Paying for College: 529 Plans versus Other Tax Incentives
529 plans are one of the most popular ways to save up for college expenses. When your children finally get to college, it might seem like a good idea to pay for everything out of your 529 savings. However, this approach may make you ineligible for some other tax credits. It’s important to consider all your available options as you figure out how to best pay for college expenses.
529 plan basics
529 plans are designed to help people save for college, and are most often used by parents and grandparents. Plan contributions are made with after-tax dollars and grow tax-deferred. Assuming distributions are used for qualified expenses such as tuitions, room and board, and books, no additional federal income tax will be due. Some states even offer tax deductions or tax credits for 529 plan contributions.
Available tax benefits
When you pay college expenses, you could be eligible for three different types of tax benefits: the American Opportunity tax credit, the Lifetime Learning credit, and the tuition and expenses tax deduction. You can only use one of these per student every year.
To claim these credits or deductions, you need to pay for qualifying college expenses out-of-pocket. Expenses that you pay out of your 529 plan don’t qualify. As a result, if you pay for everything from your 529 plan, you miss out on the potential tax savings from these other benefits.
The American Opportunity credit
For those who qualify, the American Opportunity Credit offers a good benefit. This credit can reduce your income tax liability by $2,500 a year in 2015 for paying qualified college expenses incurred within the first four years of schooling. You get a credit for 100% of your first $2,000 of qualifying college expenses and 25% of the next $2,000. In the event you (the taxpayer) have an income tax liability less than $2,500 in a given year, the credit can provide a refundable tax credit of $1,000 or 40% of qualified expenses in 2015.
To use the American Opportunity tax credit your adjusted gross income in 2015 can’t be over $90,000 if you are single or $180,000 if you are married filing jointly. The credit also starts phasing out so you get a smaller tax benefit if you are single and make over $80,000 or are married and make over $160,000. The income cutoffs are lower for the Lifetime Learning credit and tuition and expenses deduction so if you can’t qualify for the American Opportunity credit, you won’t qualify for the others either.
Choosing between using the American Opportunity Credit and 529 withdrawals
If your income is below the American Opportunity credit phase-out, and you expect to have income tax liability, it might makes sense to plan on pay qualified expenses out of pocket and claim the credit before you start using the 529 plan, assuming you have sufficient savings to put up the cash.
Using extra 529 funds
What happens if my child gets a full scholarship? Extra 529 funds can be used in a couple of ways. One option is to set aside the funds for the beneficiary’s graduate school, assuming that is a likely possibility. Another option is to transfer the account to another family member so it will pay for that person’s college expenses, avoiding taxes or penalties. . As a last resort, you can withdraw the funds for use on non-college expenses. However, you’ll owe income taxes on the growth. But the good news is that while normally there would be a 10% penalty on the earnings portion for taking a nonqualified withdrawal, the penalty is waived when scholarships are the reason for it.
College is expensive, and you don’t want to pay any more than you have to for higher education. By getting the most out of all available tax benefits and savings plans, you can make college a little bit more affordable for you and your family.
Kristin McFarland is an investment adviser representative of The Darrow Company, Inc., an SEC registered investment adviser located in Massachusetts. The material contained in this article is for general information only and should not be construed as the rendering of personalized investment, legal, accounting, or tax advice.