Parents with a child in college face all sorts of challenges. Will your kid appreciate the care packages you send? (I still have fond memories of the white cheddar Cheez-It crackers my mother sent and no memory of anything else in the box.) What will you do with yourself all day? (For ideas, see my column on Nerve.com—kidding!)
Oh, and then there are tuition bills.
The US government is ready to step in and help with those in the form of tax breaks. Most parents with a child in college are eligible to take advantage of the most valuable tax credit, but not all do.
Personal finance writers like me tend to be gung-ho about funding 529 college savings plans. And a 529—an investment account that allows tax-free withdrawals for college expenses—is a good deal.
However, it’s far from the best deal the government offers, and all parents (not just rich ones who can afford a full tuition bill) need to be careful not to overfund their 529 and miss out on the best tax break in town.
Read on for details.
Meet the American Opportunity Tax Credit
The American Opportunity Tax Credit (AOTC from here on out) is one of the most generous tax breaks in the entire tax code, period, unless you’re a large military contractor.
To qualify, you, your spouse, or your child must be working on their first undergraduate degree, attending school at least half-time, and not have a drug conviction.
You can only take the AOTC four times per student, so if you’re on the six-year graduation track, tough luck. And you have to make less than $80,000 (or $160,000 for married filing jointly).
“The AOTC is the most valuable education tax benefit, even more beneficial than tax-free distributions from a 529 college savings plan,” says Mark Kantrowitz, publisher of the invaluable FinAid.org.
Here’s how it works: the first $2,000 you spend on qualified education expenses (required tuition, fees and textbooks, but not room and board) gets a 100% credit. That means the government picks up the tab. The next $2,000 gets a 25% credit. So if you spend $4,000 on tuition, you get $2,500 back on your taxes.
And it actually gets even better than that. What if you’re among the so-called 47% of Americans who don’t pay income taxes? You can still benefit from the AOTC, because it’s partially refundable. If you pay no tax, but spend $4,000 on tuition, the government will cut you a $1,000 check.
Finally, you can take the AOTC even if you’re paying the tuition bill via student loans—but not grants or scholarships. (The student loans can be in the parents’ or student’s name; it doesn’t matter. But don’t take out parent loans, please. You have enough to worry about.)
What’s the catch?
There has to be a catch, right? Yes, a couple, but they’re minor.
As I mentioned, the government offers many different tax breaks for education and they’re generally mutually exclusive. If you withdraw money from a 529 to pay tuition, for example, that money is ineligible for the AOTC.
If you have an expected tuition bill of $10,000 coming up next year and you save $10,000 in a 529 this year to pay for it, you will blow a huge tax break. “So parents should plan on carving out $4,000 in education expenses to pay with cash or loans to qualify for the maximum AOTC,” says Kantrowitz.
In this case, you’d want to pay $6,000 from the 529 and $4,000 in cash (to get the AOTC), and leave $4,000 in the 529 for another child or a future year.
The AOTC is relatively new (it was created in 2009) and Congress is always messing with education tax credits.
In fact, the AOTC is currently set to expire at the end of 2012 and revert to a previous, less generous credit. This is part of that “fiscal cliff” you keep hearing about. No one knows yet whether the AOTC will be extended.
How to get your hands on the cash
You take the AOTC by filling out the memorably-named Form 8863 with your Federal tax return. TurboTax and other tax prep packages know about the AOTC and will check whether you qualify, fill out the form, and try to make sure you don’t take a less-generous credit (such as the Lifetime Learning Credit) by mistake.
Incidentally, the AOTC originally required the student to perform 100 hours of community service in order to receive the credit. Congress killed that part of the bill, possibly because members of Congress imagined all the whiny phone calls they’d get from their own kids.
Now that you know the AOTC drill, you can concentrate on more important things. Like sending your favorite personal finance columnist a care package. I hear they’re now making pepper jack Cheez-Its.
Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.