In part one of this two-blog series, we established that higher education is frighteningly expensive. But with a proper plan in hand, you and your clients will be better prepared to tackle college tuition bills in an organized and financially sound way.
Recently, I explored the factors that affect financial aid eligibility. In this post, I’ll provide some tax smart tips to help your clients maximize their tax benefits. (Our new research, Tackling the tuition bill, has all the details on both topics.)
While it may seem intuitive to first tap into the qualified education savings accounts when the bills come, there are a few things your clients need to consider before doing so.
Educate your Clients on Potential Tax Breaks Before They Tap 529 Accounts
Consider the AOTC for the parent, or the child. Don’t rush to deplete the 529 account in the first year, as there may be some beneficial tax credits available each year. For example, the American Opportunity Tax Credit (AOTC) is available to taxpayers who meet income eligibility requirements.
The credit amounts to the first $2,000 spent on qualified education expenses and 25 percent of the next $2,000, for a total of $2,500. Funds counted toward this credit must come from current parental income or parental-owned assets held in taxable accounts. In other words, they cannot be funds from qualified savings plans, such as 529 plans. This tax credit can be taken each year in which qualified education expenses are incurred for a maximum of four years per student. With a total benefit of $10,000 over the student’s educational career, it may be smart for eligible parents to first take advantage of this credit before spending from 529 accounts.
Note that if the parents’ income exceeds the AOTC limits, but the child is reporting income for that tax year, the child may have the option to claim the AOTC. This would require the child to file as an independent, rather than as a dependent the parent’s tax return. Although this is possible, there may be other financial implications in doing so. The AOTC is refundable up to $1,000.
See if your clients qualify for the LLC or other deductions. Some taxpayers, such as those who have exhausted the AOTC, may qualify for the Lifetime Learning Credit (LLC). This credit is worth up to $2,000 for expenses related to tuition and other qualified expenses for students enrolled at an eligible financial institution (note that for the 2016 tax year, the Lifetime Learning Credit is worth 20 percent of the first $10,000 of qualified college expenses. The LLC is not refundable). The credit can be used each tax year and applies to undergraduate and graduate school, as well as programs geared toward professional degrees or expanding job skills.
If they do not qualify for the AOTC or the LLC, the Tuition and Fees Deduction may be another option. For the 2016 tax year, this deduction can total up to a $4,000 reduction in income. Note that only one tax credit or deduction (AOTC, LLC, or Tuition and Fees Deduction) may be claimed per tax year. Keep in mind that IRS Publication 970 is a good source for more information on education tax credits and deductions. The figure below provides a brief summary of the most basic information.
Be Mindful of Tax-Sensitive Withdrawals
Aside from the potential tax benefits that can be received from paying for college expenses out of pocket, there are tax implications to be aware of when your clients are withdrawing from retirement accounts and taxable savings accounts to pay for college. Withdrawals from parent-owned and student-owned tax-deferred retirement accounts (such as traditional IRA and 401(k) accounts) are taxed as ordinary income. Note that withdrawals that meet the criteria of qualified education expenses are not subject to the 10 percent penalty tax. Withdrawals from parent-owned and student-owned Roth IRAs, on the other hand, can be taken tax free as long as the distribution is composed of the contributions made into the account on an after-tax basis. Withdrawals that represent earnings will be taxed as ordinary income. Note that Roth withdrawals in excess of contributions are not subject to the 10 percent penalty tax if used for qualified education expenses.
As you’re aware, care should be taken when selling assets from taxable accounts, whether parent-owned or student-owned. Realized gains will be subject to capital gains tax, but they may be offset with realized losses elsewhere.
Although the challenges of paying for college expenses may seem overwhelming to your clients, proper planning is critical to a successful outcome. Remember that bottle of smelling salts I suggested keeping at your desk in part 1 of this series? Put it away! Remember that balancing financial aid and grant considerations with tax-efficient spending strategies is a good way to help your clients start facing their college financing fears.
Maria Bruno, CFP®
Senior Investment Analyst
Vanguard Investment Strategy Group
Editor’s note: This post originally appeared on the Vanguard Advisor Blog. See also Part I of the series. The author gives a special thanks to her colleagues Jonathan Kahler and Jenna McNamee for their research contributions.