Funding a College Education with Taxes in Mind

February 27, 2023 – Shawn Williamson, CPA

While 529 plans are a popular way to fund expensive college educations, Buckingham Senior Tax Manager Shawn Williamson shares more options that may benefit both students and parents from a tax standpoint.

According to a recent study, a year of tuition, books, supplies and day-to-day living expenses at a four-year university will cost on average $35,551. In addition, the price of college is rising at an alarming 7.1% annually. To combat these soaring prices, many parents prepare for their children’s education by investing in 529 plans. Through this strategy, tuition funds are taken directly out of the plan, and parents avoid paying capital gains tax on the appreciation of the investments in the educational fund. They may even get a state tax deduction for the contributions.

While many agree that the benefits of the 529 are of great support to parents, there can be a few nuances that affect your tax filings. College tuition can be utilized in four different ways on a tax return:

To offset it against scholarships that would otherwise be taxable.
To claim it as qualified tuition distributions out of the 529 plan.
To claim the Lifetime Learning Credit for 20% of eligible tuition, up to $2,000 a year.
To claim the American Opportunities Tax Credit (AOTC), worth up to $2,500 a year for up to four years. Note that it only takes a minimum of $4,000 of tuition to maximize this credit.

The same tuition dollar cannot be used twice, but the total tuition paid each year can be split up and used for different purposes. Furthermore, all of those options may be utilized on either the parent’s or the child’s tax return, conditional on the dependency situation.

Higher-income individuals may be able to take advantage of four underutilized opportunities:

Determine if your child should be claimed as a dependent on your tax returns

First, it’s important to establish whether or not your college-aged child should be claimed as a dependent on your tax returns. When married parents have more than $180,000 in adjusted gross income (AGI), they cannot claim the AOTC or the Lifetime Learning Credit. Those with AGI in excess of $410,000 don’t even get the basic $500 credit for dependents older than 17. For parents who do not receive a tax benefit from claiming their child as a dependent and do not qualify for financial aid, it may be more advantageous to remove the child from the parents’ tax return.

A child is classified as independent if they are providing at least half of their own support through working a part-time or summer job or spending their own savings for room and board. They may also be taking out significant student loans in their own name or covering a huge portion of tuition by way of scholarships. If this is the case, the child has an opportunity to claim the AOTC on their own tax return. For the parents, a $2,500 tax credit might be irrelevant, but to a college student it may be a gold mine and at least worth considering.

Have distributions go directly to the school

Parents may pay college costs out of their personal checking accounts and then request reimbursement from the 529 plan later. As a tax professional, I recommend having those distributions go directly to the university. If the costs are reimbursed, the 1099-Q distribution will show up under the parent’s Social Security number (the reimbursement recipient). If the tuition is sent straight to the university, 1099-Q distributions usually show up under the child’s Social Security number (the beneficiary). If the parent is audited, there should be no debate or need for investigation of whether or not the distributions were qualified since they went straight to the school. Also, if the child claims herself or himself, then all of the college-related numbers can go on the child’s return: tuition, scholarships, 529 distributions and the AOTC. If the child happens to have taxable scholarships because their tuition was used to get the AOTC, they will likely be taxed at a much lower rate than the parent (possibly 0%).

Consider using the Lifetime Learning Credit before and after a bachelor’s degree

Since the American Opportunity Credit is only good for four tax years, normally you will want to use it during the child’s full-time pursuit of a bachelor’s degree. However, a lot of students these days are taking classes for college credit during high school. Many taxpayers do not know that they can use the Lifetime Learning Credit to benefit from those early part-time college classes. Likewise, if your child goes on to pursue a master’s degree or takes longer than four years to get a bachelor’s degree, this credit can continue to benefit the parents or the student after the AOTC expires.

Continue investing after your student begins college

Many parents are falsely under the assumption that if the child has already started college, it’s too late to make 529 contributions. In fact, contributions can even be made a week before the distributions are needed. While there is little time to earn tax-free investment growth, you may still be able to get a state tax deduction of 5% to 10%. In that scenario, it is best to invest the 529 contributions in a cash option to avoid the unnecessary risk of short-term loss.

About the author:

As a Senior Tax Manager at Buckingham Strategic Wealth, Shawn helps clients with tax planning and reviews returns prepared by the firm. Along with reviewing 20,000 individual and business tax returns in his lifetime, he has authored dozens of tax and finance related articles and has written the book “Big Success in Small Business”. He was named 100 St. Louisans You Should Know to Succeed in Business by St. Louis Small Business Monthly.

While the cost of higher learning is at record levels, there are several ways to fund your child’s education while receiving tax benefits. If you need assistance with this complicated issue or have questions, reach out to your advisor.

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become outdated or otherwise superseded without notice. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this document. R-23-4998

From time-to-time we share third-party articles/information that may be of interest to our clients. These articles are being provided for informational purposes only, do not constitute investment advice and do not necessarily represent the opinions of Homan Wealth Advisors. Homan Wealth Advisors does not provide any guarantee, expressed or implied, that the information presented is accurate or timely, and does not contain inadvertent technical or factual inaccuracies. The past performance of securities is no guarantee of their future result. The value of any investment may fall, as well as rise, and investors may not receive the full amount of their principal at the time of redemption if asset values have fallen.