04 Jun The problem with college tax breaks and 529 Plans

 Q. I know you can’t double dip with a 529 plan, meaning you can’t take tax write-offs for college and use 529 money, which is already tax-advantaged, at the same time. What strategies can I use to get both the tax deductions or credits and use the 529?

A. You’re correct. You cannot take income tax deductions or credits for expenses paid for with 529 Plan funds.

But you’re not completely out of luck.

For starters, it’s important to be efficient as you pay all your higher education costs, said Chadderdon O’Brien, a certified financial planner with Lassus Wherley in New Providence.

There are a number of credits available to taxpayers paying for qualified higher education expenses.

“The American Opportunity Tax Credit (AOTC) allows for a potential credit of $2,500 per student while the Lifetime Learning Credit allows for a potential credit of $2,000 per taxpayer,” O’Brien said. “It should be noted that only one of these credits can be used in any year and generally, the AOTC is more beneficial because of the higher credit amount, higher income limitations and the ability to apply the credit for each eligible student.”

A tax break isn’t everything, but it can be a big help.

If your balances in tax-free accounts are sufficient to fully fund all of your qualified education expenses, then you are in good shape and will merely miss out on a potential tax break, said Peter McKenna, a certified financial planner with Highland Financial in Riverdale.

But in the event that your expenses are greater than your tax free account balances you, or the student, will need to pay some expenses from other sources and those expenses may be eligible for deduction or income tax credits.

He said you can take tax-free withdrawals from the 529 or Coverdell accounts as long as they are used to pay qualified education expenses.

To complicate matters further, there are different lists of what qualifies for the tax deductions/credits and for tax-free withdrawals, McKenna said. For example, room and board outlays do not qualify for the tax deduction or education tax credits, but they are eligible expenses for a tax-free withdrawal from a 529 account as long as certain criteria are met.

He recommends you get a detailed list of all of the expenses you plan to pay, determine which expenses qualify for each and pay those expenses with funds from the appropriate account.

“If you are borrowing funds to pay the expenses, those expenses are comparable to having been paid with your own taxable savings,” he said. “It is critical to keep good records and to use each expense for either a tax deduction/credit or for a tax-free withdrawal.”

Put differently, in order to use the tax deduction or tax credit, the expense must be paid from a taxable account or taxable earnings, not from the 529 or Coverdell account, he said.

So you can take advantage of both — if you do it right.

O’Brien offered an example for someone who has a bill for $20,000 of tuition for a qualified institution.

“Assuming you meet all of the eligibility requirements, a $2,500 credit can be received on the first $4,000 of tuition paid with outside cash. The remaining need of $16,000 can then be paid for using a 529 plan,” he said. “This strategy will allow you to maximize the education tax credit you are eligible for this year while still taking advantage of the numerous tax benefits 529 plans provide.”

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This story was first posted in June 2015.