By: David K. Carboni, Ph.D.,CFPⓇ
After funding your retirement, paying for the kids’ college educations is the number one financial challenge most families face. Luckily, a recently passed tax law has suddenly made college tuition less expensive for millions of Americans. This article focuses on tax breaks available to families as a result this legislation recently passed by the Obama administration. The centerpiece of the tax break for families is the American Opportunity Tax Credit (AOTC) passed as part of the American Recovery and Reinvestment Act of 2009. The AOTC made college more affordable for millions of students and their families in 2009 and 2010. To continue making higher education more affordable for millions of students, President Obama extended the AOTC to years 2011 and 2012 as part of the Tax Relief Unemployment Reauthorization and Job Creation Act of 2010.
As a reminder, a “tax credit” is a dollar for dollar reduction of your tax bill. For most people it’s much more valuable than a “tax deduction” which is simply a reduction in the amount of your income subject to taxation.
The reauthorized law allows families with tuition expenses to obtain a tax credit of up to $2,500 each year for up to four years per student, with up to $1,000 of the credit being refundable. The credit is 100% of the first $2,000 of college expenses, and 25% of the remaining expenses, up to a total credit of $2,500. A “refundable tax credit” means that a family could receive back more than they actually paid in taxes if their college expenses exceeded their total federal income tax bill. For example, if a family otherwise owed $1,500 in federal taxes and was eligible for a $2,500 AOTC, they would get a tax credit against the $1,500 they would have paid in taxes, thereby eliminating their tax bill. In addition, they would receive an additional $1,000 “refund” from the IRS in the form of a “refundable tax credit.”
The AOTC replaces and improves the Hope Credit by increasing the amount of the credit by $700. In addition, unlike the Hope Credit, which allowed students to apply it to the first two years of college, the AOTC applies to the first four years of college. Third and fourth year students receive significantly larger benefits under the AOTC, making it more likely that they will be able to continue their educations. Furthermore, more families are eligible for the AOTC because income limits were expanded compared to the Hope Credit. Families with Adjusted Gross Income below $160,000, and single filers whose AGI is below $80,000 are eligible for the full credit. The credit gradually “phases out” (i.e., is reduced) for families with AGI’s above these levels and cannot be claimed for taxpayers with an AGI greater than $90,000 (greater than $180,000 for joint filers). Likewise, the AOTC covers textbooks, a significant expense for a typical college student, which the Hope Credit failed to cover.
By the way, as a practical matter, the AOTC is claimed by using Form 8863 and attaching it to your main tax return.
For nearly all Americans, completing higher education can be a “ticket to the middle class.” Don’t overlook the opportunity provided by AOTC which can be an important tool to help you and your family complete this journey.