American Opportunity Tax Credit

DEFINITION of 'American Opportunity Tax Credit'

American Opportunity Tax Credit (AOTC) is a tax credit available to students to enable them reduce what they owe in taxes. AOTC also applies to taxpayers who claim the students as dependents. The tax credit is to be claimed for any expenses incurred during the first four years of education.

The AOTC was introduced in 2009 and is slated to run until 2017, unless it is extended by Congress.

BREAKING DOWN 'American Opportunity Tax Credit'

A tax credit allows for a reduction in the taxes owed to the government, regardless of the taxpayer’s effective tax rate. For example, if a taxpayer claims a $2,500 against his total tax bill of $5,500, his tax payment due will only be $3,000. There are different tax credits that an individual or household can claim depending on their situation and who the tax credit is designed for. A taxpayer that is a student can take advantage of the American Opportunity Tax Credit (AOTC) which was introduced specifically for students attending a postsecondary institution.

Maximum American Opportunity Credit Claim

The American Opportunity Credit can save a household with a qualifying student as much as $2,500. The credit helps with educational expenses such as tuition and any other expenses related to the student’s coursework. Eligible students can claim 100% of the first $2,000 spent on acquiring materials for school, and another 25% of the next $2,000 in expenses. This means that the maximum amount a qualifying student can claim with the AOTC is (100% x $2,000) + (25% x $2,000) = $2,500. In other words, $2,500 worth of credit can be used to reduce the first $4,000 in educational costs.

Most tax credits are non-refundable, meaning that once a taxpayer’s liability has been reduced to zero, that’s the end of it. However, the AOTC is not one of them as 40% of the credits is refundable. This partial refund means that if the student’s tax liability has been reduced to zero with AOTC, s/he may still receive 40% of the remaining credit, up to $1,000, as a tax refund from the Internal Revenue Service (IRS).

Consider two college students, David and Lawrence. David spent $4,000 on educational material, while Lawrence spent $900 during the academic year. Since they are both qualified according to the stipulations set by the IRS, David can claim the maximum credit of $2,500 allowed under the AOTC, which would reduce his tax bill to $4,000 - $2,500 = $1,500. On the other hand, Lawrence can claim the AOTC on his tax returns and have his $900 tax bill reduced to zero. Since there’s still some leftover credit ($900 - $2,500 = - $1,600), he will also be given a refund of 40% x $1,600 = $640.

American Opportunity Credit Eligibility

According to the IRS, a qualified student is one who - must be enrolled at least part time in one academic year in an accredited post-secondary institution; must still be enrolled at the institution at the beginning of the tax year; is taking courses toward a degree or some other recognized education qualification; and has not been convicted of any felony drug offense at the end of the tax year. Check out the IRS website or a more detailed list of who an eligible student is.

The American Opportunity Tax Credit can be claimed by eligible taxpayers for up to four years of postsecondary education to reduce the costs of tuition and other eligible expenses. According to the IRS, a qualified educational expense includes tuition paid to the school, and expenses for books, supplies, and equipment that may have been bought from external sources. These expenses can be paid for with student loan to qualify, but not with scholarships or grants. Room and board, medical expenses, and insurance are expenses that do not qualify for AOTC.

A single taxpayer has to have a modified adjusted gross income (MAGI) that is less than $80,000 to qualify for the AOTC. An MAGI between $80,000 and $90,000 will have a partial credit at a reduced rate applied. A taxpayer with an MAGI over $90,000 would not qualify for the AOTC. The MAGI requirements for a married couple who files jointly can be assessed from the table below:

American Opportunity Tax Credit vs. Lifetime Learning Credit

The American Opportunity Tax Credit is one of two tax credits available to students in the US. The second tax break available for students is called the Lifetime Learning Credit (LLC). While both credits cannot be claimed in the same tax year, the LLC differs from AOTC in a number of ways. A maximum of 20% of up to $10,000 of expenses (i.e. $2,000) in tuition and other educational costs can be claimed using an LLC. The LLC is not limited to students pursuing a degree or studying at least part time. It instead covers a broader group of students: whether part-time, full-time, undergraduate, graduate, or taking classes and courses to develop a skill or other purpose. Finally, the LLC is not refundable – once a taxpayer’s bill has been reduced to zero, there will be no refund on any credit balance.

Conclusion

A tax filer who qualifies for both education tax credits, may be better off opting for the American Opportunity Tax Credit since both credits cannot be applied in the same year. A taxpayer who does not qualify for the AOTC may find that the next best option is the Lifetime Learning Credit.