My oldest child is a freshman in the Business School at the University of Illinois at Champaign/Urbana. Many people have congratulated us, not because it is difficult to get in (it is difficult) but because they assume that it must not cost much for an Illinois resident to attend an in-state university.

The U of I estimates that if you are an Illinois resident, the total cost for a year of college for an undergraduate student enrolling in the fall of 2009 is $25,654 (tuition, housing, books, supplies and other expenses).  Of course, if you are lucky enough to get into the College of Business or Engineering, the tuition is $4,318 higher.  This brings my son’s “estimated” costs to $29,972.  For non-Illinois resident, U of I estimates the costs to be $44,114.

My son was also accepted at the University of Michigan but chose not to go there, for his own reasons (non-financial). U of M estimates that the cost for a Michigan resident to attend U of M is $23,721 and for a non-resident, $46,999 (perhaps an ex-auto industry executive does their pricing for non-residents).

Over the years, the Federal government has enacted tax laws to encourage the pursuit of higher education.  Some benefits are credits (dollar for dollar reduction of tax) and some are merely deductions (reduction of income).  While this article focuses primarily on credits it is hard to know whether to take a credit unless you also know that you may have the option of instead taking a deduction.  Accordingly, certain key issues relating to education related deductions are mentioned toward the end of the article.

There are two Federal Income Tax Credits, the American Opportunity Credit (formerly known as the Hope Credit) and the Lifetime Learning Credit. Taxpayers are allowed to take either the American Opportunity Credit or the Lifetime Learning Credit in a particular tax year, but not both.

 

American Opportunity Credit:

The Hope Credit applied to 2008 and prior tax years.  The American Opportunity Credit (“AOC”), enacted as part of the American Recovery and Reinvestment Act of 2009 is available for expenses paid in 2009 and 2010.

 

How Much:

A taxpayer can get an AOC for each student.  For this purpose, the student can be you, your spouse or a person who is validly claimed as a dependent on your Federal Income Tax Return.  This means that a taxpayer can claim an AOC where they, their spouse or their dependent is the student.  The rules for who qualifies as a dependent are beyond the scope of this discussion, but they are tricky.  The AOC is limited to the lower of the following:

1)  The amount of the Qualified Education Expenses (“QEE”); or

2)  $2,500 per student (100% of the first $2,000 and 25% of the next $2,000); or

3)  The amount left after applying the Phase Out Rules.

 

QEE:

Expenses are QEE’s to the extent that they satisfy all of the following:

  1. Paid for the first 4 years of higher education (however, it ends in 2010 so there would be only 2 years of benefits regardless of whether the student was a freshman, sophomore or junior in 2009). Expenses paid for graduate and post- graduate school do not qualify.
  2. Paid to a qualified educational institution.
  3. Paid for tuition (which must be paid directly to the school)
  4. Paid for course-related books, supplies, and other necessary items (whether or not paid directly to the school).
  5. Paid for an eligible student, which means:
  • Never convicted of a felony for a controlled substance (apparently they want to discourage students from becoming drug dealers); and
  • The student must be enrolled in each semester for at least half of the number of credits that a full time student would be taking at that school.

Student housing expenses do not qualify as QEE’s, even if paid directly to the school. C.  Phase-Out:

The AOC gets Phased-Out for “wealthy” taxpayers.  That is, if your Modified Adjusted Gross Income (“MAGI”) exceeds a certain level for a particular tax year then you may not be able to get the full AOC.  If you are married, the AOC gets phased out between MAGI of $160,000 and $180,000.  If you are single, the AOC gets phased out between MAGI of $80,000 and $90,000.

Examples:

Example 1:  A Single taxpayer has MAGI of $90,000 or higher.  The entire AOC is phased-out and no credit is available.  (Same results for a Married taxpayer with MAGI of $180,000 or higher.)

Example 2:  A Single taxpayer’s QEE is $3,000 and has MAGI of $70,000.  The credit is $2,250.  The taxpayer gets 100% of the first $2,000 of QEE plus 25% of the next $1,000.

Example 3:  A Single taxpayer’s QEE is $3,000 and has MAGI of $83,000.  The credit is $1,575.  The taxpayer gets 100% of the first $2,000 of QEE plus 25% of the next $1,000.  However, $675 is phased-out. ($83,000 – $80,000 = $3,000.  $3,000/$10,000 = 30% Phased-Out.  100% possible credit – 30% Phased-Out = 70% Credit allowed. $2,250 x 70% = $1,575)

Example 4:  A Married taxpayers’ QEE is $19,000 and has MAGI of $170,000.  The Credit is $1,250.  ($170,000 – $160,000 = $10,000.  $10,000/$20,000 = 50% Phased- Out.  100% possible credit – 50% Phased-Out = 50% Credit allowed.  $2,500 x 50% = $1,250)

Claiming The Credit:

The person claiming the AOC must file a Federal Income Tax Return and attach IRS Form 8863.  These credits are dollar for dollar reductions of the actual income tax. Further, 40% of AOC is “refundable”, meaning you can get a refund for the first 40% of the AOC even if you never paid in any tax during the year.

Lifetime Learning Credit

The Lifetime Learning Credit (“LLC”) has been around for many years.

How Much:The LLC is limited to the lower of the following:

  1. The amount of the Qualified Education Expenses (“LLC-QEE”); or
  2. 20% of the first $10,000 of LLC-QEE ($2,000 per taxpayer, maximum, regardless of how many students); or
  3. The amount left after applying the Phase-Out Rules.

Please note that if the educational institution is located in a Midwestern Disaster Area the LLC might qualify to be calculated based upon 40% of the first $10,000 of LLC-QEE (rather than 20%).

 

LLC-QEE:

The definition of LLC-QEE is different than for the AOC and easier to satisfy.  Expenses are LLC-QEE’s to the extent that they satisfy all of the following:

  1. Paid for higher education (i.e. trade-school, undergraduate, graduate, post- graduate).
  2. Paid to a qualified educational institution.
  3. Paid for tuition, course-related books, supplies, and other necessary items that are paid directly to the school.
  4. Paid for an eligible student, which means the student must be enrolled in at least 1 college course.

Please note that the LLC-QEE definition is more liberal than that of the QEE for the AOC.  For example:

  • The LLC-QEE includes costs for trade-schools, graduate and post-graduate costs while the AOC is limited to the first 4 years of higher education.
  • A student can be eligible for the LLC-QEE even if they are taking only 1 course while the AOC is limited to those who are taking courses at least equal to a half- time student course load.
  • There is no limit to the number of years that a student’s costs can be eligible for the LLC while the AOC is limited to costs incurred in 2009 and 2010.

Phase-Out:

Like the AOC, the LLC gets Phased-Out for “wealthy” taxpayers, but at lower MAGI levels.  Because of this, some people who get Phased-Out of the LLC might still be eligible for the AOC.  If you are married, the LLC gets phased out between MAGI of $100,000 and $120,000.  If you are single, the LLC gets phased out between MAGI of $50,000 and $60,000.

 

Claiming The Credit:

Like the AOC, the person claiming the LLC must file a Federal Income Tax Return and attach IRS Form 8863.  However, unlike the AOC, the LLC is not “refundable”, meaning that the best a taxpayer can do with an LLC is reduce their Federal Income Tax to zero.

 

Pay to Play:

(Perhaps this is a bad choice of words coming from an attorney whose son enrolled at the U of I this year.)  In general, the Federal Income Tax laws limit tax benefits to situations where the taxpayer pays the cost (put another way, if someone else pays, you cannot get the tax benefit).  Similar rules are in place for the AOC and LLC.

People get the money for educational expenses from a variety of sources.  Some sources qualify and some do not.  A taxpayer cannot count payments toward either QEE or LLC-QEE to the extent that they got that money from any of the following sources:

  1. Tax free portions of scholarships and fellowships. B. Pell Grants.
  2. Employer provided educational assistance. D. Veteran’s educational assistance.
  3. Any other non-taxable tax free payments received as educational assistance (Fortunately, money received as a gift, inheritance, savings and 529 Plans are satisfactory sources.)

 

Interaction With 529 Plans – No Double Dipping:

Section 529 of the Internal Revenue Code presents a wonderful way of putting money away for the costs of higher education (“529 Plan”). Among other things, 529 Plans offer some income tax and estate tax benefits.  Briefly, someone puts money into a 529 Plan (most often parents or grandparents of the student) and names a student as the “beneficiary”. Money can then come out of the 529 Plan to pay for certain enumerated costs (e.g. tuition, housing and books).  The rules for determining the “qualified” costs are different for 529 Plans than they are for the AOC or LLC.  Some costs may qualify as being valid for the 529 Plan but not for the AOC or LLC.

Money taken from a 529 Plan is eligible to be QEE or LLC-QEE if they satisfy the QEE and LLC-QEE requirements listed above. However, if you use money paid from a 529 Plan to be the basis of your QEE or LLC-QEE (and elect to take the credit), the student (who may or may not be the person getting the AOC or LLC) may have to recognize some income. The reason is that the government views you as having received a tax benefit through the use of the 529 Plan (whether or not you get an AOC or LLC) and does not want you to then “double-dip” by getting additional tax benefits under AOC or LLC without paying some toll charge.  You must go through some calculations to determine what portion, if any, of the 529 Plan distribution (that gave rise to the AOC or LLC) must be included in income.

 

Deductions:

The government offers various deductions you can take for educational related costs. While the details are beyond the scope of this article I am noting a few things that are often considered when exploring the AOC and LLC:

  1. Deductions reduce income while credits reduce the actual tax. One is not always better than the other.  It is a year by year, case by case determination that requires that you complete your Federal Income Tax Return both ways to see which results in a better answer.
  2. You cannot double-dip and take credits and deductions for the same costs in the same year.
  3. Each deduction has its own set of rules that must be followed to determine the extent to which a deduction may be taken. In some cases, the deduction is valid but is phased-out or does not result in any tax benefit.
  4. The most common educational deductions are:
  • Tuition and Fees Deduction
  • You are limited to $4,000.
  • You must complete IRS Form 8917.
  • The deduction is taken on Page 1, Line 34 of Form 1040.
  • You can take this deduction even if you do not Itemize.
  • Student Loan Interest Deduction.
  • The deduction is taken on Page 1, Line 33 of Form 1040.
  • You can take this deduction even if you do not Itemize.
  • Continuing Education Deduction For Employees.
  • If you are an employee, you can deduct qualified continuing education costs as an employee business expense.
  • You must complete IRS Form 2106.
  • You cannot take this deduction if you do not Itemize.
  • The deduction is taken on Schedule A, Line 21 which means that you may not get a tax benefit even if you do Itemize.  You only get the deduction to the extent that the total of the costs listed on Lines 21, 22 and 23 exceed 2% of your Adjusted Gross Income.
  • Continuing Education Deduction For Self-Employed People.

If you are self-employed (e.g. Schedule C, partner in a partnership, or Member of an LLC taxed as a partnership) you can deduct qualified continuing education costs as a business expense.

 

Conclusion:

There are a variety of Federal Income Tax incentives enacted by our Federal government.  This presents opportunities for taxpayers to be creative, within the tax laws.  For example, you may qualify for several alternative programs and have the option to choose the one that gives you the best tax answer for that tax year. Separately, where you have several different possible sources of funds to pay for college costs you can develop a strategy to maximize the AOC or LLC benefits while minimizing the recognition of income.

Of course, sometimes the best laid plans go awry such as where your MAGI ends up being higher than projected and the benefits Phase-Out.  Finally, you must stay vigilant. The laws and your facts change each year.  Whatever you determine as being optimal for one year, may not be optimal for the next year.

 

 

12/2009

Copyright ©, Keith B. Baker – 2009

This article is designed to be a public resource of general information. It does not constitute “legal advice” nor does it create a “client-attorney” relationship. While the information is intended to be accurate, this cannot be guaranteed. Tax laws are complex and constantly changing as a result of new laws, regulations, court interpretations and IRS pronouncements. Often, there are also various possible interpretations.  Further, the applicable rules can be affected by the facts and circumstances of a particular situation. Because of this, some of the information may no longer be correct or may not apply to all situations. We are not responsible

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