Maximizing Higher Education Tax Credits

Do you have a high school student who’s on her way to college in the fall? Or a college student about to return home for the summer? Or perhaps you’re continuing your own education as an adult. Either way, you know that higher education credits can go a long way toward increasing your tax refund. Instead of taking the credits at face value with simple calculations, there is a way to make higher education go even further at tax time. Here’s how.

The two higher education tax credits, Lifetime Learning Credit and American Opportunity Tax Credit, both offer similar benefits with some key differences, noted below.

Lifetime Learning Credit

  • Provides a 20% credit on the first $10,000 in qualified higher education expenses (or $2,000 max benefit)
  • Credit applies to colleges, universities, vocational schools, or other post-secondary school, including job training courses
  • No limit on how many years the credit can be claimed
  • Cannot be used in the same year as the American Opportunity Tax Credit

American Opportunity Tax Credit

  • Provides a 100% credit on the $2,000 in qualified education expenses and a 25% credit on the next $2,000 (or $2,500 max benefit)
  • Available credit is 40% refundable
  • Limited to first four years of schooling at an approved institution
  • Cannot be used in the same year as the Lifetime Learning Credit

If the student in question receives scholarship or grant income, a tax strategy to consider is including them in gross income. Typically, anything that reduces the total cost of education, like scholarships, would be excluded from gross income. Instead, these amounts are subtracted from the cost of education and therefore, could reduce the value of the tax credits.

It’s worth it to read the fine print of scholarships and other educational assistance grants. A scholarship may not have to be applied specifically to higher education expenses, like tuition or room and board, if the student reports the amount of the grant or scholarship on his tax return as income under Regs. Sec. 1.25A-5(c)(3).

How can you tell if a scholarship or grant can be reported as gross income? Check the eligibility of each one separately, and look for these two criteria:

  • The scholarship or grant must be considered tax-free under Sec. 117(b)(1), which means that any amount of a scholarship or fellowship grant that a student receives is used for qualified tuition and related expenses, in accordance with the conditions of the grant.
  • The terms of the scholarship or grant must allow it to be applied to nonqualified expenses.

The financial aid office of the school can answer specific questions about the eligibility of any scholarship or grant.

Allocating Between Qualified and Nonqualified Higher Education Expenses

What is a qualified higher education expense? According to the IRS and tax code, if the fee is required to be paid to an eligible institution as a condition of enrollment or attendance, then it is a qualified higher education expense. Related expenses can include books, supplies, and equipment only if those fees are required to be paid to the institution itself. The American Opportunity Tax Credit does not require that these fees are paid directly to the institution.

Nonqualified higher education expenses are classified as personal expenses like room and board, medical expenses like student health fees, transportation, and other similar personal, living, or family expenses that are still a necessary part of attending school. Guidelines from the IRS are unclear on which nonqualified expenses can be used to offset qualified scholarships or grants, so it’s best to look at each one individually to see what the requirements are.

If a scholarship or grant doesn’t specify, or indicates that nonqualified expenses can be used, then the amount of that scholarship – or the amount of the nonqualified expenses – can be included in gross income and NOT as part of a reduction in total education costs.

As you can see, even in a situation where part of a scholarship or grant can be used for nonqualified expenses, part of the money can be allocated to gross income as part of a larger strategy to maximize the higher education tax credits.

With this strategy, consider how increasing the amount of adjusted gross income could impact future grants. Many financial aid tools are dependent on income limitations. It’s also important to look at how the allocation impacts both credits, as the outcome could be very different with the American Opportunity Credit versus Lifetime Learning Credit. The tax credits each have income limits to be aware of, too.

The calculations can become tedious and very detailed, so it’s important to work with a CPA who understands each credit and your personal situation. But doing some extra work ahead of time can be the difference between a refund or a liability, so it’s worth it to check into. Contact Naden/Lean for this and other tax credit questions here.