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Strategizing Your 529 Plan

Contributions to a 529 Plan such as College Savings Iowa can save you money on your state tax return, but these contributions are not deductible on your federal tax return. Earnings on investments in 529 plans can be tax-free on both federal and state tax returns.

Particularly noteworthy is the difference between what is considered a Qualified Educational Expense for federal education tax credits and what expenses meet the criteria for qualified withdrawals from 529 plans.

For the education credits, such as the American Opportunity Credit and the Lifetime Learning Credit, the IRS defines Qualified Education Expenses as “Qualified expenses are amounts paid for tuition, fees and other related expense for an eligible student that are required for enrollment or attendance at an eligible educational institution.”1

In addition to these qualified education expenses, qualified withdrawals from 529 plans can be used to pay for students’ room and board while away at college (there are some limitations).

A strategized approach considers a taxpayer’s income and assets available to spend on education along with the scholarships, grants, and other financial aid available to the student. Using 529 plan withdrawals to cover room and board expenses that are not qualified educational expenses for federal education credits is part of the strategy.

Example:  Student A has ½ of her tuition covered by scholarships and is attending at least half-time at an eligible educational institution. To benefit from state deductions for education, Student A’s parents are taking qualified withdrawals from the 529 plan to cover dorm and meal plan expenses and some of the tuition.  The parents’ income falls below the income threshold for the American Opportunity Credit, and they plan to achieve the full credit of $2500 (100% of the first $2000 spent on qualified educational expenses and 25% of the next $2000 spent on qualified educational expenses) by spending $4,000 from their personal checking account on tuition and covering the gap in tuition from their 529 plan.

The American Opportunity Credit is used to offset any tax you may owe and up to 40% of the unused credit ($1000 max) can be directly refunded to the parents.  In this manner Student A’s parents are able to be directly refunded $1,000 of the costs spent on tuition.

Example 2:  Student B’s parents combined income exceed the income threshold for educational credits and they are unable to qualify for these credits on their federal tax return.  So, Student B’s parents have taken long-term approach in maximizing their 529 plan contributions every year and benefitting from the earnings being tax free for qualified withdrawals.

For financial aid purposes, each eligible college and university has an established “cost of attendance” that includes not only tuition, books, and fees but also an allowance for room and board. I usually find this readily available on the college’s website. This in combination with filing a FAFSA application are the first steps in developing a financial plan for your student.


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