- The American Opportunity Tax credit (AOTC) is a dollar-for-dollar reduction on your income tax liability. The credit is for qualified higher education expenses paid for the first four years of college per eligible student on your tax return.
- You receive a maximum annual AOTC of $2,500 per student on your tax return. If the credit brings the tax you owe to zero, you can have up to 40% of any remaining amount of the credit (up to $1,000) refunded.
- To be eligible for the AOTC, the taxpayer (or a dependent) should have received Form 1098-T, Tuition Statement, from an eligible college or university.
You’re a hard-working parent footing the bills to put one child or more through college. Or you’re the college student, independent from your parents, grinding through a job while going to school to finance your higher education. How about a little help with these education expenses, Uncle Sam?
Fortunately, the U.S. government through the IRS places value on higher education and gives families a tax benefit known as the American Opportunity Tax Credit. The AOTC puts money back in your pocket by lowering your tax liability when you file your tax return. Learn how this tax credit works and how you can get money back by supporting the higher education goals of your family.
What is the American Opportunity Tax Credit (AOTC)?
The AOTC can be an enormous help to a family in saving on taxes owed at the end of the tax year. The credit is worth up to $2,500 per eligible student on one tax return.
The amount of the credit is 100% of the first $2,000 of qualified education expenses you paid for each eligible student attending his or her first four years of college. You also get an additional 25% of the next $2,000 of qualified education expenses you paid for that student. That means you get $2,000 plus $500, respectively, for a total credit of $2,500 per student on your taxes owed.
Let’s say the Perez family has two children attending college, Lina who’s a sophomore and Leonard who’s a senior. As long as the parents claim Lina and Leonard as dependents on their tax returns, and can show that they paid up to $12,500 in qualified education expenses for each of their children, they can claim an AOTC of $2,500 for Lina and another $2,500 for Lino. That’s how this tax benefit works, although there are additional IRS requirements listed below.
The Difference Between a “Deduction” and a “Credit”
Both tax deductions and tax credits reduce your taxes owed. A tax deduction reduces your taxable income on which marginal tax rates are applied to figure out how much you owe in taxes. The lower your taxable income, the lower you’ll owe in income taxes.
While tax deductions are valuable, income tax credits are even more valuable. Credits are applied after your income taxes are calculated and reduce your tax liability dollar-for-dollar for that tax year.
Let’s say Mr. and Mrs. Perez owe income taxes of $12,000 for 2019. With their American Opportunity Tax Credits for Lina and Leonard, each worth $2,500, their income taxes are reduced by $5,000, from a $12,000 tax liability down to $7,000 for 2019.
What’s unique about the AOTC is that if the credit brings the tax you owe to zero, you can have up to 40% of any remaining amount of the credit (up to $1,000) refunded to you.
Like most tax deductions and credits, you’ll have to watch out for conditions the Internal Revenue Service requires.
How Do You Qualify for the AOTC?
The AOTC applies strict rules for the student. To be an “eligible student”, the student must be an undergraduate, i.e. attending his or her first four years of higher education. The student can be a dependent you list on your tax return, or even yourself or your spouse. The student must also:
- Be enrolled at an eligible educational institution.
- Be pursuing a degree or other recognized education credential
- Be enrolled at least half time for at least one academic period (semesters, trimesters, quarters, including summer school) beginning in the tax year
- Not have finished the first four years of higher education at the beginning of the tax year
- Not have claimed the AOTC for more than four tax years
- Not have a felony drug conviction at the end of the tax year
2019 AOTC Income Limitations
To claim the full credit of $2,500 per eligible student, your modified adjusted gross income (MAGI) as a Single filer must be $80,000 or less, $160,000 or less for Married Filing Jointly. MAGI for most people is the Adjusted Gross Income on your tax return.
There is also an income phase-out, meaning you receive a reduced amount of the credit if your MAGI is over $80,000 but less than $90,000 (over $160,000 but less than $180,000 for joint filers).
Who cannot claim an education credit? If your MAGI exceeds $90,000 ($180,000 for joint filers), you no longer qualify for the AOTC. You also don’t qualify for the AOTC if someone else, such as your parents, lists you as a dependent on their tax return. Lastly, if your filing status is Married Filing Separately, you get no benefit at all from the AOTC.
AOTC and Qualified College Expenses
For the first four years of college only, the expenses that qualify for the AOTC are:
- Expenses incurred as a condition of enrollment or attendance, such as
- Student-activity fees paid to the institution
- Books, supplies, and equipment that the student needs for a course
Note the “condition of enrollment or attendance” requirement. For example, if your professor recommends that you purchase a textbook but you can still enroll in the class without one, then you cannot include the cost of the textbook in the expenses you claim towards the AOTC.
AOTC vs. Lifetime Learning Credit
The AOTC offers significant advantages over the other popular tax credit, the Lifetime Learning Credit. The AOTC offers a higher credit amount and allows more than one eligible student on the tax return, and has the advantage of accommodating higher income thresholds than the LLC. The AOTC is a refundable credit if your taxes due falls to $0 whereas the Lifetime Learning Credit is not.
However, the AOTC comes with stricter guidelines. It’s only available for the first four years of higher education, and the student must also be enrolled at least half time and pursuing a degree.
As such, if your expenses are toward post-graduate, continuing education or vocational studies, an LLC may be a better choice. Although the maximum credit is $2,000 and only one credit is allowable per tax return, the LLC has fewer restrictions and can be claimed an unlimited number of years.
To help you decide which one is right for you, the IRS provides a comparison between an American Opportunity Tax Credit and a Lifetime Learning Credit.
Education Tax Credits and the 529 Plan
The 529 Plan is a special savings account that offers a number of tax and financial aid benefits. In contrast to expenses applied towards education tax credits, a 529 Plan can cover more than just required tuition, fees and books. 529 plans can also be used for room and board, equipment, computer software, and even internet costs. Note that all withdrawals must go toward a qualified education expense to be tax-free. If not, the amount will incur income tax and a 10% penalty tax.
A good strategy would be to combine a 529 Plan with an AOTC or LLC. Just make sure you apply the appropriate benefit for the expense — either use the expense to claim a tax credit or pay it using a withdrawn amount from a 529 Plan.
For example, you can use funds from your checking account toward tuition and other required purchases to qualify for the LLC. Then you can use a 529 Plan to pay for supplies, internet, room, and board.
Follow the Smart Money with the AOTC
Come tax time, look out for Form 1098-T, Tuition Statement from your student’s college or university. Along the way, keep records of your payments for qualified expenses such as tuition and fees paid directly to the school. Claiming the American Opportunity Tax Credit will be easier with these in hand.
If your Adjusted Gross Income is on the borderline to qualify for the AOTC, seek further income deductions such as increasing your deductible contributions to your IRA or 401k and health savings account (FSA or HSA). You or your student might also qualify for the student loan interest tax deduction if you’re already paying interest on any education-related loans like unsubsidized student loans.
Higher education has never been more expensive, and many families such as yours still see the value in earning a college degree. Seek every opportunity to mazimize your tax savings, such as with the AOTC or the Lifetime Learning Credit. By doing so, you practice being financial savvy that pays off not only while your student is still in college, but for many years to come. Yours would be a very smart family, indeed.