You've saved for your child's education in a 529 plan. You visited several colleges. You threw a high school graduation party that everyone enjoyed. Your last job is to pay the tuition, right? Don't write that check just yet. Here are a couple of ways to make paying for college less taxing.
Give yourself some credit
With a little foresight, you might be able to qualify for up to $2,500 in an American opportunity tax credit. To get the maximum credit, plan to cover $4,000 in qualified expenses (including tuition and course materials) from sources other than your 529 account, like a checking or savings account or student loans.
If $4,000 is too much, remember that the American opportunity credit applies to 100% of the first $2,000 of qualified expenses (and to 25% of the next $2,000), so you can receive a $2,000 credit by paying $2,000 of your child's qualified expenses out-of-pocket.
The credit represents a dollar-for-dollar reduction of your federal tax bill, so if you qualify for the full $2,500, your tax bill will be reduced by that amount—and if your tax bill is less than the amount of your credit, you'll qualify for a refund of up to $1,000. It applies per student, so you might be eligible for two or more American opportunity credits in the same year.
The credit phases out for couples filing jointly with a modified adjusted gross income (MAGI) of $180,000 and for single filers with a MAGI of $90,000.i
If you're qualified to take advantage of the credit, pay careful attention to how much money you withdraw from your 529 account. If, for example, your daughter's college costs $10,000 and you plan to pay $4,000 from your savings, make sure to withdraw only $6,000 from your 529 account.
If you withdraw the full $10,000 from your 529 account and then claim the credit too, the earnings portion of the $4,000 would be counted as income and subject to a 10% penalty.
The grandparent trap
Maybe your child's grandparents have also been saving in a 529 plan. If you're not careful, their generous gift could reduce the amount of financial aid that your child receives.
Students submit the Free Application for Federal Student Aid (FAFSA) before each school year begins. As long as the money stays in a grandparent's 529 account, it doesn't need to be reported on the FAFSA.
But when a grandparent withdraws money from a 529 account and uses it to pay for your child's college expenses, your child must report the money as income on next year's form.ii
To avoid increasing his or her income and possibly decreasing the amount of aid awarded, your child should consider waiting until the year in which he or she files the final FAFSA to use a grandparent's 529 account to pay for college.
If your child expects to graduate in four years, he or she may use a grandparent's 529 money as early as the second semester of junior year, provided the grandparent makes the withdrawal on or after January 1.iii
A little homework
Tax matters can be tricky. You may qualify for a different tax credit than the AOTC, and there are other options for avoiding the problems of a grandparent's 529 account. We'd suggest talking with a tax advisor if you have questions.
The tax information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice.