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New Credit Offers Added Tax Break for College, But Parents Need to Weigh Options Carefully

Coordinating Credits Particularly Important for Parents with Kids Attending Midwestern Schools and with More Than One College Student

(RIVERWOODS, ILL., January 2010) – The American Opportunity Tax Credit provides a way for more parents to offset college costs in 2009 and 2010, according to CCH, a Wolters Kluwer business and a leading provider of tax, accounting and audit information, software and services (CCHGroup.com). However, taxpayers need to understand the rules to make the most of the limited-time credit, and it may not be the best education credit for everyone.

“The American Opportunity Credit will typically be the most generous of the credits,” said CCH Senior Federal Tax Analyst John W. Roth, JD, LLM. “However, there are restrictions and parents with students attending college in one of the 10 Midwestern disaster area states may want to compare their credit choices to determine which saves them the most money before simply claiming the new credit.”

The Education Credit Trio

There are now three credits available to offset the costs of higher education. In any situation, claiming one precludes a taxpayer from claiming any other in the same tax year.

• The American Opportunity Credit . This credit, a modification of the Hope Credit, was established under the American Recovery and Reinvestment Act of 2009 (ARRA). It provides a maximum $2,500 credit per student per year for the first four years of post-secondary education tuition and expenses, with expenses more broadly defined to include required course material. It is available to taxpayers with modified adjusted gross income (AGI) of $80,000 phasing out completely at $90,000 for single filers, and $160,000 phasing out completely at $180,000 for joint returns. Up to 40 percent of the credit is refundable; as a result, someone who owes no tax could receive up to $1,000 of the credit for each eligible student as cash back ($2,500 x 40 percent). It is available for tuition and expenses paid in tax years beginning in 2009 and 2010 .

• The Hope Credit . It provides a maximum $1,800 credit per student per year for the first two years only of post-secondary education tuition and fees paid directly to the educational institution. It is available to taxpayers with modified 2009 AGI of $50,000 phasing out completely at $60,000 for single filers, and $100,000 phasing out completely at $120,000 for joint returns. For 2009, this credit is the basis of relief for taxpayers eligible for Midwest disaster relief who elect out of the American Opportunity Credit.

• The Lifetime Learning Credit . It provides a maximum $2,000 credit per tax return regardless of the number of college students and applies if a student is enrolled in one or more courses at a qualified educational institution. As with the Hope Credit, it is available to taxpayers with modified 2009 AGI of $50,000 phasing out completely at $60,000 for single filers, and $100,000 phasing out completely at $120,000 for joint returns.

“Generally, the American Opportunity Credit offers a larger credit available to taxpayers with a higher income for each of their college students in any of the first four years of college,” said Roth. “In comparison, the other two credits offer less credit, have more income restrictions or limit the credit to the first two years of college – with the Lifetime Learning Credit going a step further and limiting the credit to one credit per return versus one credit per student.”

(For more detail on qualifications and restrictions, see the charts in Release 27: New Education Tax Breaks Require Careful Reading.)

Now Add the Midwestern Disaster Area

On face value, it would seem the American Opportunity Credit would be the obvious choice. However, the tax code isn’t always obvious.

For students attending an eligible college in the Midwestern disaster area during 2009, the amount of the qualified tuition expense eligible for either the Hope or Lifetime Learning Credits is doubled and qualified expenses are expanded to include room and board. For the Hope Credit, this means a credit of up to $3,600 in 2009; for the Lifetime Learning Credit, this means a credit of up to $4,000. States identified in the Midwestern disaster area are Arkansas, Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Missouri, Nebraska and Wisconsin.

Rather than the American Opportunity Credit, the Lifetime Learning or Hope Credit would provide a bigger tax break for parents meeting the more restrictive income requirement for either of these credits and with just one first- or second-year college student attending an eligible school in one of these states. Specifically, the American Opportunity Credit would be just $2,500 compared to $3,600 for the Hope Credit or $4,000 for the Lifetime Learning Credit.

The math, however, gets a bit more complicated when more than one student is involved. Under IRS rules, taxpayers can elect out of claiming the American Opportunity Credit in favor of the Hope Credit if there is an eligible student attending an eligible educational institution in a Midwestern disaster area. However, if they make the election to waive claiming the American Opportunity Credit, the taxpayer waives claiming the credit for all student dependents.

For example, say a family has two college students. One is in his first year of post-secondary studies in one of the eligible colleges in the Midwestern disaster areas; the other student is in her second year of post-secondary studies at a university outside the Midwest disaster area. If the parents qualify, waive the American Opportunity Credit and take the maximum Hope Credit for their son attending school in the Midwestern disaster area, they would receive a credit of $3,600 for him. They would then need to choose whether to take the Hope or the Lifetime Learning Credit for their daughter. The Hope Credit for the daughter could be up to $1,800. The Lifetime Learning Credit covers up to 20 percent of the first $10,000 in qualifying education expenses, or $2,000. However, if the daughter had only $6,000 in qualifying expenses, because, for example, she went to a community college or had scholarship funds, the maximum Lifetime Learning Credit she could take would be $1,200.

However, if in the above example, the second student were in her third year of post-secondary studies, the parents would not be allowed to take a Hope Credit for her as the credit only applies to the first two years of post-secondary study. The rules also preclude them from taking a Hope Credit for one child and an American Opportunity Credit for another. As a result, the parents would need to decide if they wanted to take the Hope Credit with the Midwestern disaster area provision for their first-year student of $3,600 and take the Lifetime Learning Credit for the second child or take an American Opportunity Credit for both students for a total of $5,000.

Education Credits Outweigh Deductions

One additional restriction applying to all the education credits is that a taxpayer claiming any of the credits cannot also claim the above-the-line deduction for higher education in the same year.

This is a deduction of up to $4,000 if a taxpayer’s modified AGI is not greater than $65,000 for a single filer or $130,000 for joint filers; a deduction of up to $2,000 is available for taxpayers with modified AGI up to $80,000 for a single filer or $160,000 for joint filers.

These income restrictions of $80,000 for single filers and $160,000 for joint filers are the same as apply for the American opportunity credit. As a result, people will benefit more from taking the credit than the deduction.

“A credit reduces your tax liability dollar for dollar, whereas a deduction reduces your taxes based on your tax bracket,” said Roth. “So, if you were in the 25-percent tax bracket, a $2,000 deduction would only reduce your taxes by $500, whereas a $2,000 credit would reduce your taxes by the full $2,000.”

About CCH, a Wolters Kluwer business

CCH, a Wolters Kluwer business (CCHGroup.com) is a leading provider of tax, accounting and audit information, software and services. It has served tax, accounting and business professionals since 1913. CCH is based in Riverwoods, Ill. Wolters Kluwer is a leading global information services and publishing company. Wolters Kluwer is headquartered in Alphen aan den Rijn, the Netherlands (www.wolterskluwer.com).

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