There are few things that you will need to be aware of in order to max out your education credits. But, before we get started with that, you need to be aware that there have been changes in the tax laws. Starting with 2016, taxpayers will not be allowed to claim the American Opportunity Tax Credit or the Lifetime Learning Credit unless the taxpayer has received a Form 1098-T from the educational institution. So no 1098-T, no education credit.
Most of our clients save for college using a 529 Plan. This type of college savings plan allows you to fund up to the gift limit each year ($14,000 in 2017). These plans also allow you to "front load" up to 5 years of gifting so if you have a windfall of income, you can put more in up front. It's important to understand that the 529 Plan does not give you a deduction for funding the plan. However, subject to a few rules, money coming out, including earnings, is tax free as long as the funds are used for college expenses. In order for 529 Plans to be tax free, the money must be spent on Tuition, Room and Board, Fees and Books and Supplies.
There are basically three different types of education related tax benefits available.
1. American Opportunity Credit (applies to the first four years of undergraduate studies). $4,000 of Tuition and fees expenses can net you $2,500 of credit. This credit phases out starting with incomes of $80,000 for singles and $160,000 for married filers.
2. Lifetime Learning Credit (applies to any year of college), but you have to spend $10,000 to net a $2,000 credit. This credit phases out starting with incomes of $55,000 for singles and $130,000 for married filers.
3. Deduction for Higher Education (applies to any year of college). This deduction expires after 12/31/2016. This credit phases out starting with incomes of $65,000 for singles and $130,000 for married filers.
Since credits are worth more than deductions (credits reduce taxes dollar for dollar), the American Opportunity Credit and Lifetime Learning Credit generally benefit you more than taking a deduction for higher education.
If you find yourself in a situation where you qualify for one of the credits and you also have funded a 529 Plan for your children, then you need to make sure that some of the tuition and fees are paid out of pocket (or a loan). You can't take an education credit on your tax return if the expenses were paid out of your 529 Plan. No double dipping!
Here's an example: In the Freshman year of college, you pay Tuition of $15,000, Room and Board $10,000, and your AGI is $100,000. In this case, the best credit is the American Opportunity Credit. To get the most from the credits (assuming you have enough in your 529 Plan) you should pay for $4,000 of the tuition from your own funds (not the 529 Plan). The rest of the tuition, and all of the room and board can then be paid from the 529 Plan. That way, you get the full benefit of the American Opportunity Credit and the rest of the expenses paid out of the 529 Plan.
One more thing to be concerned with. The IRS sometimes sends out letters because they can't match up the 529 distributions with the 1098-T issued by the university. So, do your best to take the distribution from the 529 Plan in the same year you pay the tuition. For example, don't take the distribution from the 529 Plan in December and then pay the tuition in January. While the IRS may allow this with an explanation, it's a lot easier to avoid IRS problems to begin with by paying the expenses in the same year as the distribution.
As always, this advice is meant to be general in nature and not specific to your situation. If you would like some assistance with your specific situation please feel free to call me.
The above is considered to be general tax information and is not intended to be used as tax advice. If you believe that any of the above applies to you, please consult with a tax professional. See our Legal Statement.