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COLLEGE SAVINGS 101
No. 3 - How do 529 withdrawals affect your ability to claim the Hope or Lifetime Learning credit?
http://www.savingforcollege.com/articles/no-3---how-do-529-withdrawals-affect-your-ability-to-claim-the-hope-or-lifetime-learning-credit
Posted: 2002-11-01
I read in a recent magazine editorial that using 529 funds may make you ineligible for the Hope and Lifetime Learning credits. Could you discuss why that is? - K.C.
Answer: K.C., you've touched upon the most worrisome aspect of the new education tax breaks: their complexity. It's wonderful that Congress has created so many special incentives to help families afford college and graduate school costs, but now you have to deal with an intricate web of rules that can frustrate even the most experienced tax professional. When preparing your taxes, you will be forced to apply a certain priority so that the same dollar of education expense cannot be used to provide multiple tax savings. In other words, no double-dipping.
529 plans and the Hope and Lifetime Learning credits are a perfect example of this, although it doesn't work exactly as you suggest. You must first figure your Hope or Lifetime Learning credit on qualifying tuition and fees, Then you use any leftover tuition and fees, along with other qualifying college expenses such as books, supplies, and room and board, when computing the portion of your 529 account withdrawals that come out tax-free.
Is this reason to stay away from 529 plans? Hardly. An example will demonstrate:
Mom originally put $6,000 into a 529 plan for her daughter Sue and the account grows to $10,000 by the time Mom uses it to pay for Sue's first year of college. Mom expects the $4,000 in gains to come out tax-free because the money is used to pay for Sue's $10,000 in qualified higher education expenses ($4,500 of which is tuition).
When preparing her taxes, Mom finds that she can claim a Hope credit of $1,500, which is 100% of the first $1,000 of Sue's tuition and 50% of the next $1,000. Because she has ""used up"" $2,000 of tuition in claiming the Hope credit, only $8,000 of qualified expenses is left for the $10,000 withdrawal from the 529 plan. This means that $2,000 of the withdrawal is "nonqualified" and that one-fifth of the $4,000 in gains, or $800, is taxable as ordinary income to Sue.
If Sue is in the 15% federal tax bracket, she pays $120 in tax on the 529 withdrawal. But Mom has earned a $1,500 tax credit. It's obvious that they are still much better off. (If Sue had incurred at least $12,000 in qualifying 529 expenses, rather than $10,000, the family would have had the full benefit of both tax breaks.)
Want more complications? You'll find them if Sue receives any scholarships; or if she takes withdrawals from a Coverdell education savings account in the same year; or if Mom takes early distributions from her IRA; or if Mom redeems certain qualifying Series EE United States savings bonds. Special coordination rules apply in all these instances. Get the Excedrin ready.
I read in a recent magazine editorial that using 529 funds may make you ineligible for the Hope and Lifetime Learning credits. Could you discuss why that is? - K.C.
Answer: K.C., you've touched upon the most worrisome aspect of the new education tax breaks: their complexity. It's wonderful that Congress has created so many special incentives to help families afford college and graduate school costs, but now you have to deal with an intricate web of rules that can frustrate even the most experienced tax professional. When preparing your taxes, you will be forced to apply a certain priority so that the same dollar of education expense cannot be used to provide multiple tax savings. In other words, no double-dipping.
529 plans and the Hope and Lifetime Learning credits are a perfect example of this, although it doesn't work exactly as you suggest. You must first figure your Hope or Lifetime Learning credit on qualifying tuition and fees, Then you use any leftover tuition and fees, along with other qualifying college expenses such as books, supplies, and room and board, when computing the portion of your 529 account withdrawals that come out tax-free.
Is this reason to stay away from 529 plans? Hardly. An example will demonstrate:
Mom originally put $6,000 into a 529 plan for her daughter Sue and the account grows to $10,000 by the time Mom uses it to pay for Sue's first year of college. Mom expects the $4,000 in gains to come out tax-free because the money is used to pay for Sue's $10,000 in qualified higher education expenses ($4,500 of which is tuition).
When preparing her taxes, Mom finds that she can claim a Hope credit of $1,500, which is 100% of the first $1,000 of Sue's tuition and 50% of the next $1,000. Because she has ""used up"" $2,000 of tuition in claiming the Hope credit, only $8,000 of qualified expenses is left for the $10,000 withdrawal from the 529 plan. This means that $2,000 of the withdrawal is "nonqualified" and that one-fifth of the $4,000 in gains, or $800, is taxable as ordinary income to Sue.
If Sue is in the 15% federal tax bracket, she pays $120 in tax on the 529 withdrawal. But Mom has earned a $1,500 tax credit. It's obvious that they are still much better off. (If Sue had incurred at least $12,000 in qualifying 529 expenses, rather than $10,000, the family would have had the full benefit of both tax breaks.)
Want more complications? You'll find them if Sue receives any scholarships; or if she takes withdrawals from a Coverdell education savings account in the same year; or if Mom takes early distributions from her IRA; or if Mom redeems certain qualifying Series EE United States savings bonds. Special coordination rules apply in all these instances. Get the Excedrin ready.
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