Uncle Sam Wants to Help You Pay for College: Tax Tips

NEW YORK ( TheStreet) -- Millions of students have just begun college, meaning that millions of parents and grandparents -- and some students all on their own -- have begun paying for what can now cost more than $100,000 over the course of four years. That's a very expensive proposition, and as a result, maximizing the tax code as it relates to college costs has never been more critical.

Statistics indicate that the average annual cost of an undergraduate college education -- including tuition, room and board, and books and supplies -- is $17,563 for public colleges and universities, $27,854 for private, for-profit schools, and $33,969 for private non-profit institutions.

Scholarships and grants can cover some of the costs, but the majority of expenses will be "out of pocket" for most students. Many will turn to student loans to finance their education. According to the Federal Reserve Bank of New York, the amount of student loan debt among borrowers under age 30 has more than doubled since the beginning of 2005 to $292 billion and the average student loan debt has risen 56 percent to $20,835, as of the end of March of this year.

Uncle Sam can offer help in paying for college via the Tax Code. The American Opportunity Credit, which is scheduled to expire at the end of 2012, could provide a college student who, at the beginning of the tax year, has not yet completed the first four years of post-secondary education (determined not by calendar year, but by the student's status of freshman, sophomore, etc.), a credit of up to $2,500, $1,000 of which may be refundable.

The credit is 100% of the first $2,000 of qualified expenses and 25% of the next $2,000. In order to get the maximum credit you must have at least $4,000 in qualified expenses. The $2,500 maximum is per student and not per return. So if you have two kids in college at the same time you can get up to $5,000 from Uncle Sam.

In addition to tuition and fees you can also include required course materials, which includes books, supplies and equipment needed for a course of study, whether or not the materials are purchased from the educational institution as a condition of enrollment or attendance.

The phase-out range for the AOC is "modified" Adjusted Gross Income of between $80,000 and $90,000 for single taxpayers and $160,000 and $180,000 for joint filers.

To qualify for the American Opportunity Credit a student must be enrolled in a post-secondary education program at an "eligible institution" that leads to a degree, a certificate or another recognized credential at least half-time for one semester during the year. An "eligible institution" is an accredited college, university, vocational school or other accredited institution able to participate in a student aid program administered by the U.S. Department of Education. The student must not have a felony conviction for possession or distribution of a controlled substance.

Only the person claiming the student as a dependent can claim the credit. This can be the student if he/she is not claimed as a dependent by his/her parents or anyone else. It doesn't matter who actually pays the tuition. If the grandparents pay all the student's expenses, but the parents claim the student as a dependent, the parents get the credit.

The credit is available if the eligible expenses are paid using money from a student loan or any other borrowing.

Eligible expenses must be reduced by any tax-free scholarships or grants, employer-provided education assistance, veterans' assistance and any other tax-free payments or reimbursements. All such payments are applied first toward tuition, fees and course materials. They are not allocated between eligible expenses and room and board. If the student has $10,000 in eligible expenses and $4,000 in room and board expenses and received a scholarship for $7,500, only $2,500 in expenses can be used to calculate the credit.

Unfortunately, many parents with dependents attending college will be unable to receive any tax benefit from the American Opportunity Credit due to the AGI limitations. However, there is hope, thanks to IRS Field Service Advice FSA 200236001. While the AOC is only available to the person who claims the student as a dependent, there is a way for a dependent student to receive a tax benefit from the credit on his/her return.

James, son of John and Jane, is a 20-year-old unmarried full-time college student in his junior year. He had net taxable income from a part-time job. John and Jane are entitled to claim James as a dependent on their Form 1040.

James' eligible education expenses for the year exceeds the $4,000 minimum needed to qualify for the maximum credit, but John and Jane's Adjusted Gross Income is $185,000.

James' tax liability is more than the amount of federal and state tax savings John and Jane would realize from claiming James as a dependent.

John and Jane could, although entitled to, elect not to claim James as a dependent on their 1040. James cannot claim an exemption for himself because his parents could have done so, but he can claim the American Opportunity Credit on his return.

James is not eligible for the refundable portion of the credit. None of the American Opportunity Credit is refundable if you are under age 18 (or a student under age 24 and your earned income was less than one-half of your support), at least one of your parents was alive at the end of the tax year, and you are not filing a joint return.

James can only claim a credit against actual tax liability. If his tax liability is $500 his credit is limited to $500. If his tax liability is $2,800 he can claim the full $2,500 credit. If the amount of James' taxable income can be controlled it would be good to make sure James earns at least enough to generate a tax liability that assures he will be able to take full advantage of the credit.

As I told you earlier, the American Opportunity Credit is only available to undergraduate students. For 2012, graduate students, or their parents, can claim a Lifetime Learning Credit or, if it is extended by Congress, an above-the-line deduction for tuition and fees.

--By Robert Flach

Robert Flach has more than 40 years of experience as a tax professional and also blogs as The Wandering Tax Pro .

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