We welcome back Ann Garcia to our Learn from the Experts series. Ann is a Certified Financial Planner, the mom of two college kids, and the author of How to Pay for College.
During our discussion about 529s and taxes, Ann shares her personal journey saving and financing college, reviews tax advantages, and stresses the importance of getting the most from your savings.
“529 plans have at least two tax benefits, often three,” says Ann. “The two you always get with a 529 are tax-free growth and tax-free distributions for qualified higher education expenses. In the case of 529s, that means tuition and fees, room and board, books, and any required supplies.”
“The third tax benefit is many states offer tax incentives to their residents for contributions to their state 529 college savings plan,” says Ann.
States set their own rules on whether they offer this third benefit — and for how much — so it’s best to research ahead of time.
Additional reading: Why do I need a 529 plan?
“We pass up a lot of opportunities to save on taxes,” says Ann. “As a financial advisor, I can tell you that happens quite a bit, and 529s are a really great example of that.”
Ann hears from many families who avoid 529s because of higher expense ratios (when compared to taxable accounts) or because they’re not flexible enough. However, she likes to use real numbers when revisiting the tax advantages of 529s.
“Let’s say, for example, you contributed $1,000 to a 529 when your child was born, and every year you contributed another $1,000 to that account and then your account grew at an average rate of 5% per year. Once they get to college age, you’d have about $40,000 in that account, and about half of it would be contributions and half would be growth. When you withdraw that money from a taxable account, the growth portion — that $20,000 — is taxable to you. Even if it’s long-term capital gains, it’s still taxed at 15% federal and then whatever your state tax rate is.”
Using 529 funds
“As long as your distributions are for qualified higher education expenses, they’re tax-free,” says Ann. “It also doesn’t matter when, over the course of the year, you take those distributions, so you do not have to match your distribution to a payment.”
What happens if you take non-qualified distributions?
“If that’s the case, you pay taxes and a 10% penalty on the growth portion of the distribution,” says Ann. “That 10% penalty is waived if your excess is due to scholarships. So, let’s say you saved aggressively and then your kid got a great financial aid package and you have to take more money. You don’t pay the 10% penalty as long as you’re within the realm of what was covered by scholarships.”
Education tax credits
“[Education] tax credits can make a huge difference for families, and of the two credits, the AOTC [American Opportunity Tax Credit] and the Lifetime Learning Credit, the AOTC is by far the most beneficial for undergraduate,” says Ann.
The AOTC is worth up to $2,500 a year per student for four years of undergraduate education (maximum of $10,000 per student). Beyond that, there are several criteria for students and their families to claim the credit:
- Enrollment. Must be enrolled at least half the time.
- Income. Must be below the phase out range: adjusted gross income (AGI) of $160,000-$180,000 for married couples; $80,000-$90,000 for single parents.
- Eligible expense. Only for tuition, fees, books, and required supplies; excludes room and board.
- No double dipping. As it relates to 529 plans, you can’t use your 529 for any expense for which you claim the AOTC.
- Timing matters. Because this is a tax credit, you must spend the money in the calendar year in which you’re claiming the AOTC.
- Not automatic. To claim the credit, you need to file form 8863 when completing your taxes.
One further and critical point is how the AOTC credit is applied.
“The way it works is it’s a 100% credit of the first $2,000 of qualified expenses that you incur and then 25% of the next $2,000 of expenses. To get the full credit, you need to spend $4,000. But you get the most bang from your buck from the first $2,000. Again that money has to come from someplace other than your 529,” says Ann.
The second tax credit, the Lifetime Learning Credit, works like the AOTC but is less beneficial.
“It’s only 20% of the first $10,000 of qualified expenses. So basically, you have to spend $10,000 to get a $2,000 credit,” says Ann. “It also has a lower income cutoff. It’s $118,000 to $138,000 of AGI for married filing jointly and $59,000 to $69,000 for a single filer.”
On the plus side, there are three benefits the Lifetime Learning Credit offers that the AOTC does not.
First, you can claim the Lifetime Learning Credit for more than four years. Second, you or your student can claim the credit for graduate school. Third, you are not required to be enrolled at least half the time to claim the credit, making it a great option for part-time students.