Gregory Burke

Ask the Experts: Weighing 529 Plan withdrawals against federal education tax credits

Published: Wednesday, Nov. 14, 2012 - 12:00 am | Page 7B

When it comes to paying a student's college costs, the choices can be tricky. Here with some advice for parents is Gregory Burke, a Sacramento CPA and IRS tax expert.

He and our other local "Ask the Experts" advisers answer readers' questions on taxes, investing, money matters and wills/trusts.

We have about $6,000 in a 529 Plan for our daughter's college expenses. Now that she is a freshman, we have incurred a few expenses: a $1,200 laptop and $700 for payments and books.

My question: Is it better to withdraw the funds from our 529, or use the education credit on our federal tax return? I know I can't use both, and I'm not clear about the education credit options.

Reading the IRS site, it appears you can't use the federal American Opportunity tax credit for room/board. I don't want to make a 529 withdrawal until I'm sure we're unable to use the credit for our daughter. (She also received a CSU Cal Grant of $3,000 a semester, a $1,000 Pell Grant and a $1,000 scholarship.)

There is no simple answer to questions regarding which education incentive is best to use because there are so many variables involved. The IRS publication explaining the tax benefits for education (Publication 970) is 87 pages long!

The following comments are intended to be general guidance. You should talk to your tax adviser regarding your specific situation.

In general, the American Opportunity Credit is the most favorable, as 40 percent of the credit is refundable. That means that if your deductions and other nonrefundable credits reduce your tax to zero, you will get back the refundable portion of the credit.

The maximum credit is $2,500 per student, of which up to $1,000 can be refunded to you. There is an income limit. If you are filing a joint income tax return with your spouse, your income must be below $180,000 ($90,000 if you are single or head of household). You cannot claim the credit if you are married filing a separate return, regardless of income level.

Expenses that qualify for the credit include tuition and certain expenses paid to an eligible educational institution. Expenses for books, supplies and equipment are included as qualified education expenses. Room and board are not.

Qualifying education expenses must be reduced by tax-free educational assistance, such as scholarships, grants or assistance provided by an employer.

The American Opportunity Credit is available only for the first four years of postsecondary education. See Publication 970 (page 10) for a flowchart that helps determine whether you qualify for the American Opportunity Credit.

If your income is over the limit or if your expenditures include room and board, it may be better to use funds from a 529 account. The earnings portion of funds withdrawn to pay for qualified educational expenses, including room and board, is not taxable. There is no income limit affecting this tax break.

You can claim an American Opportunity Credit and take tax-free distributions from a 529 plan in the same year, as long as expenses qualifying for 529 distributions do not qualify for the American Opportunity Credit. In other words, you can pay qualifying room/board expenses from 529 distributions, while claiming the American Opportunity Credit for qualifying tuition and fees.

There is also a Lifetime Learning Credit. You cannot claim both the American Opportunity Credit and the Lifetime Learning Credit for the same eligible student in the same tax year.

The Lifetime Learning Credit is limited to $2,000 per year and is nonrefundable. The income limits are lower: $122,000 married filing joint, $61,000 single/head of household. Married taxpayers filing separate returns do not qualify for this credit. It is available for an unlimited number of years. Qualifying expenses are similar to the American Opportunity Credit.

Most tax preparation software has an education tax break feature. Once you input the raw data, the software will determine which education tax incentive is best. The choice may change from year to year depending on your specific circumstances.

– Compiled by Claudia Buck

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