Education Tax Credit

Education tax credits are incentives provided to taxpayers to help them reduce the tax money they owe to the government and ease the cost of higher education. There are two types: the American Opportunity Tax Credit or the AOTC and the Lifetime Learning Credit or LLC.

It has several financial implications. Tax credits help make higher education affordable to individuals. This makes education accessible to a wide range of the public and leads to various economic benefits. They help in human capital development, health, employment, and economic growth and result in positive societal impacts in the long run. 

Education tax credits are benefits provided by the government to help individuals cope with higher education costs. They are claimed while filing annual tax returns, resulting in a reduction of the amount of taxes owed to the government. This makes education costs more affordable and accessible to a broader segment of the population, not just those with higher incomes.

These credits offer financial relief to students or their families by helping to offset the costs of higher education. This support can improve enrollment rates, increase the skilled workforce, and enhance the employability of students. With increased employment opportunities, overall health and well-being improve, leading to positive social outcomes and better societal well-being.

The determination of whether educational expenses qualify for tax benefits depends on several factors, including:

• Different filing statuses (e.g., single or married filing jointly) can affect eligibility and the amount of credit.
• The student must be enrolled at least half-time in a program leading to a degree or recognized educational credential.
• The credit amount may be reduced or phased out for higher-income earners.
• Qualified expenses include tuition, fees, and other related expenses paid during the academic period.
• Expenses paid with tax-exempt funds such as scholarships, grants, or Coverdell education savings accounts generally do not qualify.
• Generally, the taxpayer must be a U.S. citizen or resident alien to claim the credit.

There are two types of credits: the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC).

1. The American Opportunity Tax Credit (AOTC) is available for the first four years of higher education. The credit is worth up to $2,500 per eligible student per year. If the credit brings the amount of tax owed to zero, 40% of any remaining amount of the credit (up to $1,000) can be refunded. To be eligible for the AOTC, the student must:

• Be enrolled at least half-time in a program leading to a degree, certificate, or other recognized educational credential.
• Need to complete the first four years of higher education at the beginning of the tax year.
• Not have claimed the AOTC for more than four tax years.
• Not have been convicted of a felony drug offense at the end of the tax year.

2. The Lifetime Learning Credit (LLC) is available for qualified tuition and related expenses paid for eligible students enrolled in eligible educational institutions. It can be used for undergraduate, graduate, and professional degree courses, including courses to acquire or improve job skills. Unlike the AOTC, the LLC does not have a limit on the number of years it can be claimed. The maximum credit is $2,000 per tax return, regardless of the number of students.

Income limits for the LLC as of 2023: The credit is gradually phased out for taxpayers with a Modified Adjusted Gross Income (MAGI) between $80,000 and $90,000 for single filers. For those filing joint returns, the phase-out range is between $160,000 and $180,000.

Note: The values provided are based on limits for the year 2023.

Given below are the eligibility criteria to be fulfilled to claim either of the higher education tax credits (AOTC or LLC):

• Qualified educational expenses: The taxpayer, their dependent, or a third party must pay qualified educational expenses. These expenses include tuition and fees required for enrollment or attendance at an eligible educational institution, as well as course-related expenses such as books, supplies, and equipment. Expenses that do not qualify include room and board, insurance, medical expenses (including health fees), transportation costs, and personal, living, or family expenses.
• Eligible educational institutions: The student must be enrolled at an eligible educational institution. These are institutions that offer higher education, such as colleges, universities, and trade schools. Eligible institutions must issue Form 1098-T, Tuition Statement, to eligible students.
• Eligible students: The student must be the taxpayer, the taxpayer's spouse, or a dependent for whom the taxpayer claims an exemption on their tax return.
• Identification requirements: The taxpayer and the qualifying student must have a valid Social Security number (SSN) or taxpayer identification number (TIN) issued before the due date of the tax return for claiming the AOTC. The AOTC also requires an employer identification number (EIN) for the educational institution, which is reported on Form 8863 (used to claim education credits).

Let us look at some examples to understand the concept better.

Example #1

Imagine John is a college student pursuing an undergraduate degree. The total expenses he incurred for tuition, fees, books, and other qualifying expenses amounted to $10,000. Based on the eligibility criteria for the American Opportunity Tax Credit (AOTC), John can receive a credit of up to $2,500.

The AOTC provides a 100% credit for the first $2,000 of qualified expenses and 25% of the next $2,000 of expenses. So, for John:

• 100% of the first $2,000 = $2,000
• 25% of the next $2,000 = $500

Therefore, John qualifies for the maximum $2,500 credit. If this credit reduces his tax liability to zero, up to 40% of the remaining credit ($1,000) may be refunded to him. This reduction in tax liability helps make his educational expenses more affordable.

Example #2

A study published in the Journal of Student Financial Aid in 2020 examined the effectiveness of education tax credits and their alignment with policy goals. The study concluded that education tax credits have not significantly increased college enrollment rates nationwide. Additionally, these credits have reached a broader range of income levels than initially intended, which has led to increased government spending.

The study highlighted that providing tax credits to families who can already afford college does not represent the most efficient use of federal taxpayer dollars. However, it also suggested that with appropriate program adjustments, it could be better targeted to support students from lower-income families who need additional financial aid to enroll or remain in college. The study implied that while universal benefits might appeal to voters, effective use requires careful consideration and targeted implementation to achieve desired economic and educational outcomes.

Given below are some of the criticisms of education tax credits:

• Income limits: Income limits can restrict eligibility for claiming these credits, excluding middle—and higher-income families who may still struggle with education costs.
• Complexity: The system can be complex and confusing, which may prevent eligible taxpayers from applying for or correctly claiming the credits.
• No double-dipping: Taxpayers can claim up to one education benefit for the same student in the same year, limiting the financial relief they can receive.
• Less impact on access and quality: There is criticism that tax credits do not necessarily lead to increased access to education or improvements in the quality of education.
• Inflation in education costs: Some argue that the reduction in tax liability can lead to increased disposable income, which may contribute to inflation in education costs as institutions might raise prices knowing students have additional financial support.