On Monday we discussed Coverdell IRAs and yesterday we discussed Section 529 Plans. Today we turn our discussion to educational tax credits.
In 1997, President Clinton introduced the Hope Credit. The Hope Credit offered a $1,500.00 a year tax credit for qualified education expenses. This credit was introduced to offset the cost of college tuition for students and/or parents. In 2009, President Obama signed the American Recovery Reinvestment Act, which increased the size of the Hope Credit, and changed its name to the American Opportunity Credit (AOC).
This is really a nice tax credit for college students and parents. First of all, I want to discuss the difference between a deduction and a tax credit. Generally, a tax deduction is a deduction you receive for spending money on a something. A tax deduction is a reduction of income subject to tax. For businesses, tax deductions are generally expenses that are used in the reduction of income. For individuals, tax deductions are usually itemized deductions. For instance, let’s say that you pay mortgage interest on your home. The amount that you pay in interest is a deduction. Let’s say that you paid $12,000.00 in interest that would translate to a tax savings of a little over $1,000.00. So you spent $12,000.00 to get a savings of $1,000.00.
Tax credits are much different from tax deductions. Tax credits are dollar for dollar credits against your income tax liability. For example, let’s say you have a tax liability of $4,000.00. You find that you are eligible for a $2,000.00 tax credit. The $2,000.00 credit is subtracted from the $4,000.00 tax liability, leaving you with a $2,000.00 tax liability. See how that works? Most tax credits can only take your liability down to zero. Because of this, tax credits are generally better than tax deductions. If you are faced with the option to receive a tax deduction or a tax credit, it is typically better to go with the tax credit.
Just when you didn’t think the news could get any better it does. Certain tax credits are refundable. Let’s say that you have a $1,000.00 tax liability, and you are eligible for $2,000.00 refundable tax credit. You would subtract the $2,000.00 from the $1,000.00, leaving you with $1,000.00 refund. The American Opportunity Credit can be a refundable credit. The credit works like this: the credit is $2,500.00 of the first $4,000.00 that you pay on tuition for an eligible undergraduate student. In addition, up to 40% of the credit can be refundable.
Individuals can claim the AOC either for themselves, or their dependents, if the student is enrolled, at least half-time in a college, university, or other accredited post-secondary educational institution. Another condition of the credit is that the student must not have a felony drug conviction.
The AOC is available for the first four years of a student’s post-secondary education, which is the first four years of education after high school. The AOC is not allowed if a student has already completed four years of college education in a previous year or if the student already claimed the AOC four times on a previously filed tax return.
For the purposes of the AOC, qualified education expenses are tuition and student-activity fees, only if the fees must be paid to the institution as a condition of enrollment. In addition, books, supplies, and equipment needed for a course of study are included in qualified education expenses.
You cannot claim the credits if any of the following apply:
· Your filing status is married filing separately
· You are listed as a dependent on someone’s tax return
· Your modified adjusted gross income (MAGI) is $90,000.00 or more in the case of a single individual, or $180,000.00 in the case of a married individual
· You (or your spouse) were a nonresident alien for any part of 2012 and the nonresident alien did not elect to be treated as a resident alien for tax purposes
The good news about the AOC is that the American Taxpayer Relief Act of 2012 extended the credit until 2017.
For more information visit www.smalleynco.com
If you have any questions you can email Craig W. Smalley E.A.
Author of the books: It Starts With an Idea – Tax Tips for Small Businesses available on Nook and Kindle, The Ultimate Real Estate Investor Tax Guide, available on Nook and Kindle, The Complete Guide to the New Tax Law – American Taxpayer Relief Act of 2012 available on Nook and Kindle, Everything You Wanted to Know about the IRS – Audits, Appeals and Collections available on Nook and Kindle, and Tax Avoidance is Legal! The Complete Guide to Individual Income Tax available on Nook and Kindle
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