With both my kids in college now, you might think I have planned exactly how I’m going to spend down their 529 plans. However, until recently I was making decisions based on whims. For instance, when Covid hit, I stopped taking any 529 withdrawals since my daughter’s tuition was fully covered by a scholarship (and colleges were reimbursing some room and board fees) and due to the sudden drop in the markets.
Since then, I have made basic calculations to determine if their plans will last for the duration of their undergrad education. The good news is I should be able to pay 90% or more of their college costs unless stocks tank another 20%. I’ve also watched our 529 withdrawals to ensure I wouldn’t have a problem qualifying for the full American Opportunity Tax Credit (this provides a maximum $2,500 tax credit for students who spend $4,000 in qualified expenses).
If you are just starting out here are some things to remember when you’re spending 529 college plan money.
529 Refresher
For those of you who aren’t familiar with a 529 plan, it’s pretty simple. You can open a plan in your or any state to invest money for your child’s education. It’s similar to an IRA in that you are investing after-tax money and receive tax benefits when you withdraw the money for specific educational needs.
Note – I’ll focus on college expenses but know that up to $10,000 per year can be spent on tuition for elementary through high school education.
What’s covered
When you are ready to withdraw money to cover your child’s expenses, it’s important to understand exactly what is considered a qualified expense: tuition and fees, room and board, books, supplies, and computer equipment. Also, although this normally doesn’t occur while your child is a full-time student, 529 funds can be used for student loan repayment.
Tuition is pretty straight-forward; the 529 can pay for whatever it costs to attend classes. Room and board is more nebulous though. If your child lives in a dorm and eats at the dining halls, those costs are covered. If your child lives in an apartment and orders meals three times a day, costs above the school’s cost of attendance used for federal financial aid calculations are not reimbursable through the 529.
As you can imagine, it’s similar with computer equipment. Specific software required for a class is covered; the latest Super Mario game isn’t unless it’s required for a class. Know too that transportation costs – whether involving a tank of gas or an airline ticket – also aren’t covered.
Take advantage of the tax credit
Now that you know what’s covered for 529 withdrawals, consider taking advantage of one of the two tax credits (the American Opportunity Tax Credit and the Lifetime Learning Credit).
The American Opportunity Tax Credit (AOTC) is limited to four years of undergraduate education. Like I mentioned above, if you have $4,000 in qualifying expenses you can receive a credit of $2,500 for each dependent. Your adjusted gross income (married couples filing joint) must be below $160,000 (2022) to receive the full credit.
The Lifetime Learning Credit (LLC) is not limited to only four years of undergraduate education; it can be used to help with costs for any year of post-secondary education and for job-related coursework. In fact, students do not have to be pursuing a degree. To receive the full credit of $2,000, you must spend $10,000 in qualified expenses and have a gross adjusted income (married filing joint) of $138,000 (2022) or below.
Now that you know a little more about each credit, there’s one key point with both: you cannot double-dip. In other words, if you use the 529 to pay for your child’s dorm room, you cannot use that expense to qualify for one of these credits. Also, you can only use one credit at a time. This is where careful planning enters the picture.
Make too much for the credits
First off, if your income exceeds the maximum limits for each plan this becomes an easy decision. Simply look at your 529 plan total and determine when you need the money. Some of you will have more than enough, some of you may have saved just a little less so you would be sure to spend the full amount of the account on college. Try to estimate your yearly expenses (based on your child’s first semester), realizing that college costs will rise. Remember too that your happy dorm-living freshman may decide they want an apartment in a couple of years.
If you can claim a credit
Here’s where it gets tricky. If you can claim an education credit, you will have to maintain precise records. In a best-case scenario, you will be able to use $4,000 for the credit and still have enough left over to pay down your 529 as you’d hoped when you did the earlier estimate.
Grants and scholarships can make this more difficult than it first appears though. One area to research is having your child claim some of the 529 withdrawal as income. That can result in low or no taxes to them and still leave you enough to quality for the credit and to pay down your 529.
Where to send the check
After you’ve decided how to split your funds between tax credits and your 529 plan, take a moment to consider where to send the check.
Straight to school. Some people choose to send money from their 529 directly to the school to cover the bill each semester. There’s nothing wrong with this, but make sure that you understand both the amount of time it will take your 529 administrator to send the check and the date on which your child’s school must receive the check, then send it early.
To the owner of the account. Many colleges prefer that you pay via electronic payment, usually straight from your checking account. This can provide more flexibility especially if you can float the payment since you aren’t strictly tied to the 529 plan administrator sending the check on the exact date. You can pay for college and reimburse yourself with the 529 funds or withdraw the money early and transfer the semester expenses to arrive on time.
To your child. Sending the check in your child’s name to your place of residence may be the best option available. Your child can sign the money over to the owner (e.g. you) and deposit it into your account. However, since it was sent to your child, any money that can’t be used to cover expenses can be reported on the child’s tax return (as noted above).
When to start the AOTC
One of the more interesting aspects of this credit is that it’s based on a January through December year, yet most students begin college in the fall and graduate in the spring. This means you may not have a full year of expenses either at the start or the end of your child’s college career. Some experts have suggested if you can qualify for the credit, do so as soon as possible. Often, students starting college may have a few larger expenses (like a computer) that can help you reach the $4,000 AOTC threshold.
Determining how to spend down your 529 fund can be confusing. However, if you take a few minutes and plan out how the tax credits can work with your 529 withdrawals, you will be able to maximize any benefits while reducing your 529 balance so you aren’t left with an overage.
Photo by Honey Yanibel Minaya Cruz