You've probably gotten a tuition bill from your child's college or university at this point if they will return to college in the fall.
First-time college-bound families may look at this daunting bill as a major you may wonder what strategic moves you can make, tax-wise, when opening your checkbook or making 529 plan withdrawals. However, you can make some excellent moves prior to making that first tuition payment, which may affect your 529 plans and taxes.
Take a look at how to take the bite out of high education costs if you'll have a college-bound student this fall.
It's Easy to Make Tax Missteps
When you have a child going off to college, you may think you're doing everything right, but you might end up making innocent missteps. Take a look at these tips.
Tip 1: Use 529 plans for qualified educational expenses only.
You probably already know that when you pay qualified educational expenses from a 529 account, you won't pay taxes or penalties on your withdrawals. However, you'll get hit with a penalty if you don't use your child's 529 plan for qualified educational expenses.
You can use the money to pay for qualified educational expenses at any college, university, vocational school or other postsecondary educational institution, as long as the institution can tap into the student aid program administered by the U.S. Department of Education.
Let's talk through all qualified educational expenses (and check with the school to find out what's required in case you accidentally take a nonqualified distribution):
- Tuition and fees
- Room and board, but the costs can't exceed the school's cost of attendance for financial aid and the costs must be the actual amount charged if your student will live in housing operated by the school. In other words, you can't utilize the 529 plan for more money than the school's estimates for room and board.
- Textbooks, as long as they are required reading for a course
- Computers and related equipment and services, though equipment for sports, games or hobbies don't count.
Keep your receipts and avoid expenses that don't qualify, like insurance, sports expenses, health club dues, and travel expenses.
Here's what happens if you withdraw money for anything that doesn’t meet the qualified expense criteria: It gets taxed as ordinary income and could also invite a 10% federal penalty.
Tip 2: Know that 529 account funds may conflict with other tax incentives.
The federal government offers additional tax incentives to help families combat the costs of college, but you can't use a 529 account at the same time you use these tax incentives. The IRS considers that practice double-dipping, so you'll want to factor in whether you'll claim the tax credit when you choose the amount to withdraw from your 529 account.
A tax credit goes directly against your tax liability — not the same as a deduction. You can only claim one deduction per student each year.
- American Opportunity Tax Credit: Families of undergraduates can deduct the first $2,000 they spend on qualified education expenses and 25% off the next $2,000. Single taxpayers who have adjusted gross income between $80,000 and $90,000 and joint tax filers with adjusted gross income between $160,000 and $180,000 may get it. Taxpayers whose adjusted gross income exceeds the $90,000 and $180,000 thresholds cannot tap into the tax credit. The total credit cannot exceed $2,500 per tax year and the credit can be claimed for only 4 years.
- Lifetime Learning Credit: The Lifetime Learning Credit provides up to a $2,000 tax credit on the first $10,000 of college expenses. You won't face limits on the number of years you can claim this credit. Beginning in 2021, the income limits for the Lifetime Learning Credit may be claimed by people with modified adjusted gross income (MAGI) of up to $80,000 for single taxpayers and $160,000 for married taxpayers filing jointly.
Is your income too high to get either the American Opportunity or Lifetime Learning credit? You may want to consider not claiming your child as a dependent and let your student claim the credit on his or her own tax return.
Tip 3: Consider your state's 529 college savings plan.
You might think this seems like advice that's too little, too late if you've already invested in another state's 529 plan for years. However, you can still opt to save in your own state's 529 plan. Many states offer state income tax deductions or credits on contributions to your state's 529 plan.
However, did you know that the IRS allows one tax-free rollover of a 529 account per beneficiary in a 12-month period? If you violate the 12-month rule, you must treat the transaction as a nonqualified distribution and pay federal income tax and a 10% penalty on anything you've earned.
Just note that when you roll over to another state's plan, some states require you to pay the state income tax on any contributions for which you've received a deduction.
In this case, opt for a direct rollover and communicate with your current plan to move it from one plan into another.
Tip 4: Check for tax-free savings bonds.
Got some bonds lying around? You can benefit from any Series EE or Series I savings bonds issued after 1989: They're tax-free if you use it to pay for qualified college tuition and fees.
This tax break begins to phase out at $123,550 of modified adjusted gross income (MAGI) for married joint filers and at $82,350 for single taxpayers.
You cannot use this perk if you plan to claim other educational tax breaks, such as the American Opportunity or Lifetime Learning credits.
Check Your Tax Options with a Professional's Help
Consider asking the right tax professionals to help you determine the right credits and deductions to give you the biggest tax breaks. They'll offer the right advice and tax credit options for your situation. Whether you have a simple or complex tax situation, you may want to tap into specific tax advice for students going off to college.
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