A Tax Credit Strategy to Add to Your 529 College Savings Plan

Contributed by: Melissa Joy, CFP® Melissa Joy

No one ever said that college finances were easy. For parents looking to help their kids pay for college, first there’s the gargantuan task of putting away a massive pile of money. Then comes the dreaded FAFSA, used to calculate aid and loans available to a student. With all this complexity, there’s an often overlooked strategy to potentially save on a parent’s income taxes during their child’s college years.

A recent Wall Street Journal article emphasized that parents who save for their kids’ college through 529 plans often miss the opportunity to receive tax benefits for tuition through the American Opportunity tax credit, the Lifetime Learning credit, and deductions for tuitions and fees. When parents pay for all of college directly from 529 plans, they miss out on these credits and deductions.

While foregoing a deduction may make sense for many families if there is already money set aside in a 529 plan, there may be an advantage to trying to qualify for an education tax credit. By dividing the source of funds between out-of-pocket expenses and 529 plans, parents may get the best of both worlds.

Your Eligibility

You need to understand the differences between a 529 plan, tax credits, and tax deductions.

  • 529 plans: There is no income limit although 529 contributions may offer state tax breaks for parents under certain conditions. Funds can grow tax-deferred and can be withdrawn without penalty for tuition, fees, books, and supplies.
  • American Opportunity Tax Credit: This is a tuition credit of up to $2,500 per student for tuition, fees, and course materials. A phase-out occurs at $160,000 of modified adjusted gross income for joint filers or $80,000 for individual filers.
  • Lifetime Learning Tax Credit: This is a tuition credit for up to $2,000 and eligibility phases out at $128,000 modified adjusted income for joint and $64,000 modified adjusted income for individual filers.
  • Additional Restrictions: Each credit has some additional restrictions based upon years in school, types of courses, criminal record, etc. The best way to weave your way through eligibility to determine what you may be eligible for would be through consultation with your financial planner and/or CPA or tax preparer. Additionally, the IRS has a handy Am I Eligible tool, which can help get you on the right path.

The College Tax Credit Strategy

Here is an example of how the strategy may work.

  • You determine that you are eligible for the American Opportunity Tax Credit, you can receive the full credit of $2,500 by paying the first $4,000 out of college expenses out of pocket.
  • The remaining college expenses could be paid from 529 accounts which have already been set aside for the student.
  • This can be repeated over four tax years, potentially reducing your taxes by $10,000. If you were going to have to use some out-of-pocket money anyway over the course of college, this strategy may have lowered your tax bill. If you had already saved enough in your 529 plans to pay for all eligible college costs, the remaining funds can be transferred to a sibling or relative.

There are nuances to any strategies and coordinating with your financial planner and tax professional will allow you to ensure that you’ve looked at all of the options in light of your specific situation. No one ever said that college savings and spending was easy, and adding taxes to the mix often adds to complexity. That said, you may find that by lightening your tax burden, using credits or deductions to your advantage are a welcome silver lining to an education expense cloud.

Melissa Joy, CFP® is Partner and Director of Investments at Center for Financial Planning, Inc. In 2013, Melissa was honored by Financial Advisor magazine in the Research All Star List for the third consecutive year. In addition to her contributions to Money Centered blogs, she writes investment updates at The Center and is regularly quoted in national media publications including The Chicago Tribune, Investment News, and Morningstar Advisor.

Financial Advisor magazine's inaugural Research All Star List is based on job function of the person evaluated, fund selections and evaluation process used, study of rejected fund examples, and evaluation of challenges faced in the job and actions taken to overcome those challenges. Evaluations are independently conducted by Financial Advisor Magazine.

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