Coordinating College Tax Breaks
The American Opportunity Tax Credit (AOTC) can be a valuable tax credit for students (and their parents) who have paid college expenses. However, to make the best use of the AOTC, eligible taxpayers may need to coordinate the credit with other education tax breaks.
The AOTC is available for the first four years of post-secondary education. It is equal to 100% of the first $2,000 of qualifying expenses (generally, tuition and fees) and 25% of the next $2,000, for a total credit of up to $2,500 for each eligible student. The AOTC is phased out for higher income taxpayers.
Using the AOTC with a 529 Plan
Section 529 college savings plans benefit taxpayers through income exclusion rather than a tax credit. Generally, withdrawals from a 529 college savings plan are tax free if they do not exceed the account beneficiary's qualified higher education expenses for the year.
Though taxpayers may not "double-dip" - use the same qualified expenses for both the AOTC and the Section 529 income exclusion - they should look to use both tax breaks to their advantage. As a dollar-for-dollar reduction of the final tax bill, the AOTC is generally more valuable. Eligible taxpayers should consider limiting 529 plan withdrawals and I paying at least some qualified expenses out ' of pocket so that the AOTC may be claimed at the end of the year. Some planning may be necessary; for example, room and board is a qualified expense for Section 529 plan .- purposes but not for the AOTC.
Using the AOTC with Scholarships
Similarly, the Treasury Department recently advised* that many recipients of Pell grants and other scholarships may be losing money by failing to properly coordinate their use of the AOTC with their scholarship and grant awards. Generally, students may choose to allocate such awards in either of two ways for tax purposes:
- To qualified tuition and related expenses, making the scholarships excludable from taxable income but also reducing the student's AOTC-eligible expenses, or
- To living expenses, such as room and board, rendering the award includable in the student's taxable income and therefore not reducing AOTC-eligible expenses.
Since many students would benefit more from the credit than the income exclusion, they should consider claiming at least a portion of their qualified tuition and related expenses for the AOTC. However, each family's situation will be unique.
* Fact Sheet: Interaction of Pell Grants and Tax Credits: Students May Be Foregoing Tax Benefits by Mistake, Treasury Department, www. treasury. gov
Your Tax Refund
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Pay Down High-interest Debt
Credit card debt is typically accompanied by a high rate of interest, which continues to accrue on any principal and interest left unpaid at the end of each month. And personal credit card interest is not tax deductible.
Save for College
If you make contributions to a Section 529 college savings plan, any earnings will be tax deferred, and all distributions will be tax free if applied to qualifying education expenses.
Save for Retirement
There are many choices among retirement savings vehicles, such as taxable investment accounts and traditional and Roth individual retirement accounts. You also might consider using your refund to pay current expenses and then contribute an equivalent amount to your employer sponsored retirement plan.