the student is your dependent, IRS regulations give you the tax credits for your dependent student’s payment of the qualified tuition and expenses.5

Example. You claim your daughter as a dependent. Grandma pays $20,000 directly to an eligible educational institution to pay for your daughter’s qualified tuition. The rules above treat the $20,000 as paid by you to the institution, and only you can qualify for the tax credits.

Grandma can never qualify for the tax credit money, because your daughter is not her dependent.6

Further, Grandma made a gift to your daughter in the amount of $20,000. That’s no problem for Grandma. The gift tax does not apply to tuition payments made on behalf of another individual directly to a qualifying educational organization, regardless of amount.7 Thus, even though the gift exceeds $14,000, it does not cut into Grandma’s gift tax exemption.

And your daughter also has no problem with the money from Grandma. Gifts do not produce taxable income for the recipient.

Qualified Education Expense

The IRS has varying nuances of what a qualified education expense is, depending on which of the 11 educational tax benefits it applies the term to. For the two credits in this article, qualified education expense includes

tuition required for the enrollment or attendance of a student for courses of instruction at an eligible educational institution and8
fees for books, supplies, and equipment used in a course of study that must be paid to the eligible educational institution for the enrollment or attendance of the student at the institution.9

And remember that you get the tax credit or deduction when you, your spouse, Grandma, or some other third party pays the qualifying tuition and/or expenses. The parent or the student, even Grandma, can borrow the money to pay the tuition and/or expenses. A gift or inheritance can make the money available.

Expenses That Don’t Qualify

Qualified tuition and related expenses do not include the costs of room and board, insurance, medical expenses (including student health fees), transportation, and similar personal, living, or family expenses, regardless of whether or not you must pay the fee to the eligible educational institution for the enrollment or attendance of the student at the institution.10

If the student receives a scholarship or fellowship that she can apply against any of her college expenses, the IRS allows her to choose how to allocate the funds. The choice is important because:

Scholarship funds allocated to qualified educational expenses count as nontaxable income that can reduce the tax credits or the deduction.11
Scholarship funds allocated to non-qualified expenses such as room and board count as earned income by the student.12 The good news here is that the earned income triggers the $6,300 standard deduction, and that helps reduce or eliminate the student’s taxes.13

In the next section, you’ll see how to make these rules work to your advantage.

Shifting Funds to Maximize Your Tax Benefit

Let’s look at an example. Susan and Bill have a daughter, Leanne, who enrolled in an undergraduate studies program at an accredited university. Susan and Bill used various tax strategies to get their taxable income down to $94,000.

The university gave Leanne a $14,000 scholarship for expenses. At her university, tuition is $14,000 and room and board is $11,000. Leanne’s grandfather paid $11,000 to the university to make sure all Leanne’s expenses were covered.

Susan and Bill helped Leanne with the allocations so they could qualify for the maximum $2,500 tax credit. Here are the allocations and results:

Leanne allocates $4,000 of the scholarship to room and board.
Leanne must count the $4,000 as earned income, but she pays no federal taxes, as the $6,300 standard deduction wipes out that $4,000.
Leanne allocates $4,000 of Grandpa’s gift to tuition. Now Susan and Bill have $4,000 in qualified tuition payments that qualify them for the $2,500 tax credit.

·The remaining $10,000 ($14,000 - $4,000) of scholarship money is tax-free.14

·Grandpa’s $11,000 payment is a gift to Leanne, and it’s not taxable to Leanne. She allocates the remaining $7,000 of the gift to room and board.

Note that if all the funds Grandpa paid were allocated to just the nonqualified room and board, Leanne would have made no payments for qualified expenses, and that would have denied the tax credit to her parents, Susan and Bill.

Going into this, Susan and Bill owed approximately $15,000 in taxes. Now they qualify for the AOTC and can use the $2,500 credit. That reduces their tax liability to $12,500.

Leanne will have $4,000 in taxable income from the portion of the scholarship used for nonqualified expenses, but since her taxable income is less than her standard deduction, she will owe no income taxes. It’s a win-win with just that simple allocation.

Form 1098-T

The educational institution will send the student a Form 1098-T, which estimates qualified expenses as well as any reductions from scholarships or grants. You must reduce the qualified educational expenses by tax-free educational assistance and payments, such as15

tax-free scholarships and fellowships under tax code Section 117,
Pell Grants,
VA benefits,
employer-provided educational assistance,
payments from a qualified tuition plan (QTP) (also known as a 529 plan), and
Coverdell Education Savings Account (ESA).

Form 1098-T is the educational institution’s report of payments received and/or amounts billed, depending on its reporting method.16 You may have paid more or less. In completing IRS Form 8863, use the amounts you paid.17

Planning Your Business Income

Lawmakers stick it to you by taking away your education tax credits if you make too much money. They use this stick-it-to-you denial in many tax code sections by taking away deductions and credits or taxing you on otherwise nontaxable income, such as Social Security income.

Whenever the government tries to take away your money, we make it our mission to help you stop it from happening. And that’s the case here.

To get your education tax credits, you need modified adjusted gross income below the thresholds in the table above. Because you are in business, you have strategies available to control your income and qualify for the education credits. For example, consider:

Claiming a large Section 179 expensing deduction. (If lawmakers pass the 2015 extenders tax package and increase the Section 179 deduction from a maximum of $25,000 to $500,000, you will have much to work with. And we do expect lawmakers to pass the higher Section 179 deduction, but nothing is certain.)
Examine your vehicles for a big tax-deductible loss on sale. This can happen regardless of how you deduct your vehicles (actual expenses or IRS mileage rates). For more on this, see Tips for Best Tax Result on Vehicle Disposition.
Sell an ungrouped rental property that has a good-sized suspended loss. For ideas on this, see 4 Tactics That Turn Suspended Passive Losses into Tax Deductions.
Create a defined-benefit retirement plan or some other plan, and make a sizable contribution. For ideas on this, see Choosing the Right Retirement Plan Design if you have no employees. If you have employees, see Retirement Plan Design When You Have Employees.

Failing the Income Test

If you can’t get your income down to the right level, don’t waste the credit. Have your son or daughter claim it if he or she has taxable income. In fact, you might consider hiring your child to create the taxable income needed.

If your son or daughter claims the credit, you may not claim your son or daughter as a dependent. That’s likely no big deal. If you are failing the income test because you have too much income, tax law has likely phased out your student’s personal exemption from your personal tax return, so you were getting no benefit from that exemption anyway.

But let’s be clear. You first want the credit yourself. If that doesn’t work, your child is the next-best choice.

Takeaways

·You get a nice cash bonus when you qualify for education tax credits.
Try to qualify for the largest tax credit.
Remember that you don’t have to pay the money to qualify for the tax credits (e.g., Grandma can pay).
Allocate scholarship funds so that you maximize your tax credits.
If your income is too high for you to qualify for the credits, consider lowering your business income with tax losses, Section 179 deductions, and retirement plan contributions.

1 IRC Section 25A(f).

2 IRC Section 25A(i)(5).

3 Ibid.

4 Reg. Section 1.25A-5(b).

5 Reg. Section 1.25A-5(a).

6 Reg. Section 1.25A-5(b)(3).

7 IRC Section 2503(e); Reg. Sections 25.2503-6(a); 25.2503-6(b).

8 Reg. Section 1.25A-2(d).

9 Reg. Section 1.25A-2(d)(2)(i).

10 IRC Section 25A(f)(1)(C); Reg. Section 1.25A-2(d)(3).

11 Reg. Section 1.25A-5(c)(4), Example (1).

12 Reg. Section 1.25A-5(c)(3).