09 September 2015
There are 79 numbered lines on a (2014) form 1040, and 3 of them are about getting a tax break for college education. Line 34 is the Tuition and Fees Deduction (which is actually an adjustment). Line 50 is for education credits from form 8863 - the American Opportunity Credit (AOC) and Lifetime Learning Credit (LLC). Line 68 is for the refundable portion of the AOC.
You can only use ONE of those credits for any given qualifying higher education expense (QHEE). So, what we all want to know is - which is the best?
The AOC is the best tax benefit for education available. If you qualify for it, you should use it. Unfortunately, the AOC is also the most restrictive. Not everyone qualifies to use it. It can only be used four times per individual, and is only for undergraduate education expenses. If a student is pursuing a graduate degree or is taking longer than four years to get an undergraduate degree you will run out of eligibility for AOC before you run out of college expenses. When that happens you need to choose between the Lifetime Learning Credit and the Tuition and Fees Deduction.
In most cases the Lifetime Learning Credit will provide the greatest tax advantage - but not always. There are times when the Tuition and Fees Deduction will be better. I made the flowchart below that gives some guidance on when LLC is always better, and when Tuition and Fees Deduction is always better. Unfortunately, that leaves some grey area where it might be one or the other, so I left that to "come see me". Any flow chart that covered all of the variables involved would be half eyesore and half comic mess. The flow chart I built is complex enough that I also built a slideshow (bottom of page) you can use to go step-by-step through the flowchart.
The value of the Tuition and Fees Deduction depends on your top marginal tax rate. Deductions reduce the amount of your income that is subject to taxes. If you had $4,000 worth of qualifying expenses and your top marginal tax rate was 25%, the benefit to you would be $1,000. But if your top marginal tax rate was 15%, those same $4,000 worth of qualifying expenses would only be worth $600.
Because the Tuition and Fees Deduction is completely phased out for MFJ taxpayers with modified adjusted gross income over $160,000 ($80,000 for single and HoH), the maximum top marginal rate you can be in and still qualify for the Tuition and Fees Deduction is 25%. The cap on qualifying expenses under the Tuition and Fees Deduction is $4,000. Therefore the largest possible benefit of the Tuition and Fees Deduction is $1,000 - the highest qualifying top marginal tax rate (25%) times the highest amount of qualifying expenses ($4,000).
By comparison, the LLC can be worth up to $2,000. It is a tax credit given at the fixed rate of 20% on the first $10,000 of QHEE. If you have the maximum qualifying expenses ($10,000) you can take a tax credit for 20% of that amount, or $2,000. Therefore, anytime your qualifying expenses exceed $5,000, you will always take the LLC, because your credit will be over $1,000 and eclipse the highest possible benefit of the Tuition and Fees Deduction which tops out at $1,000.
The Lifetime Learning Credit is phased out at a lower income threshold than the Tuition and Fees Deduction. If you're MFJ with an MAGI over $128,000 you cannot claim the LLC. $64,000 for single and HoH filers. (A reduction of the LLC benefit begins at $108,000 and $54,000 respectively.) If your income gets you completely phased out of LLC, you may still qualify for the Tuition and Fees Deduction.
The different phaseout ranges, different tax rates, and differing levels of qualifying expenses add too many variables to construct a flowchart covering ALL of the possibilities. If you don't fall into either the obviously Lifetime Learning Credit category (over $5,000 of qualifying expenses), or the obviously Tuition and Fees Deduction category (income too high for LLC) then you should come see me. I'll help you figure out the most advantageous tax benefit for your situation. With two children in college, tax credits for education are near and dear to my heart. They can be a bit complex, but I don't mind spending extra time discussing them. If you have questions, just ask.