Original article written by legacy firm, KDP Advisors (2022)
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Navigating the costs of higher education can be a challenging task. Luckily, the U.S. tax system offers relief through education tax credits, which can significantly reduce your financial burden. These credits, namely the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC), are designed to help students and families offset educational expenses. But which one is right for you? This guide will explain the key differences, eligibility requirements, and how to maximize the benefits of both credits.
What is a Tax Credit?
Before we get into the details of education tax credits, it’s important to understand how tax credits work. A tax credit directly reduces the amount of tax you owe. For instance, if you owe $5,000 in federal taxes and you qualify for a $2,000 tax credit, your tax bill is reduced to $3,000. Some tax credits, like the AOTC, are refundable, meaning if the credit exceeds your tax liability, you could get a portion of it as a refund.
Tax credits differ from deductions, which lower your taxable income instead of directly reducing the taxes you owe. For example, a $10,000 deduction on a $100,000 income reduces your taxable income to $90,000. While both save you money, credits often offer greater financial benefits.
The American Opportunity Tax Credit (AOTC)
The AOTC offers significant savings for students in their first four years of higher education. It provides a maximum credit of $2,500 per student per year. Here’s how it works:
How the AOTC is Calculated:
- 100% of the first $2,000 of qualified education expenses.
- 25% of the next $2,000 of expenses.
Qualified expenses include tuition, fees, and required materials such as books and supplies.
Who Qualifies for the AOTC?
To claim the AOTC, students must meet the following conditions:
- Be pursuing a degree or a recognized education credential.
- Be enrolled at least half-time during one academic period in the tax year.
- Not having completed four years of post-secondary education.
- Have no felony drug convictions at the end of the tax year.
Income Restrictions:
The AOTC is subject to income limits:
- Full Credit: Available to taxpayers with a modified adjusted gross income (MAGI) up to $80,000 ($160,000 for joint filers).
- Reduced Credit: Phases out for MAGI between $80,000 and $90,000 ($160,000–$180,000 for joint filers).
- No Credit: MAGI above $90,000 ($180,000 for joint filers) disqualifies you from the credit.
Additional Benefits:
One notable feature of the AOTC is its partial refundability. If the credit reduces your tax liability to $0, you can receive up to 40% of the remaining credit (maximum $1,000) as a refund.
The Lifetime Learning Credit (LLC)
The LLC is a versatile credit designed for students at any stage of post-secondary education, including graduate school, professional courses, and job skills improvement. Unlike the AOTC, you can claim the LLC for an unlimited number of tax years.
How the LLC is Calculated:
- The credit covers 20% of the first $10,000 of qualified education expenses, with a maximum credit of $2,000 per tax return.
Who Qualifies for the LLC?
The eligibility criteria are broader compared to the AOTC:
- Enrollment in at least one course at an eligible educational institution.
- Courses must help earn a degree, improve job skills, or gain a professional credential.
- No requirement to pursue a degree or enroll half-time.
Income Restrictions:
Similar to the AOTC, the LLC has income limits:
- Full Credit: Available to taxpayers with MAGI up to $59,000 ($118,000 for joint filers).
- Reduced Credit: Phases out for MAGI between $59,000 and $69,000 ($118,000–$138,000 for joint filers).
- No Credit: MAGI above $69,000 ($138,000 for joint filers) disqualifies you from the credit.
Key Differences from the AOTC:
- The LLC applies to multiple years of education, including professional development.
- The LLC is non-refundable, so it only reduces your tax liability and does not offer refunds.
Choosing the Right Education Tax Credit
If you’re deciding between the AOTC and LLC, here are some guidelines:
- Undergraduate Students: The AOTC is usually the better option due to its higher dollar-for-dollar value and partial refundability.
- Graduate Students or Lifelong Learners: If you’ve exhausted the AOTC or don’t meet its eligibility requirements, the LLC is an excellent alternative.
Other Tax Savings for Education
Education tax credits aren’t the only financial relief available. Here are additional options to consider:
Student Loan Interest Deduction
If you’re paying off student loans, you can deduct up to $2,500 in student loan interest each year. This deduction applies to your taxable income and doesn’t require you to itemize deductions. To qualify, your MAGI must be below $85,000 ($170,000 for joint filers).
Education Savings Plans
Education savings accounts, such as 529 plans and Coverdell ESAs, allow you to save for future educational expenses. Contributions grow tax-free, and you won’t owe taxes on withdrawals used for qualified education expenses.
Scholarships and Fellowships
Many scholarships and fellowships aren’t taxable if they’re used for tuition, fees, or other eligible expenses. Be sure to review the terms of your award, as some may count as taxable income.
Maximize Your Savings on Education
Education comes with a hefty price tag, but tax credits and other financial tools can help lighten the load. Whether you’re financing an undergraduate degree or taking professional development courses, options like the AOTC and LLC provide meaningful savings.
Need help navigating your options or filing your tax return? Our team of tax experts is here to guide you every step of the way. Contact us today to learn how we can help you save on educational costs!
Original article written by legacy firm, KDP Advisors (2022)
