Educational Credits

The first two items discussed, the Hope Credit and the Lifetime Learning Credit, are both types of Education Credits.  Both of them provide a significant tax credit to the taxpayer.  Recall the value of a tax credit from our earlier discussion under the Tax Planning Section at page 38.  A credit reduces tax liability dollar for dollar.  Thus, a dollar of tax credit is far more valuable than a dollar of tax deduction that merely reduces the tax base, Taxable Income, by one dollar.  Therefore, you want to make sure that you avail yourself of these Educational Credits before moving on to the other tax-favored educational funding tools.  Here is how the Educational Credits work.

Rules That Apply to Both The Hope Credit and The Lifetime Learning Credit

Both credits are "non-refundable" credits.  This means if these Educational Credits are more than your gross tax liability for the year (before crediting your federal income tax withheld by your employer) the excess is not refunded to you or is otherwise useable.  (Look at page 39 under the Tax Planning Section and review the analysis of refundable versus non-refundable tax credits).

Expenses that qualify for the Educational Credits are based on tuition and fees that you have paid for yourself, your spouse or a dependent. If you are paying this qualified tuition expense for a dependent child (a child whom you claim as a dependent on your tax return), only you can claim an Education Credit for that tax year.  If you do not claim the child as a dependent, only the child, to the extent he or she pays qualified tuition expense with his or her funds, can claim the Education Credit for that tax year.

NOTE:  The Instructions to Form 8863 (discussed below) provide a helpful rule.  Amounts paid by a dependent child for his or her educational expense are considered having been paid by the parents when the parents are figuring out how much eligible tuition expense they have paid.  The student is not eligible to take the credit directly as he or she is claimed as a dependent on the parents' return.

Tuition expense is qualified for the credit if it goes toward tuition and fees required for attending an "eligible educational institution."  An eligible educational institution includes a college or university that is eligible to participate in a student aid program administered by the Department of Education.  Thus, the definition covers just about all legitimate public and private post-secondary institutions of learning in the country.  Qualified tuition expense does not include room and board expense.

Tuition and fees paid to such an eligible educational institution from your or your child's savings constitute tuition expense qualified for the credit.  Additionally, tuition and fees that have been paid for via a student loan constitute payment of qualified tuition expense and can be factored into the computation of your Educational Credit.  Not qualifying as qualified tuition expense for purposes of computing your Educational Credit are higher education expenses paid with certain tax-free monies.  Thus, to the extent you paid tuition expense with tax-free money from scholarships or grants (discussed below), Employer Educational Assistance Programs (discussed below), Veterans' educational assistance monies, Education U.S. Savings Bonds (discussed below), Qualified Tuition Program (discussed below), or Coverdell ESAs (discussed below), those expenditures do not count as payment of qualified tuition expense. The college will provide a tax form, Form 1098-T, which highlights qualified tuition expense that the family has paid as well as non-qualified tuition expense paid from a tax-free source.

NOTE:  Do not misinterpret the prior paragraph.  An Educational Credit generally may be taken in a year in which you use certain tax-free monies to fund some of your educational expense.  For example, say you paid for $2,000 of tuition expense from tax-free Education U.S. Savings Bond or a Qualified Tuition Program, but the child's tuition expense for the year totaled $5,000.  You paid the other $3,000 from other savings.  You would have paid $3,000 of "qualified tuition expense" and would be eligible for an Educational Credit in an amount detailed below.

The wonderful tax benefits provided by the Educational Credits are unavailable for upper-income taxpayers.  If you are a married taxpayer filing jointly, the tax benefits of the Educational Credits begin to be phased out once your and your spouse's Adjusted Gross Income (see pages 9-10) hits $85,000, and is completely phased out by the time AGI reaches $105,000 (the range is $42,000/$52,000 for single taxpayers).

You can compute the amount of your Educational Credits by filling out IRS Form 8863.  Also look at Publication 970 – Tax Benefits for Higher Education, for additional information on the Educational Credits as well as the other tax favored educational funding tools discussed under this Section of the book.  The Form is available under the Tax Planning section of my Web site (http://www.personal.kent.edu/~maltieri/web/guide/home.htm).  Publication 970 is located at my Web site under the Educational Savings tab as well as under the Tax Planning tab.

More Information on the Specific Educational Credits:  The Hope Credit

To be eligible for the Hope Credit, the student must be enrolled at least one-half of the normal full-time course load for at least one academic term (either a semester or a quarter) for the tax year.  The maximum Hope Credit is $1,500 each year for the first two years of the student's post-secondary education.  The maximum $1,500 per year would be made up of 100% of the first $1,000 of eligible tuition expenses paid plus 50% of the next $1,000 of tuition expenses.

Lifetime Learning Credit

This is the second of the Educational Credits.  With regard to a given student, the Lifetime Learning Credit is taken in a year in which the Hope Credit is not claimed.  Thus, you would normally use the Lifetime Learning Credit for tuition expenses after the first two years of post-secondary education.  There is no limit on the number of years for which this Credit can be claimed for each eligible student.  Unlike the Hope Credit, the Lifetime Learning Credit is not based on the student being enrolled at least one-half time.  The amount of the Lifetime Learning Credit is 20% of the first $10,000 of eligible tuition expense paid for the student in a given year.  Therefore, the maximum Lifetime Learning Credit allowed in a given year is $2,000 (20% x $10,000).

Example:  Dick and Jane are married and file a joint tax return.  Their Adjusted Gross Income is $75,000 and they have two children, Bob and Laura.  Both of the children attend school full-time and are claimed as dependents on their parents' tax return.  Bob is in his senior year of college and Laura is in her freshman year of college.  Laura's qualifying tuition expenses totaled $6,000 for the year and Bob's were $8,000 for the year.  Dick and Jane may claim a $1,500 Hope Credit (100% x the first $1,000 and 50% of the second $1,000 of tuition expense) relating to Laura's expenses.  They may additionally claim a $1,600 Lifetime Learning Credit (20% of the first $8,000) with regard to Bob's expenses.  Bob's expenses are not eligible for the Hope Credit because he is past his first two years of post-secondary education.