Income tax center

Can I claim the American Opportunity or Lifetime Learning credit in the same year that I withdraw from my 529 account to pay for college?

[Excerpts from Chapter 3 of The Best Way to Save for College – A Complete Guide to 529 Plans (2015-16 Edition)]

Yes, the American Opportunity credit or Lifetime Learning credit can be claimed regardless of whether the tuition and related expenses that are used to compute the credit are paid out of a 529 account. However, in order to prevent "double-dipping," Section 529 requires that QHEE be reduced by the amount of tuition and related expenses applied to the credit (see discussion of AQHEE above). Unless you pay out-of-pocket an amount at least equal to the amount of tuition and fees used in determining the American Opportunity or Lifetime Learning credit, some portion of your 529 distribution will no longer be qualified and will become subject to income tax. The 10% penalty tax is waived in these circumstances.

Example: Eric, a second-year college student, has his own 529 account. He withdraws $24,000 from the account during 2015 to pay for all of his QHEE, including $8,000 in tuition. The entire $24,000 distribution would be tax-free, except that Eric claims the maximum $2,500 American Opportunity credit against $4,000 of his tuition. He must reduce his $24,000 QHEE by $4,000, leaving $20,000. This means that $4,000 (or one-fifth) of his 529 distribution is no longer qualified. If we assume the earnings portion of the distribution is $5,000, then one-fifth of $5,000, or $1,000, is taxable to him as ordinary income. If Eric's marginal federal tax bracket is 15%, he incurs $150 in federal tax. The 10 percent penalty tax is waived when the income is caused by this type of adjustment.

You may elect to waive the American Opportunity and Lifetime Learning credit if you decide that the negative impact of the QHEE adjustment on 529 distributions is greater than the amount of credit. This will occur in a relatively small number of cases, as the benefit of either credit will nearly always outweigh the tax on that portion of your 529 distributions.

Note that similar coordination rules apply to withdrawals from a Coverdell education savings account. Furthermore, if withdrawals are taken from both a Coverdell ESA and a 529 account in the same year for the same beneficiary, the QHEE must be divided between them to determine the amount of tax exclusion on the withdrawals from each type of account.

Next: How about the above-the-line deduction for qualified tuition and related expenses?
Can I claim the deduction for expenses I pay using funds from my 529 account?