Qualified tuition programs (QTPs), also known as 529 plans, offer substantial tax benefits. Investment earnings inside such plans avoid income tax. In addition, distributions from 529 plans to cover qualified higher education costs are tax-free. However, you’ll lose the full value of 529 tax benefits if you’re not careful about managing distributions. One trap is taking out too much money; another involves not pulling enough money from your 529.
The risk of insufficient 529 withdrawals may be easier to grasp. If you leave money in the account after all the relevant college bills have been paid, further distributions may be highly taxed. Example 1: Art and Kim Wilson open up a 529 account for their daughter, Eve. After Eve graduates and gets a full time job, there is still $20,000 left in the 529 account. The senior Wilsons have no younger children to whom they might transfer the account. If the Wilsons want to use that $20,000 for purposes other than education, distributions will be taxable. The taxable amount will depend on the ratio of earnings to the overall account value. The Wilsons also will owe a 10% penalty on the amount included in income. Qualified (that is, tax-free) distributions from a 529 plan may cover tuition, fees, books, supplies, and equipment, as well as room and board, in many cases. However, money spent by the Wilsons or by Eve to repay student loan debt will not be considered a qualified 529 expense, for this purpose. Ideally, 529 account owners should fully draw down 529 accounts for qualified higher education costs before all the likely beneficiaries are finished attending classes.
Another 529 tax trap involves other college tax breaks such as the American Opportunity Tax Credit, the Lifetime Learning Tax Credit, and the tuition and fees tax deduction. Many taxpayers can save taxes by claiming such benefits. For instance, the American Opportunity Tax Credit is fully available to joint filers with modified adjusted gross income (MAGI) of $160,000 or less, and to single filers as well as household heads with MAGI of $80,000 or less. (Partial credits are available with slightly higher income.) Someone who qualifies can trim taxes by as much as $2,500, on $4,000 worth of higher education outlays. However, you can’t claim these education tax benefits and 529 qualified distributions for the same expenses. To claim either credit or the deduction, you may owe tax on your 529 distribution.
Example 2: Eve Wilson’s total qualified college costs in 2013 are $25,000. Her parents take a $25,000 distribution from their 529 account to pay those bills. When the senior Wilsons file their 2013 tax return, they discover they are eligible for a full American Opportunity Tax Credit, which they claim. Because the Wilsons use $4,000 of Eve’s qualified expenses to claim the tax credit, only $21,000 of their 529 withdrawal counts as a qualified distribution. Thus, the Wilsons must treat $4,000 as a nonqualified distribution. (Note: Taxpayers won’t owe the 10% penalty if they lose the 529 tax break because of a conflict with the American Opportunity Tax Credit.) If the Wilsons had been aware of this tax treatment, they could have paid $4,000 of Eve’s college bills from another source to align with the American Opportunity Tax Credit. Then they could have withdrawn only $21,000 from the 529 plan, all of which would have been tax-free. Our office can help you determine which accounts to tap for college bills to maintain maximum tax efficiency.