How a New Tax Credit Can Help You Pay for College

"Are grandparents who are paying the tuition of a grandchild eligible to claim the new American Opportunity Tax Credit" of up to $2,500? —Ken F.

Only the taxpayer who takes the student as an exemption on the 1040 tax form can collect the credit, the IRS says. If Ken can declare the student as a dependent (in other words, if the student has lived with him at least half the year and if Ken supplied at least half of the student's support), he can get a big tax break when he files his taxes next year.

But if Ken can't, then his kids, or his student grandchild, could collect the credit, the IRS says. In fact, even if the students or parents don't spend a penny of their own for tuition or books, they could still collect the tax credit. For example, Uncle Sam could send a $1,000 check to piggyback on Grandpa's check of $2,500. Or Ken's kids or grandkids could reduce their tax bills by $2,500 if Ken contributed $4,000 toward tuition and books. That means the IRS could turn a $2,500 gift into $3,500. Or it could turn a $4,000 gift into $6,500!

Here's how the American Opportunity Tax Credit works: For the 2009 and 2010 tax years, those who earn less than $80,000 a year (or $160,000 for couples who file jointly) and claim a college student as a dependent can deduct from their tax bills 100 percent of the first $2,000 spent on tuition or books. They can also deduct 25 percent of the next $2,000. So those with bills totaling $4,000 can reduce their tax bites by up to $2,500. Better yet: Filers who don't earn enough to owe any taxes can get refund checks for 40 percent of their tuition and books expenses, up to $1,000.

Let's look at Ken's case as an example of how the new tax credit could work. Let's say Ken sends a check for $4,000 to a college to cover a grandchild's tuition bill this fall. If Ken can prove he supports his grandchild and earns less than $80,000 a year, he can reduce his tax bill by up to $2,500 when he files next year. If Ken doesn't owe any taxes, he can file for a refund check of up to $1,000.

But if his grandchild files his or her own taxes and takes the personal exemption, the student can get the credit or the rebate, no matter how much or little the student contributed toward books and tuition.

So if Grandpa, say, pays all of a student's tuition and books bills at a community college for 2009, which typically run about $2,700 a year or so, the grandkid could get an IRS check for a cool grand next year. Uncle Sam will send the refund check even if the student doesn't contribute a penny of his or her own cash toward tuition or books AND the student doesn't pay or owe any federal income taxes, says John Roth, senior tax analyst for CCH, a tax and accounting information firm. Parents (or anyone) who declare the student as a dependent on their tax forms can collect this credit instead of the student. They can knock up to $2,500 off their tax bills or, if they don't earn enough to pay taxes, qualify for a check for up to $1,000.

There is another beneficial tax quirk that applies to anyone who makes tuition payments—grandparents, aunts, cousins, friends, and even strangers: Those who pay a student's tuition can avoid gift taxes as long as they send their checks directly to the college.

Of course, the average four-year public university charges about $7,000 in tuition. And students generally pay $700 to $1,000 more for textbooks. So even if a grandparent does contribute as much as $4,000 toward college costs, many students and parents will still have around $4,000 in eligible expenses of their own that qualify them for the credit.

Roth warns that there is lots of fine print that might catch some families. University bills for college-related costs such as dorms or cafeteria plans don't qualify for the tax credit, for example. And some families, such as those with high incomes or those who live in officially designated Midwest disaster areas, could get a bigger tax benefit from claiming other education deductions or credits.

The education benefits "started out simple. But they have turned into a real mishmash," says Roth. If more than a few hundred dollars is at stake, it could pay to consult a tax professional, he says.