Tuesday, October 8, 2019

The $10,000 Question for Students and Parents

The American Opportunity Credit is worth up to $10,000 over four years of undergraduate schooling. Getting this right is a HUGE deal...like $10,000 huge. So read on!

In many cases, where students or parents are paying for school, or using student loans for expenses, the credit is straightforward and the choices limited. I'll briefly discuss the one main choice in this area, but the real purpose of this article is about students getting scholarships, or using 529 plan assets to pay for school. Their choices can be more complicated, and the dollar amounts lost due to mistakes are staggering.

First, let's talk about the easy scenario. If you pay all or most of your tuition, books and course related fees out of pocket or with loans, and you meet the other qualifications discussed later, your only real decision is which years to use the credit. You see, you can take the credit a maximum of 4 tax years, but most students will spend 5 or more tax years in school (because they start in the fall of one year and finish in spring of the fifth tax year, even when only in school 4 years). If expenses are extremely low in the first year, it might make sense to wait and take the credit in the second year to maximize benefits. This is kinda like playing tax-chicken - waiting to swerve until the last second hoping you spend more time in school and pay more for it in later years. It's not easy. I generally advise taking it at the earliest opportunity unless the dollar amounts are VERY low, or the undergraduate experience will be long - such as several years of Community College before going full bore into a bachelor's degree.

Now let's talk about the 2nd scenario - scholarships or college savings plan (529 or other tax deferred education account - names vary by state) plan money: Obviously, if you can get college paid for with your college savings plan or a scholarship you should just do it and not be out of pocket for any money, right? Sure, you don't get an education credit on your taxes, but your college is paid for, so, Even-Steven, right?

Not so fast. The American Opportunity Credit (I'll use AOTC from now on) gets you $2,500 for the first $4,000 of qualified education expenses. That's a 62.5% return on your money. To make things even more crazy, the first $2,000 of expenses come back DOLLAR for DOLLAR! Spend $2,000, get $2,000 - that's a 100% return! So the first $2,000 is MAGIC, but the next $2,000 ain't bad either.

I'm going to refer to all tax advantaged college savings plans as 529's from now on.

For 529 plans, it's easy: if you meet the requirements for the AOTC summarized at the end of this article, there will rarely be a situation where you don't win by paying $4,000 out of pocket and NOT using the 529 plan for that portion of education expenses. Run the numbers both ways before deciding, just to make sure (a tax pro might be useful). Unless you are in a very high tax bracket (in which case you probably don't meet the income limits for the AOTC anyway) the tax credit will exceed the tax benefits you get from using 529 plan money. Keep in mind, even though you are paying for college out of pocket instead of using 529 plan money which you had already saved, the 529 plan money is STILL THERE. It's still yours. You can use it for later years of school, transfer it to another student, roll it over into a Roth IRA (new for 2023) or just take it out and pay the penalties and taxes. These taxes will ALWAYS be less than the maximum AOTC on $4,000 - a LOT less, since you only pay taxes and penalties on 529 plan EARNINGS, not the whole amount.

For scholarships and Pell Grants, which are generally tax free, you can include some or all of them as the recipient's income in order to allow the AOTC to be taken. Just add it to your wages line on your Form 1040 with "SCH" on the line in front of it (you have to figure out how to make your software do this). Generally, $4,000 of scholarships claimed as taxable income, meaning it was used for "living expenses" instead of tuition, will have less taxes on it than the $2,500 in AOTC that you get.

Over 4 years, this can make you $10,000 that you wouldn't otherwise have had. It is well worth working with a professional to make sure you do it right if you aren't certain. The IRS is pretty anal about the AOTC, but that's no reason not to take it.

Here are a few more things to consider:

This article has nothing to do with VA or other military education benefits. If you get them, you almost never get the AOTC, except maybe on books.

The simplified formula for determining how much expenses you get AOTC for is tuition  PLUS course related books and fees MINUS tax free scholarships and grants MINUS 529 type funds used. This amount, up to $4,000, gets you the credit. We are manipulating the 529 plan amount, and changing tax-free scholarships and grants  to make them taxable, to change the final number to maximize education credits.

Make sure you include the income and credits on the right tax return: parent or student. Mostly, the 529 plan and taxable scholarship money will be on the student's return, and the credit will be on the parent's. Unless a student is over the age of 24, or has job income that equals more than half their support, or is fully emancipated, the AOTC will be far better on the parent's return (and may not be allowed on the student's). If there is a choice, do the returns side by side to make sure. If you still aren't sure, talk to a pro.

If either the student or the parent is getting the Earned Income Tax Credit for having a low income and children, the inclusion of scholarship money as income can have a bigger negative effect. Run the numbers, using no AOTC, $2,000 for AOTC and $4,000 for AOTC to see which is better, and then act accordingly.

Some of these tricks can be applied to using retirement account or U.S. Savings Bond money as well. You are aloowed to use the education expense exception to paying a penalty on an early IRA distribution and still use that money for getting the AOTC.

Here are the simplified requirements for the AOTC (don't rely on them for final decisions, these are just here to let you know if this entire article might be useless to you):

For 2021 tax year, if you file Married Filing Jointly, your AOTC is limited if your AGI (basically income before most deductions) hits $160,000 and is gone at $180,000. Other filing statuses the numbers are $80,000 to $90,000.

The student must be going at least half time
The student can't have been convicted of a felony drug offense
You get AOTC a maximum of 4 tax years per student

The AOTC is for undergraduate work, so you can't have completed a 4 year degree (you can get AOTC for graduate work you do in the same year you finish your bachelor's degree - TAX SAVING SECRET)

Must be attending an eligible education institution for an eligible degree or certificate (most 2 or 4 year schools will qualify, others, double check yourself.)

For more great information designed for College Students, Check out The Short Cheap Tax Book for Students

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