Combine 529 plan with other credits



Dear Joe, I am an engineer who has been employed in the automotive industry for the past 15 years and am tired of the constant threat of losing my job due to repeated downsizing. Actually, I finally did lose my job earlier this year. Seeking more stability in my employment, I have decided to go back to school for a career in the health sciences field. I just made this decision. In a little over a month, I will be starting classes at the local commmunity college. I want to know if I can get the tax benefits offered by my state (Indiana) of a 529 plan and the federal Hope Credit. IRS Publication 970 and my call to the IRS still leaves this question unanswered for me. Please help me! Thank you! -- Gail


Dear Gail,

First of all, you will not qualify for the Hope Credit -- renamed the American Opportunity Tax Credit, or AOTC, for 2009 and 2010 -- if you have already been through four years of college. Pursuing a degree in a different field like health sciences does not get you around that rule, which is too bad, because the Hope/AOTC returns 100 percent of the first $2,000 in tuition, required fees and the cost of course materials paid during the year and 25 percent of the next $2,000, for a total credit of as much as $2,500.

But all is not lost. You may be eligible to claim the Lifetime Learning Credit, which is calculated at 20 percent of up to $10,000 in tuition, required fees and the cost of course materials, for a total annual credit of as much as $2,000. The Lifetime Learning Credit is more flexible than the Hope/AOTC as it does not require at least half-time attendance and there is no limit to the number of years it can be claimed. However, the credit is phased out in 2009 for taxpayers with modified adjusted gross incomes between $50,000 and $60,000, or between $100,000 and $120,000 for joint filers.

You can combine the benefits of a 529 plan with one of the federal educational tax benefits, but you cannot double dip. Any expenses used to compute a Hope/AOTC or Lifetime Learning Credit cannot be included as a qualified higher education expense in determining the tax exclusion for 529 withdrawals.

For example, let's say you withdraw $10,000 from a 529 plan to pay for qualified higher education expenses, consisting of $5,000 for tuition, fees and the cost of course materials, and $5,000 for room, board, books, supplies and computer technology. If you claim a $1,000 Lifetime Learning Credit on the $5,000 in tuition, fees and course materials ($5,000 times 20 percent equals $1,000), you must reduce your 529-qualified expenses by $5,000. That will leave you with a "nonqualified" withdrawal of $5,000, and you will have to report as income on your federal tax return a percentage (in this example, 50 percent) of any earnings withdrawn from your 529. The principal portion of your 529 withdrawal remains tax-free.

Now consider the state income tax benefits. As an Indiana resident, you can claim a tax credit on your Indiana personal income tax return for 20 percent of up to $5,000 in contributions to the Indiana 529 plan, for a maximum annual credit of $1,000. If you claim the credit but later take a nonqualified withdrawal, you will need to pay back at least a portion of your credit to the state. It appears that a withdrawal that becomes nonqualified as a result of the anti-double-dipping adjustment described above can still be a qualified withdrawal for Indiana tax purposes, as long as it was used to pay qualified higher education expenses. However, any withdrawal from an account that is terminated within 12 months after it was opened is considered a nonqualified withdrawal for purposes of the Indiana recapture tax.

Federal and state rules are notoriously tricky when it comes to the education tax benefits, and you should consider seeking the advice and guidance of a tax professional in your state. Several important changes to the federal tax code were made with the American Recovery and Reinvestment Act of 2009, and at the time this article was written, the IRS had not yet updated Publication 970, Tax Benefits for Education.