I know. You started your 529 account soon after your child’s birth, and family members have contributed to it for the kids’ birthdays and special occasions. That money has been specifically earmarked for your kids’ education, and now some random guy, is telling you to not pay your kids’ entire college costs from your 529. The reason is because the American Opportunity Tax Credit (AOTC) is more beneficial tax wise. I know this is a strong assertion. The balance of this post will justify this statement by going through a calculation to demonstrate, giving a background of 529s and the AOTC, and some strategies to maximize tax efficiencies through coordination of 529 distributions and the AOTC.
AOTC calculation
The AOTC is a refundable tax credit for qualifying taxpayers equal to 100% of the first $2,000 of qualifying education expenses at an eligible institution and up to 25% on the next $2,000 of expenses. This amounts to a maximum $2,500 tax credit on the first $4,000 of college expenses. There are some important caveats that we will dive deeper into later, but this is a best case scenario. One of the biggest caveats is that this credit is available for taxpayers with a modified adjusted gross income (MAGI) less than $80,000 and $160,000 for single and married filing joint taxpayers, respectively. This credit begins to phase out as MAGI goes past these numbers and completely phases out once MAGI is above $90,000 and $180,000 for single and married filing joint taxpayers, respectively.
One of the biggest tax benefits of 529s is that earnings are tax free when used for qualified education expenses. If distributions are not used for education, the earnings are taxable and subject to a ten percent penalty.
On a relevant side note, tax credits are generally more beneficial than tax deductions. Tax deductions reduce taxable income while tax credits reduce taxes dollar for dollar.
Married filing joint taxpayers qualifying for the maximum AOTC have a MAGI less than $160,000. This puts them in a 22% tax bracket. Tack on the ten percent penalty, and you have a maximum tax burden of 32% on non-qualified 529 distributions. If a taxpayer were to end up reducing their 529 distributions by $4,000 per year to pay for qualifying expenses out of pocket, they might end up with money leftover in their 529. Many people would likely be opposed, but let’s run the numbers.
Distributions from a 529 are considered a portion of nontaxable return of principal and a portion of earnings. Only the earnings are taxable and subject to the ten percent penalty on non-qualified distributions. For the sake of mathematical simplicity, we are going to assume the entire $4,000 nonqualified distribution is taxable. As previously mentioned, the maximum tax burden would be 32%. This amounts to a maximum tax liability of $1,280 on $4,000 of nonqualified 529 distributions. The $1,280 amount would be the maximum tax savings for distributions taking for qualified purposes. Compare this to the $2,500 AOTC savings on the $4,000 of expenses paid out of pocket.
As you can see, the AOTC provides a bigger tax savings than qualified 529 distributions. However, why stop there? What if we could maximize the AOTC and deplete the entire 529 balance through qualified distributions?
529 Background
There are two kinds of 529 plans: prepaid and college savings plans. The prepaid ones are programs such as the Texas Tomorrow Fund, and they typically lock in today’s costs for tuition and fees. The other kind invest in mutual funds, and the earnings depend on the performance of the investments. The earnings are tax free when distributions are used for tuition and fees; books, supplies, and equipment including the purchase of a computer, software, and internet access; room and board including off campus housing as long as it does not exceed the allowance for room and board in the institution’s cost of attendance. Some of these expenses must be required by the school and some must be incurred by students who are enrolled at least half time.
Thanks to the SECURE ACT at the end of 2019, up to $10,000 per beneficiary can be used from a 529 to pay back a student loan.
American Opportunity Tax Credit (AOTC) background
The MAGI limits and the amount of credit were discussed earlier. So, we are going to discuss some other important housekeeping items. The credit is only available for students who have not completed their first four years of postsecondary education. The AOTC is only available to claim for four years. The AOTC can be claimed for tuition, required enrollment fees, and course materials that the student needs for a course of study. An important expense missing is room and board.
The student must be enrolled at least half time and enrolled in a program leading to a degree or other recognized educational credential. Lastly, the credit cannot be claimed by married filing separate taxpayers or if a student has been convicted of a drug felony.
Strategies to maximize tax efficiencies
How do we tie all this together? Simply put: pay at least $4,000 of tuition and fees from sources other than a 529 including current cash flow; use 529 to pay the balance of tuition and fees and room and board costs; use student loans to pay for costs not covered by 529 or the AOTC.
Why is all of this necessary? Double dipping is disallowed. In other words, the AOTC cannot be claimed for expenses that were used for qualified 529 distributions. There are three common scenarios where coordinating can help minimize overall taxes.
The first scenario is a parent that has saved the entire cost of college in a 529 and does not have enough savings or cash flow to support payments from outside of a 529. As we previously stated, the AOTC can only be claimed on up to $4,000 of qualifying education expenses. So, the goal would be to pay for $4,000 from sources other than a 529 to maximize tax efficiency, but the parent might not have any other funds available. The AOTC can be claimed for qualifying expenses paid by loan. The credit is claimed in the year the expense is paid, not the year the loan is repaid. The downside is the parent may end up with $4,000 leftover in their child’s 529. Again, the AOTC provides a bigger tax benefit than taking a qualified 529 distribution. While not ideal, taking a nonqualified 529 distribution to claim the AOTC is more tax beneficial.
The second scenario is a family that does not have a 529 with enough funds to cover the entire cost of college and is paying out of current cash flow and 529 funds. Since the AOTC cannot be claimed for room and board while the 529 can, this family should pay for tuition and fees out of current cash flow and pay for room and board out of the 529. Implementing this will allow families to claim the AOTC and use tax free 529 distributions to maximize tax efficiencies.
The third scenario is a family that is still contributing to a 529 while the student is going to school. The parents should consider sending their 529 contributions directly to the educational institution to get the biggest tax bang for their buck. Sending their funds to the 529 locks their distributions into the lesser tax advantaged vehicle. Paying the institution directly would allow the parents to claim the more favorable AOTC. If qualified distributions are taken from a 529, the AOTC cannot be claimed for the same expenses used to qualify the 529 distribution,
Another important strategy to consider is the use of student loans. Some student loans cover expenses not covered by 529 qualified distributions or the AOTC. Some of these expenses include utilities for off campus living, food, and insurance. Tying it back to the first scenario, parents with left over balances can use student loans and the SECURE Act to their advantage. Assume the same facts in the first scenario. The student in this scenario took out an additional loan to cover living expenses. The parents would be able to use up to $10,000 of the student’s 529 to pay for the student loan. This would allow the family to take advantage of three major education tax benefits: 529 qualified distributions, the AOTC, using the SECURE Act amendment that allows 529s to repay student loans.
Conclusion
The tax laws are always changing. While these strategies are true today, they may not be relevant by the time newborns are off to college. Proactive, adaptive tax planning can help utilize education tax benefits. Coordination amongst professionals such as tax pros and financial advisors can also help ensure maximum tax efficiency.
Disclosures
Strategic Insights Financial Planning Group and LPL Financial do not provide tax advice or services. Please consult your tax advisor regarding your specific situation.
Prior to investing in a 529 Plan investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state's qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.