Education tax credits: tax year 2021

The tax law has become increasingly family focused in recent years, providing tax breaks for families with children including tax credits for children, tax breaks for child care, tax-favored accounts for education savings, and much more. However, to make the best use of these tax benefits, families must understand how they work. Here is an excerpt of the white paper “Tax strategies for families with children” that covers several of these child-centered tax benefits—and highlight tax strategies for maximizing tax savings and avoiding potential pitfalls. Feel free to pass this information on to clients to help them understand their options.

The tax law provides two tax credits to offset the cost of higher education: the American Opportunity Credit and the Lifetime Learning Credit (Code Sec. 25A).

American Opportunity Credit. The American Opportunity Credit can be claimed for the first four years of an eligible student’s post-secondary education. An eligible student may be the taxpayer, the taxpayer’s spouse, or a dependent claimed on the taxpayer’s return.

The credit is allowed for a year if the student was enrolled for at least one academic period in a program leading to a degree, certificate, or other recognized academic credential, and carried at least one-half the normal workload for their course of study. As a general rule, the credit can be claimed for each of a student’s freshman through senior years of college. However, if a student takes more than four years to graduate, the credit can be claimed only for the first four years of attendance.

The maximum annual credit is equal to 100% of the first $2,000 of qualified education expenses paid for an eligible student and 25% of the next $2,000 of eligible expenses paid for that student—for a maximum annual credit of $2,500. The credit is a per-student credit—thus, it can be claimed for each eligible student for whom qualified expenses were paid. The credit is phased out for taxpayers with $160,000 to $180,000 of modified adjusted gross income on a joint return or $80,000 to $90,000 on another return. However, the credit cannot be claimed on a married filing separately return.

Qualified expenses include tuition, fees, and course materials (books, supplies and equipment needed for the student’s course of study), adjusted for tax-free educational assistance.

Up to 40% ($1,000) of the American Opportunity Credit is refundable if the credit exceeds the taxpayer’s tax liability for the year. However, the credit is not refundable if the taxpayer is a child subject to the kiddie tax rules. The credit can, however, offset the child’s tax liability.

Lifetime Learning Credit. The Lifetime Learning Credit is not limited to expenses for a student’s post-secondary education. Moreover, there is no limit on the number of years the credit can be claimed for a student. The credit can be claimed for qualified education expenses required for a course at an eligible educational institution as part of a post-secondary degree program, or taken to acquire or improve jobs skills.

The credit is equal to 20% of up to $10,000 of qualified expenses for a maximum credit of $2,000 per year. However, unlike the American Opportunity Credit, the Lifetime Learning Credit is available on a per-family basis—that is, the maximum credit is $2,000 per return regardless of the number of students with qualifying expenses. The Lifetime Learning Credit is not refundable. The credit phased out at the same income levels as the American Opportunity Credit and cannot be claimed by marrieds filing separately.

Tax strategies. Both the American Opportunity Credit and the Lifetime Learning Credit cannot be claimed for a student in a given year. On the other hand, either (but not both) education tax credits can be claimed for a student in the same year that tax-free distributions are made from a qualified tuition plan (QTP) or education savings account (ESA) to pay the educational expenses for the student. However, the same expenses cannot be taken into account for both benefits.

Although QTPs, ESAs, and education credits are not strictly speaking an either-or proposition, let’s take a look at how different options stack up on a standalone basis.

Example. Jane and John Smith are expecting a child. They anticipate that their offspring will start college in 20 years, and want to start saving for their college education. They plan to set aside $5,000 a year for the next 20 years—$100,000 total. Assume that the contributions have grown to $200,000 by the time the child starts college and that all of the funds are used for qualified education expenses.

QTP—The Smiths can contribute the full $100,000 to a QTP. Moreover, the earnings on the contributions are not subject to capital gains tax while they remain in the account and are not subject to tax when used for qualified education expenses. Therefore, the Smiths total tax cost is zero and their tax savings equal the $20,000 of capital gains tax that would otherwise be payable on the $100,000 of earnings ($100,000 x 20% capital gains tax rate).

ESA—Of the Smiths’ $100,000 of savings, only $40,000 can be contributed to an ESA, with the remaining $60,000 in a non-tax-sheltered savings or investment account. Assuming the same growth rate for both accounts, $40,000 of earnings will be tax-free while in the ESA and will be tax-free when distributed for qualified education expenses. However, the Smiths will pay capital gains tax of $12,000 ($60,000 x 20%) on the non-tax-sheltered savings, and their total tax savings will equal the $8,000 of capital gains tax that would otherwise be payable on the $40,000 of earnings in the ESA ($40,000 x 20%).

American Opportunity Credit—If the Smiths choose to save outside of a QTP or ESA, but claim the American Opportunity Credit for the child’s education expenses, their entire $100,000 of earnings will be subject to capital gains tax at a tax cost of $20,000 ($100,000 x 20%). However, that amount will be partially offset by $10,000 of tax savings from the credit ($2,500 per year for four years).

Editor’s note: Nadia Rodriguez, CPA, and Sarah Molouki, CPA, MST, contributed to this article.