Editor’s note: Woodberry Forrest, financial aid director, Mike Szylowski, who’s also our friend, colleague, and financial aid and education financing expert, offers his thoughts on how a family using a 529 plan to help pay for college costs might also benefit from the American Opportunity Tax Credit.
I know this doesn’t directly pertain to boarding schools. But, college is the next step and there are few of us out there who aren’t looking for the best ways to help with college bills.
Is your child an at least half-time college student?
Do you plan to pay some or all of your child’s college costs using proceeds from a 529 plan (a QTP)?
Is your Modified Adjusted Gross Income (MAGI*) below $160,000 for Married Filing Jointly (MFJ), $80,000 if single?
I believe many parents who are taking distributions from a 529 plan are not benefiting from the $2,500 American Opportunity Tax Credit (AOTC) but they could be.
Some background: 529 plans come in two ‘flavors:’
1. a pre-pay type plan where your savings are guaranteed to cover the full cost of tuition and required fees (but not room and board)
2. a market return based plan where your savings are not guaranteed to cover full cost (tuition, fees, room & board), the amount available for college costs is strictly the amount you contributed to the plan plus return on investment. Market based plans are more common.
For 529 plan distributions, Qualified Education Expenses (QEE’s) include tuition, required fees, books, supplies and room and board.
Several years ago the Hope college credit (good for only the first two years of college) was replaced by the AOTC. The AOTC is available for all 4 years of college.
Under the ATOC, the maximum credit increased from $1,850 to $2,500. The AOTC is a partially refundable credit (up to 40% of the full credit, if your tax liability is $0 you could receive a tax refund up to $1,000) and most importantly income limits were increased dramatically from about $115,000 for Married Filing Joint filers to $160,000. Under the AOTC, QEE’s are tuition, required fees, books and supplies but not room and board.
The amount of the AOTC is determined using the following formula: 100% of the first $2,000 of QEE’s, basically tuition, required fees, books and supplies paid + 25% of the next $2,000 QEE’s paid ($2,000 + .25 x $2,000 = $2,500).
But what happens if the family takes a distribution from their market based 529 plan that covers at least the full amount of their AOTC QEE’s? If so, they will not qualify for the AOTC even if their MAGI is below the income limits above.
Here is an example:
The tuition, required fees and supplies at your in-state University or College are $12,000 and the room and board is an additional $10,000. Your 529 plan balance is $60,000 and you plan to take $15,000 out each year to help pay for annual college costs, leaving you a balance due of $7,000 ($22,000 total cost – $15,000 from your QTP = $7,000). You could either pay this $7,000 out of pocket or use loans, doesn’t matter for this example.
In this case your $15,000 QTP distribution will disqualify you from benefiting from the $2,500 AOTC (i.e., you will owe $2,500 more in federal income tax than if you had been able to claim the AOTC). However, if you designate the first $7,000 of the amount you have to pay as being specifically for AOTC QEE’s and then take the distribution from your 529 plan you will benefit from the full $2,500 benefit of the AOTC if you meet the income limits!
The strategy here is to be sure that you designate your QTP distribution to pay for room and board and pay at least the first $4,000 of your QEE’s with non 529 plan distributions.
*MAGI is AGI plus a) the foreign earned income and housing exclusion and/or deduction, and b) excluded income from bona fide residents of American Samoa and/Puerto Rico.