As we enter the heart of tax season, many parents of college students are looking forward to reaping the rewards of all of the college tuition checks they’ve been writing recently: an education tax break!
American Opportunity Credit
As we recently wrote on our blog, the most valuable education tax break for most parents of college students is the American Opportunity Credit (AOC). You may be eligible to take this credit if you are paying the tuition and required enrollment fees of a dependent child in first 4 years of his or her undergraduate education, attending at least half-time. The AOC provides a credit equaling 100% of the first $2,000 of qualified expenses paid and 25% of the next $2,000. That means that parents paying at least $4,000 in qualified colleges expenses may be able to claim the maximum $2,500 AOC. Taxpayers with modified Adjusted Gross Incomes (mAGIs) less than $80,000 (single) or $160,000 (joint) can claim the full credit, while taxpayers with mAGIs up to $90,000 (single) or $180,000 (joint) may be eligible for a reduced credit. Forty percent of the credit is refundable.
Before you go cashing that refund check in your mind, you should be mindful of other education tax breaks that you might already be receiving that may interfere with your claiming of the American Opportunity Credit.
529 Savings Plan
Some of you may have saved for college in a 529 College Savings Plan, and are now reaping the benefit of that tax-saving strategy. You are allowed to make tax-free withdrawals from a 529 Plan to pay for tuition, fees, and special needs services, required books, supplies and equipment, and room and board expenses (if studying at least half-time) of a qualified college student, without income limitations. You’ve likely saved yourself a hefty tax bill over the years by saving and then paying your child’s college bill out of your 529 Plan—all of the earnings of that account can be used completely tax-free!
When planning your college payments, however, you should be aware that the IRS does not allow you to claim two education tax breaks for the same college expense. That means you can’t spend money out of your 529 Plan and count it towards your eligible expenses for the AOC. With this in mind, when planning your annual 529 withdrawals, you may want to actually hold back on $4,000 each year. Pay at least $4,000 of tuition expenses out of your income, a taxable saving account, or even with a loan, so that you may be eligible to claim the full $2,500 American Opportunity Credit. If you’ve already paid all of your child’s 2014 college expenses out of your 529 Plan, it may actually be in your best interest to pay taxes on the earnings portion of $4,000 worth of withdrawals (effectively not taking any tax break for that part of your 529 payment), so that you may then claim the full AOC. The benefit gained from the tax credit will likely be larger than the tax hit on your 529 withdrawal.
For more information on coordinating education tax breaks, see IRS Publication 970, and before employing the above (or any other) tax-saving strategy, be sure to consult with your tax preparer.