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Year-End Financial Aid Moves

Mark Kantrowitz

December 20, 2012

As the year draws to a close, there are several steps families can take to get more need-based and merit-based financial aid.

Prepay Next Year’s Tuition

Taxpayers can claim one of two education tax credits based on amounts paid for qualified higher education expenses, such as tuition and fees. These are the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Tax Credit. Generally, the AOTC will be better for most taxpayers, leaving the Lifetime Learning Tax Credit for taxpayers who don’t qualify for the AOTC.

The AOTC provides a tax credit per student of up to $2,500 based on 100% of the first $2,000 in qualified higher education expenses and 25% of the second $2,000. (The AOTC modified the Hope Scholarship tax credit, which provided a tax credit of $1,800 based on 100% of the first $1,200 and 50% of the second $1,200 in qualified higher education expenses.)

The Lifetime Learning Tax Credit provides a tax credit of up to $2,000 based on 20% of the first $10,000 in qualified higher education expenses per taxpayer.

In some cases taxpayers will be able to claim next year’s expenses on this year’s return. In particular, if the taxpayer pays for qualified higher education expenses this year for an academic period that begins in January, February or March of next year, the taxpayer can claim the expenses on this year’s federal income tax return.

This is based on the prepayment rule from the regulations that appear at 26 CFR 1.25A-3(e) and 26 CFR 1.25A-5(e).

In general. If qualified tuition and related expenses are paid during one taxable year for an academic period that begins during the first three months of the taxpayer’s next taxable year (i.e., in January, February, or March of the next taxable year for calendar year taxpayers), an education tax credit is allowed with respect to the qualified tuition and related expenses only in the taxable year in which the expenses are paid.

If the taxpayer will qualify for the AOTC in both years, there may be no benefit to prepaying next year’s qualified higher education expenses this year. That’s because the AOTC pays more on the first $2,000 in qualified higher education expenses than on the second $2,000. Prepaying the expenses might yield a lower tax credit overall if the prepayment shifts the expenses from a higher tax credit percentage to a lower percentage.

However, if the taxpayer expects to lose eligibility for the AOTC next year, prepaying the expenses may be beneficial. That’s because the tax credit percentage on the second $2,000 in qualified higher education expenses for the AOTC is still higher than the tax credit percentage for the Lifetime Learning Tax Credit.

A taxpayer might lose eligibility for the AOTC if next year’s income will exceed the income phaseouts or if the student will reach the four year limitation on eligibility.

In addition, the AOTC expires at the end of 2012. If Congress does not extend the AOTC, the tax benefit will revert to the terms of the Hope Scholarship Tax Credit. This includes reducing the income phaseouts and cutting the number of years of eligibility from four to two. If this will cause the taxpayer to lose eligibility, it may be beneficial for the taxpayer to prepay the spring semester’s tuition this year. It all depends on whether the AOTC will be extended or not.

The ability to prepay expenses for academic periods that begin within the first three months of the year also helps taxpayers deal with the mismatch between academic years and tax years. The first tax year might have expenses only from the fall semester. But if the taxpayer pays the spring semester tuition in December, that allows the taxpayer to claim the full tax credit during the first year. A similar approach is used for each subsequent tax year, with each year prepaying the spring semester expenses for the subsequent year.

The regulations for other education tax benefits, such as the tax-free distributions from 529 college savings plans and the student loan interest deduction, do not discuss prepayment.


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