Tax credit for students has a few pitfalls

Exemption is generous, but rules for claiming it require careful planning

Families paying college tuition are often relieved that they can claim education credits on their income tax returns, which helps ease the financial burden of higher learning.

But some planning early in the school year may help families avoid complications at tax time, financial planners and student aid experts say.

The American Opportunity Tax Credit allows families to reduce their annual tax bills by as much as $2,500 per student during the first four years of higher education.

The credit is generous, but the rules for claiming it are complex, and present multiple ways for families to make mistakes, said Mark Kantrowitz, a financial aid expert, and those errors could prompt a letter from the IRS questioning the credit.

For starters, students must be enrolled at least half time and families must meet income requirements to claim the credit. To receive the full credit amount, a single taxpayer can earn up to $80,000. A partial credit is available for filers with income up to $90,000. For married filers, the income limits are $160,000 for the full credit and up to $180,000 for a partial credit.

The credit is calculated based on 100 percent of the first $2,000 of qualified expenses, and 25 percent of the second $2,000, so a student needs at least $4,000 of eligible expenses to receive the full credit.

Expenses that qualify for the credit include tuition and required fees and course materials, including books and, as long as it is required by the school, a computer, said Lauren Haynes, a feeonly financial planner with Evolution Advisers in Midlothian, Va.

Families who have saved for college in a tax-favored 529 account should plan carefully, if they also want to take advantage of the opportunity credit. Under IRS rules, the same expenses cannot be used to justify both an education tax credit and a withdrawal from a 529 account.

Say a student has tuition and expenses of $10,000, and receives a $5,000 scholarship. The remaining $5,000 in expense could qualify for the opportunity credit. But if the student pays the balance using funds withdrawn from a 529 account, those expenses are no longer qualified for the tax credit, Haynes said.

In this situation, a family might want to pay at least $4,000 of the balance from non-529 funds, so they can qualify for the full tax credit, then pay any remaining expenses from the 529.

Families also might want to take advantage of the greater flexibility offered by 529 funds. Unlike the opportunity tax credit, 529 funds can be used to pay for costs like room and board. So families could use money from the 529 for those living expenses, while paying tuition with other funds, so they can claim the credit.

“You do need to do a little bit of coordination,” Haynes said.