American Opportunity Tax Credit: What you need to know

The American Opportunity Tax Credit (AOTC) provides college students or their parents with an annual tax credit up to $2,500 of eligible expenses out of the first $4,000. Students are only eligible for the first four years of college, and it requires at least half-time enrollment. 

Unlike other tax credits for higher education, qualified expenses for the AOTC extend to books and supply fees. It is also a refundable tax credit. This means if your credit reduces your taxes to a zero balance or below, you could receive an income tax refund of a portion of the money up to $1,000.

Qualifying for the AOTC is serious because you can face tax penalties if you claim it in error. Eligibility is determined by course load, time in school, and income-based rules. If the tax filer's modified adjusted gross income exceeds $90,000 as a solo filer or $180,000 for married filing jointly, the AOTC cannot be claimed.

American Opportunity Tax Credit vs. Lifetime Learning Credit

The AOTC covers a wider range of expenses than the Lifetime Learning Credit (LLC). At $2,500 per year, it also provides a larger credit than the $2,000 per return offered by the LLC. However, the LLC can be claimed for an unlimited number of years while the AOTC is limited to the first four.

The LLC is perfect for students who have maxed out their eligibility for the AOTC and still have expenses to deduct. While it does not cover course materials, it is still an opportunity to claim up to $2,000 per year in tax credits for tuition and fees — no room and board allowed. If obtaining a four-year degree takes you longer to complete for any reason or you pursue graduate school, the LLC is a great tax credit option.

When to choose the LLC: The LLC works for students who are not pursuing a specific degree or other recognized educational credit but are improving job skills. For example, if you opt to take a medical coding course or an office accounting class at a technical college to further your career, you can do so and receive the credit without enrolling in a full program. Your eligibility for an LLC ends at lower modified adjusted gross income limits of between $69,000 for single filers and $138,000 for joint tax filers.

When to choose the AOTC: For independent students or parents who meet the MAGI or modified adjusted gross income guidelines for AOTC eligibility, this credit is the best option during your first four years of college because you obtain credit for more out-of-pocket expenses. This includes textbooks and required course supplies. For example, a computer or software required for a design class counts as a supply, but a computer purchase for general purposes does not. The AOTC could also provide you with a cash infusion. Unless you are one of the few college students without a cash flow problem, receiving a tax refund of up to $1,000 is a major financial boost. The LLC does not provide a refundable credit.

American Opportunity Tax Credit eligibility

The AOTC allows you to claim up to $2,500 of eligible education expenses. For qualified students, the first $2,000 in expenses is covered dollar-for-dollar. The next $2,000 is covered at 25%, or $0.25 per $1, meaning it takes $2,000 in costs to generate an additional $500 in credit.

Eligibility for the tax credit requires examining both school attendance requirements and income guidelines. AOTC credit recipients must be pursuing a degree or credential and be enrolled at least half-time for one semester, trimester, or quarter that started in the tax filing year, such as in 2021 for a 2021 tax return. It is only available for the first four years of higher education, and it cannot be claimed for more than four years. The student must also not be convicted for a felony drug crime to qualify. Students will need Form 1098-T, a tuition statement provided by the college, to qualify.

To claim the full amount of the credit, a single filer needs a MAGI of $80,000 or less. For those married and filing jointly, the limit increases to $160,000. The credit phases out for MAGI exceeding $90,000 for singles and $180,000 for joint filers. If your MAGI is between $80,000 and $90,000, you still qualify but will receive a reduced credit amount.

According to the IRS, the MAGI for most education credit filers is the adjusted gross income, or AGI, on the tax return. However, if you earn income overseas, you may need to do additional calculations. Refer to IRS Publication 970, Tax Benefits for Education, to access a worksheet to calculate MAGI for the AOTC.

Unlike a tax deduction, which reduces your taxable income, a tax credit is a reduction in the amount of tax you owe. Most income tax credits stop applying when you reach a $0 tax bill and will not generate a refund. The AOTC does provide a refund for up to $1,000, making it a valuable credit.

The amount provided in a refund is determined by the 40% rule. The amount of the credit remaining after your tax bill reaches $0 is multiplied by 40% to determine your credit. To receive the full $1,000, you must claim a credit of $2,500 and owe $0 in taxes. If you have $2,000 in credit remaining after the tax balance is paid, you would multiply $2,000 by 40% to arrive at a refund of $800. If you file taxes independently, you receive a refund. If you are claimed as a dependent on your parent's taxes, it goes to the tax filers. Parents with multiple dependents in college can claim one credit per eligible student.

How to claim the American Opportunity Tax Credit

To claim the AOTC, you need to refer to Form 1040, the core income tax filing document. On page 1, you will enter the required information regarding your dependents, income, and deductions. Look for the line that states “This is your adjusted gross income.” You need this total to calculate your MAGI.

In Publication 970, enter your AGI in the Worksheet titled “MAGI for the American Opportunity Tax Credit.” Subtract any of the following: foreign earned income, foreign housing deductions, and income from Puerto Rico and American Samoa. This is your MAGI, and it is entered on Form 8863, Education Credits.

Part III of Form 8863 pulls over information from the 1098-T form sent by the college and asks questions regarding qualification, such as the number of tax years claimed and if there is a drug conviction. You then enter the total of qualified expenses, including tuition, course fees, and the cost of textbooks and required supplies. The form guides you through calculating the amount of your credit. This information is then transferred to Part I of the form.

Part I guides you through determining your eligibility based on income. If you qualify, it uses the 40% rule to determine your refundable credit amount. Refundable credits and nonrefundable credits are entered separately on Form 1040, meaning that you claim the AOTC with two separate entries. Your nonrefundable credit amount is tallied in Part II and added to other credits and payments on form Schedule 3 before being transferred to the 1040.

The bottom line

The AOTC is an excellent opportunity to recover a portion of the costs of higher education whether you are a student or a parent supporting a child at college. Use Publication 970 to determine your eligibility for the credit.

[This article was originally published on The Simple Dollar in January, 2020. It was updated in December, 2021.]