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The American Opportunity Tax Credit: What to Know and How to Use It

Families paying the steep costs of higher education may be looking for any break they can get. Enter the American opportunity tax credit. This tax credit, which is designated for taxpayers who pay qualified tuition and related expenses, can reduce taxable income and even create a tax refund.

If you're eligible to claim this credit, it's absolutely worth taking advantage of. Here's what to know about the American opportunity tax credit.

What Is the American Opportunity Tax Credit?

The American opportunity tax credit, or AOTC, is an education tax credit to offset qualified education expenses incurred by an eligible student during the first four years of higher education. This tax credit is worth up to $2,500 per year and has a refundable portion of 40%, meaning it can create a tax refund of up to $1,000 if you owe no taxes.

"It's really to help middle-income families pay for their kid's first four years of undergraduate studies," says Ryan L. Losi, certified public accountant and executive vice president of Piascik, an accounting firm, in Glen Allen, Virginia.

The American opportunity tax credit covers 100% of the first $2,000 of qualified higher education expenses and 25% of the next $2,000, giving it a total value of $2,500.

Eligible expenses are those incurred during the first four years of higher education, including tuition, books, supplies and other equipment necessary for your studies. Expenses that don't qualify include room and board, insurance and transportation.

Here's how a tax credit differs from a tax deduction: "A credit is a direct, one-for-one reduction of your current tax year liability, whereas the deduction does reduce your liability but does so at your tax rate," says Sean Stein Smith, certified public accountant in New York City and member of the American Institute of CPAs' Financial Literacy Commission.

Who Qualifies to Claim the American Opportunity Tax Credit?

Taxpayers who pay some or all of the qualified tuition and related expenses for the first four years of higher education for themselves, a spouse or an eligible dependent may be eligible to claim the American opportunity tax credit.

Filers who earn too much can't take full advantage of the American opportunity tax credit. Taxpayers will begin to see the credit lose value if their modified adjusted gross income is more than $80,000 (single) or $160,000 (married filing jointly). The American opportunity tax credit becomes unavailable for filers earning a modified adjusted gross income of more than $90,000 (single) or $180,000 (married filing jointly).

Families in which the parents are paying qualified higher education costs but earn too much to qualify for the credit may want to discuss the potential of having their college student file taxes as an independent, if he has an income and pays some school expenses, and claim the credit for himself. It will require running the numbers to see which scenario is more valuable, but it may be a savvy choice in the right circumstances.

How Do I Claim the American Opportunity Tax Credit?

To claim the American opportunity tax credit, you'll need to keep track of some important documents, including the Form 1098-T, which is a tuition statement from your university. Typically, this form arrives before Jan. 31. You'll also want to track any course materials and fees paid out-of-pocket. "You want to be able to demonstrate that the expenses were paid, and it wasn't covered by some other type of expenditure like a 529 plan or Coverdell or some kind of scholarship," Losi says.

Essentially, you can't double dip. If your college expenses are already being paid with a tax-advantaged financial vehicle such as a 529 savings plan, you can't also use the American opportunity tax credit to offset those expenses.

To claim the American opportunity tax credit, you'll file the Form 8863 and attach it to your Form 1040. Any good tax software program or tax preparer should be able to walk you through the steps, experts say. Another useful tool is the IRS's interactive Am I Eligible to Claim an Education Credit? worksheet, which takes about 10 minutes to complete online.

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