There are several overlapping education tax benefits and it isn’t immediately obvious which benefit is best. For example, there are three tax deductions for college savings as well as two tax credits and one tax deduction for tuition.
Coordination restrictions prevent taxpayers from double dipping. When eligibility for an education tax benefit is based on qualified education expenses, taxpayers must use separate qualified expenses for each benefit. For example, while a taxpayer can take a tax-free distribution from the student’s college savings plan and claim a tuition tax credit in the same year, the taxpayer cannot use the same expenses to justify both benefits. Likewise, the taxpayer can take a tax-free distribution from several different college savings plans, but the tax-free status cannot be based on the same qualified expenses. If a taxpayer doesn’t have enough expenses to enable all of the education tax benefits, the taxpayer has to choose which benefit has the greatest financial impact.
When comparing the American Opportunity Tax Credit with a tax-free distribution from a 529 college savings plan, the tax credit yields the greatest financial benefit, 100 percent of the first $2,000 in qualified higher education expenses and 25 percent of the second $2,000. This suggests that families should reserve $4,000 in tuition and textbook expenses each year to be paid for with cash or student loans to qualify for the maximum tax credit and then rely on scholarships and 529 plan distributions to pay for the remaining expenses. This is true even when one adds in the impact of each option on eligibility for need-based financial aid.
Taxpayers cannot claim the tuition deduction and a tuition tax credit for the same student in the same year. Only one of the tuition deductions and tax credits can be claimed per student per year. The three tax benefits are mutually exclusive on a per-student basis. Of the three, the American Opportunity Tax Credit is the best because it provides the greatest direct financial benefit (both per dollar of qualified expenses and overall) and has the highest income phaseouts. Students who do not qualify for the American Opportunity Tax Credit will typically derive a greater financial benefit from the Lifetime Learning Tax Credit if they have at least $5,400 in qualified higher education expenses. But, sometimes students will derive a greater indirect financial benefit from the Tuition and Fees Deduction because the reduction in adjusted gross income (AGI) enables the taxpayer to qualify for other tax benefits, increased need-based financial aid or other means-tested federal benefit programs. This is especially true for low-income students who might qualify for the earned income tax credit, the simplified needs test or automatic zero EFC because of the reduction in AGI. (The simplified needs test ignores assets for determining eligibility for need-based financial aid when the family AGI is less than $50,000, among other criteria. Automatic zero EFC makes the student eligible for a full Federal Pell Grant when the family AGI falls below a particular income threshold.)
There are a handful of loopholes in the coordination restrictions. The tax-free interest on a U.S. Savings Bond and the exclusion from income for employer tuition assistance can be used in conjunction with tax-free distributions from 529 college savings plans and Coverdell education savings accounts without restriction.
Although the student loan interest deduction can be claimed at the same time as other education tax deductions or credits, the loan must have been used to pay for qualified education expenses for which no other education tax benefit was claimed. However, in practice this is difficult to enforce, since the deduction is claimed years after the expenses were incurred.
To determine the best mix of education tax benefits, first check eligibility. Compare income with the income phaseouts for each benefit. Also review the definition of qualified higher education expenses. Then, calculate the financial value of each benefit, adjusting for any active income phaseouts. Use each benefit in order of value, from highest to lowest, until all qualified education expenses are “consumed” by the benefits.
To illustrate, consider three students: Alice, Bob and Charlie.
Alice’s family income is low enough that she could qualify for the American Opportunity Tax Credit, the Lifetime Learning Tax Credit or the Tuition and Fees Deduction. After subtracting the Pell Grant, her net tuition and textbook costs are $4,000. She pays for this with a Federal Stafford loan. Her parents could qualify for $2,500 under the American Opportunity Tax Credit, $800 under the Lifetime Learning Tax Credit or a $4,000 exclusion from income under the Tuition and Fees Deduction (worth the equivalent of about a $600 reduction in tax liability). The $4,000 reduction in adjusted gross income (AGI) under the Tuition and Fees Deduction is not enough for her family to qualify for other tax benefits that would increase the financial value of this $4,000 exclusion from income. Her parents’ net tax liability is only about $1,000, not enough to fully offset the American Opportunity Tax Credit. However, the tax credit is 40 percent refundable, so her parents can qualify for $1,000 in the refundable portion of the tax credit in addition to the $1,000 nonrefundable portion, a total of $2,000. That’s $500 less than the $2,500 they would otherwise be eligible for. But since this amount still provides the greatest financial benefit, her family chooses to use the American Opportunity Tax Credit instead of the Lifetime Learning Tax Credit or Tuition and Fees Deduction.
Bob’s family income is low enough that he is also eligible for the three main education tax benefits. Their tax liability is high enough that he could qualify for the full American Opportunity Tax Credit. The main potential limitation is the coordination restrictions, which might limit the amount of the tax credit his parents can claim if they use the prepaid tuition plan all in a single year instead of spreading it out over four years. They need to carve out $4,000 in tuition and textbook expenses each year that are not paid for by the prepaid tuition plan to ensure that they qualify for the maximum $2,500 tax credit. They do not need to rely on the partial refundability because their net tax liability exceeds the full amount of the tax credit. However, they should also consider the Tuition and Fees Deduction because a $4,000 reduction in AGI might enable them to qualify for a more valuable tax credit unrelated to education.
Charlie’s family income is high enough that they are ineligible for the Lifetime Learning Tax Credit and the Tuition and Fees Deduction would be reduced to $2,000. The financial value of the Tuition and Fees Deduction based on their marginal tax rate is 28 percent of $2,000, or $560. The $2,000 reduction in AGI does not yield any threshold effects that would help them qualify for other tax benefits. So, it is best for Charlie’s parents to can claim the American Opportunity Tax Credit. They just need to manage distributions from the 529 college savings plan carefully to ensure that they have enough tuition and textbook expenses paid for with cash or loans to qualify for the maximum $2,500 tax credit. If her family income increases, however, her eligibility for the American Opportunity Tax Credit might begin to be phased out.
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