Two ways to save on taxes while going to school

Uncle Sam wants you to get educated, and that means there’s a tax credit that can help pay for your education. Two of them, actually: the Lifetime Learning Credit and the American Opportunity Tax Credit (AOTC). 

Whether paying to educate yourself or a dependent (such as your child), these credits can save some serious tax money if you meet certain income and other requirements. 

Learning new skills and taking on new education opportunities can help you or a family member live a more meaningful, fulfilling life while pursuing a passion and saving on taxes at the same time. 

Here’s what you need to know to take full advantage of these credits.

First, understand tax credits

Many people confuse tax credits with tax deductions, but they’re very different ways to save on taxes.

A tax deduction reduces taxable income. The standard deduction is a prime example. 

For example, a taxpayer earning $100,000 can take the standard deduction of $19,500 when filing a tax return. 

The result: taxes are calculated as if the person earned only $86,150 instead of $100,000 ($100,000-$13,850).

But that doesn’t mean the person will save $13,850 on taxes; depending on their finances, this tax deduction will cut their potential taxes by a few thousand dollars.

On the other hand, a tax credit reduces taxes by the amount of the credit.

For example, a person who owes $11,000 in taxes and receives a $2,000 tax credit will only owe $9,000.

In accounting terms, a tax credit is a 1:1 offset: every dollar of tax credit offsets a dollar in taxes owed. That makes tax credits especially valuable. 

It’s as if the government said, “Here’s $2,000 in Monopoly money you’ve earned by taking classes. You can use it to help pay your taxes.”

How the Lifetime Learning Credit works

The Lifetime Learning Credit lets parents and students lower their tax liability by up to $2,000 per year to help offset higher education expenses. 

There is no lifetime limit. The credit can only help offset taxes. If the person taking the credit owes less than $2,000 that year, they will not receive a tax refund because of the credit.

To claim the credit, taxpayers must meet all three of these criteria, according to the IRS:

• You, your dependent, or a third party pay qualified education expenses for higher education. The IRS has a list of education expenses, such as tuition and books, that are considered qualified.
• You, your dependent, or a third party pay the education expenses for an eligible student enrolled at an eligible educational institution.
• The eligible student is yourself, your spouse, or a dependent you listed on your tax return.
• The student must have incurred at least $10,000 in eligible education expenses to receive the full $2,000 credit (the maximum credit is 20% of the first $10,000).

The school does not have to be a college or university; the student does not have to be enrolled in a degree program or pursue a degree. They just have to be learning to advance their careers or gain a professional certification if they’re not pursuing a degree.

Eligible schools include any college, university, trade school, or other post-secondary educational institution eligible to participate in a student aid program run by the US Department of Education.

Note that both a student and a parent cannot claim the same tax credit, and couples who file their taxes as ‘Married Filing Separately’ are also not eligible. 

And even if you have multiple children enrolled in post-secondary education, such as college, a trade school, or a course to obtain a license or certification, you qualify. It’s important to note the limit is $2,000 per year per taxpayer, not per student.

Income limits

The Lifetime Learning Credit is phased out and eventually eliminated for higher-income taxpayers. 

The phase-out begins at $80,000 for single taxpayers and $160,000 for taxpayers whose tax returns are ‘Married Filing Jointly.’ 

Individual taxpayers with a modified adjusted gross income of at least $90,000 or couples filing a joint return with an adjusted gross income of at least $180,000 do not qualify for the credit.

How the American Opportunity Credit works

The American Opportunity Tax Credit also encourages learning after high school, but some of the limits and rules are different. 

For many, the most significant difference is that the American Opportunity Tax Credit is up to $2,500 per year—a bit more than the Lifetime Learning Credit. 

The American Opportunity Tax Credit is 100% of the first $2,000 of qualified expenses and 25% of the next $2,000. 

And, unlike the Lifetime Learning Credit, the tax credit is per student: three students in college could mean $7,500 ($2,500 x 3) in tax credits. 

Plus, if the tax credits total more than the amount of taxes owed that year, 40% of the American Opportunity Tax Credit will still be refunded. This counters with the Lifetime Learning Credit, which does not have a refundable component.

One caveat: a taxpayer may only take one of the tax credits every year. Unlike the Lifetime Learning Credit, the American Opportunity Tax Credit may only be taken four times.

Income limits

Income limits are the same as the Lifetime Learning Credit, but some restrictions are looser. For example, the American Opportunity Tax Credit only requires that the student enrolls in one course (Lifetime Learning Credit requires that the student is at least a part-time student). In addition, the student does not have to pursue a degree or professional certification.

The IRS has a helpful table outlining all the requirements and differences.

Which credit to choose?

Some families and students may only qualify for one of the credits, such as a student who’s only taking one class and doesn’t qualify for the Lifetime Learning Credit, so there’s no decision to be made.

For many taxpayers facing years of educational expenses, the best approach is to take the American Opportunity Tax Credit for four years, which offers greater tax savings, and then switch to the Lifetime Learning Credit. 

For families with more than one student in school, the American Opportunity Tax Credit is the only one that offers credits for multiple students, so the tax savings can be even more significant.

Do the math or consult a tax professional to see which credit offers the most tax savings for your situation.

How to qualify for either tax credit

Most eligible educational institutions will issue a Form 1098-T at the end of the year, which outlines the amount of tuition and other expenses paid on behalf of the student. If you opt to claim any expenses not reported on the 1098-T, be sure to keep all of your supporting documentation (receipts, etc.).The penalties associated with unqualified (or, here, unsubstantiated) claims can be steep. 

Some other educational expenses that won’t appear on that form, such as books and materials, may also qualify for the credit. (The American Opportunity Tax Credit and Lifetime Learning Credit have different criteria on what qualifies and what doesn’t.)

When completing a tax return, that information is entered on Form 8863, Education Credits. The instructions outline how to take advantage of either credit.

Although these tax credits will only offset a portion of qualified education expenses, anyone eligible should take advantage of one or both. It’s money in your pocket for doing what you’re already doing: paying for education.

Final word

Taking advantage of education tax credits can provide you with significant savings. While these credits are similar in some regards, there are differences between the two; understanding those distinctions can be helpful when deciding which credit will be most beneficial for you and your lifestyle. 

Ultimately, for taxpayers who meet the eligibility criteria these tax credits serve as valuable tools offering substantial savings. It is well worth taking full advantage of them   While you pursue your education, or any other opportunity to learn and grow your skill set.