Wednesday, February 11, 2015

The Tax-Smart Way to Draw ‘529’ Funds


If you have a college-tuition bill coming due this year and plan to pay it all with money from a 529 savings account, you might be missing out on some valuable tax benefits.

Americans are pouring billions of dollars into 529 college-savings plans—more than $221 billion was invested in these plans as of mid-2014, up from $52 billion a decade earlier, according to the Investment Company Institute, a mutual-fund trade group.

The plans are popular because earnings grow and are distributed tax-free if the money is spent on qualified education expenses. (A recent proposal from President Barack Obama to curtail the tax benefits of new contributions to 529 plans was withdrawn quickly.)

But there are other tax breaks available for college expenses, for those who qualify based on their income. You can’t claim them, though, for expenses you cover with money from a 529 plan.

So if you are eligible for these other credits, “a big tax-planning mistake would be to take the total education expenses and withdraw that from the 529 plan,” says Tom Fredrickson, founder of Fredrickson Financial Planning in New York.

Figuring out whether you qualify for various tax breaks will help you determine which expenses to pay with money from your 529 account and which expenses to pay out of regular savings, cash flow or loans.

Big Opportunity
Three of the most valuable tax benefits for education are the American Opportunity tax credit, Lifetime Learning credit, and tuition-and-fees deduction. The tuition-and-fees deduction has expired for 2015, but it’s a provision that Congress tends to resuscitate at year-end. (It had also expired for 2014 but was extended in December.)

These three are mutually exclusive, meaning you can’t use more than one per student. For most eligible taxpayers, the American Opportunity credit is the most valuable, says Mark Kantrowitz, senior vice president and publisher of, a consumer-information website based in Las Vegas.

The American Opportunity credit can reduce your tax bill by as much as $2,500, more than most taxpayers can save with either of the other two options. Also, while the American Opportunity credit is unavailable to wealthier taxpayers, the income limits are higher than those for the Lifetime Learning credit and tuition-and-fees deduction. If your income is below the level where the American Opportunity tax credit starts to phase out, “it’s a no-brainer,” Mr. Kantrowitz says. Except in rare cases, he says, “the AOTC is going to yield more financial benefits.”

If you’re eligible for the American Opportunity tax credit, you can maximize your tax benefits by planning to spend $4,000 from your cash, regular savings or loan proceeds on qualified education expenses. Then, any remaining expenses can be paid with money from your 529 plan.

Why $4,000? You can claim an American Opportunity tax credit for 100% of the first $2,000 of qualified education expenses, plus 25% of the next $2,000.

“You don’t want to leave the tax credit on the table by paying for everything out of the 529 plan,” says Maura Griffin, founder of Blue Spark Capital Advisors in New York.

Don’t forget to consider financial aid and other education benefits, such as scholarships and grants. Any of those that are tax-free will reduce your qualified expenses. After taking those benefits into account, focus on finding expenses that qualify for the American Opportunity credit, Mr. Kantrowitz says, adding that “529 plans have the broadest definition of qualified expenses, so you’d first focus on the AOTC.” For example, room and board isn’t a qualified expense under the American Opportunity credit but generally is for 529-plan distributions.

Income Limits
Of course, you won’t qualify for the American Opportunity credit, the Lifetime Learning credit, or a tuition-and-fees deduction if your income is too high. The American Opportunity credit, with the highest threshold, is unavailable for those with modified adjusted gross income above $90,000, or $180,000 for joint filers. (Modified adjusted gross income is adjusted gross income plus foreign income and some other income added back.)

American Opportunity tax credits are reduced for those with modified adjusted gross income between $80,000 and $90,000, or between $160,000 and $180,000 for joint filers. If your income is in those ranges, the benefit essentially is halved, Mr. Kantrowitz says. Instead of a credit for 100% of the first $2,000 of qualified expenses and 25% of the second $2,000, “it’s effectively 50% of the first $2,000, 12.5% of the second $2,000,” he says.

That might mean that taking money out of your 529 plan will give you a bigger tax benefit, depending on your tax bracket and other factors. “If you’re in the income phase-outs I suggest you do the calculations to see what the benefit is each way,” he says.

If you do that, remember that for federal taxes you only benefit from a tax break on the earnings in your 529 plan, not the contributions, since the contributions were made with after-tax money.

Say, for example, one-third of your 529 withdrawal is earnings. If you are in the 25% tax bracket, the tax benefit of that 529 money is 25% of one-third of the amount you withdraw, or a little more than 8 cents per dollar of education expenses. Check your state’s rules for possible additional tax benefits.