24 Aug Balancing 529 plan money with college tax breaks

Q. I know you can’t take certain tax deductions for college if you also use a 529 Plan to pay tuition bills. Is there a strategy I can use to figure out what to do?

A. It sure can be complicated, and it’s not an area you want to mess up.

There are two different sets of criteria to determine what is a qualified education expense, said Peter McKenna, a certified financial planner with Highland Financial in Riverdale.

One set is used to determine if an item can be deducted on an income tax return, and a different set is used to determine if it can used for tax-free withdrawals from a 529 account.

Qualified education expenses paid from savings or taxable earnings can be included on the parent’s or student’s tax return as deductions or tax credits, McKenna said

“The tax deduction or tax credit can be very valuable if you, or the student, meet the criteria,” 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.

“It is critical to keep good records and to use each expense for either a tax deduction/credit or for a tax-free withdrawal,” McKenna said. “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.”

If the balances in your 529 accounts are large enough to completely fund all college expenses, then a tax break may not be as significant, said Bryan Smalley, a certified financial planner with RegentAtlantic Capital in Morrsitown.

However, if college expenses exceed your 529 account balances, you will ultimately pay some of the college expenses from other sources, and that’s when you might qualify for the credits or deductions.

If you will have to pay some costs out-of-pocket, you should identify what qualifies for tax deductions or credits and what qualifies for tax-free withdrawals from your 529 account.

For example, Smalley said, room and board expenses do not qualify for a tax deduction or education tax credits, but are qualified higher education expenses which can be covered by funds in a 529 account.

Smalley offered this simplified example of an efficient strategy: First, spend at least $4,000 from a taxable account on qualified education expenses to receive the full $2,500 American Opportunity Tax Credit (AOTC). The AOTC provides a tax credit of 100 percent of the first $2,000, plus 25 percent of the next $2,000 paid for tuition, Smalley said.

After taking advantage of this tax credit, you can use your 529 account to fund the remaining college education expenses, thus maximizing tax credits available and taking advantage of the tax-free withdrawal from your 529 account, he said.

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 a529 account as long as certain criteria are met, McKenna said.

“A new laptop may or may not qualify depending on whether it is an explicit requirement of the school or course of study, e.g. my daughter’s laptop is eligible because her school had a specific laptop that was required for all engineering majors,” McKenna said

He recommends you, or your tax preparer, review in detail the financial aid award letter that the school provided. There should be a reasonably accurate estimate of the cost of attendance included in that package. If there isn’t much detail, the college’s web site or financial aid office should be able to provide a more detailed estimate, McKenna said.

Then, determine which expenses are qualified for the tax deduction/credit and which ones are qualified for tax-free withdrawals from the 529/Coverdell accounts. Finally, figure out if the remaining expenses are eligible for tax-free withdrawal from the 529 accounts, which you can pay for from that account.

Going over it all with a tax professional to determine which option would be most beneficial to you would be a smart move.

“Whether to use one of the two education tax credits or a deduction on your income taxes will depend on your specific tax situation, including if your income is below the phase-out limits,” Smalley said.

Summary of what costs qualify:

If you effectively pay your college expenses from the appropriate financial resource, you can benefit by getting both a tax deductions/credit as well as a tax-free withdrawal from 529 account.

Qualified higher education expenses for tax deduction and education tax credits:
• Tuition and fees
• Student activity fees you are required to pay to enroll at the school
• Expenses for books, supplies, and equipment required for enrollment and attendance (AOTC only)

Qualified higher education expenses for 529 accounts:
• Tuition
• Mandatory fees
• Expenses for books, supplies, and equipment required for enrollment and attendance
• Room and board expenses

Source: Bryan Smalley

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This story was first posted in August 2015.