Before we go any further, it is important to have a short discussion about the difference between a tax deduction and a tax credit because both will come up in this chapter. It’s an important discussion because a tax credit can be worth three to seven times more than a tax deduction, depending on your income tax bracket.

To understand the difference, you need to understand how the taxes you end up paying each year are calculated. Although your personal situation might be complex, the actual formula is pretty straightforward. Here’s the ultra-simplified version:

So in summary, tax credits directly offset what you owe, while tax deductions only lower the amount of income your taxes are calculated on. This means that a tax credit is typically worth its full computed amount. By contrast, a tax deduction is only worth a fraction of its initial amount because it only reduces the amount of income that you would be taxed on.

For whatever you think of President Obama, when it comes to paying for college, you owe him a thank you. The American Opportunity Tax Credit (AOTC) he pushed through, even though watered down from his campaign promise, puts up to $2,500 back in the pockets of students and parents. It’s a big deal and something that you need to take advantage of if you’re eligible.

The AOTC, with its higher dollar limit and broader eligibility, was originally enacted only for the 2009 and 2010 tax years and replaced the existing Hope Scholarship tax credit. It’s likely that the AOTC will be renewed, but if it is not, the old Hope Scholarship will once again become available.

Here’s how the AOTC works:

Is that a great deal, or what? For most American families, that means that spending $4,000 really costs them only $1,500. There are few limits on who can use this, so I want you to only add this to your College Cash Strategy Worksheet in Appendix B, under the “Spending and Savings Strategies” section, for each year you qualify.

To qualify, a student must meet all of the following criteria:

If you are ineligible for the AOTC, you can probably claim the Lifetime Learning Credit. It can still knock off a significant chunk (up to $2,000) from what you owe Uncle Sam on your taxes, but you have to spend a lot more to get it.

The Lifetime Learning Credit is calculated by multiplying your qualified college expenses (tuition, fees, books, and other materials) by 20 percent. The maximum amount of expenses on which this can be calculated in any one year is $10,000 per student, resulting in a maximum credit of $2,000. Unfortunately, this credit is not refundable like the AOTC for taxpayers who owe no taxes is.

However, the Lifetime Learning Credit has two key advantages over the AOTC. First, it can be used for any year of college, even graduate school or continuing education at your local community college. Second, students do not have to be enrolled at least half-time to claim the credit. Thus, even if you take one cooking class per year at your local community college, you can claim this credit.

As previously mentioned, you have to file a tax return to be able to claim these credits. If you haven’t needed to or don’t expect to file a tax return, you should talk to an accountant to see whether it is worth it to claim either of these credits. If you are paying for a student to attend college and he is considered your dependent for tax purposes, you can claim these credits on your return.

To claim these credits, you have to use a special IRS form (Form 8863 in 2009) that must be filled out and returned along with your regular tax return. This form is the supporting documentation for the credit that you are actually claiming on your main IRS Form 1040.

It is important to note that the IRS hates “double-dippers” and will come after you with a vengeance if you do it. No, I’m not talking about sticking a half-eaten chip back in the dip (though I wouldn’t do that in front of an IRS agent either). I’m talking about trying to claim more than one credit for the same person, in the same year. In other words, you cannot claim both the AOTC and the Lifetime Learning Credit in the same year for the same person. Further, you cannot claim the Tuition and Fees Deduction, which I discuss a little later in this chapter, at the same time you claim either credit for a specific student. That’s double-dipping. However, you are free to claim the same or different credits for different members of your family, as long as they each have valid educational expenses.