529 Plans and their Limitations
529 Plans can be an excellent planning tool to save for educational expenses. While there are no specific federal deductions for them, many states provide a deduction for contributions to one either sponsored by that state or any state. The Federal break comes on the back end when you take distributions from them. Distributions received to pay for “qualified educational expenses” are withdrawn tax-free. These expenses now include post-secondary costs (college or beyond) without limit, secondary costs (K-12) up to $10,000 per year, and student loan payments up to $10,000 per year. However, there are some downsides to taking advantage of those benefits without proper consideration of what you lose.
Educations Credit Lost
When you use 529 Plan proceeds to pay for higher education costs, you lose access to the Federal Education Credits & Deduction: the American Opportunity Credit (AOC), the Lifetime Learning Credit (LLC), and the Tuition and Fees Deduction. The AOC can generate a credit of up to $2,500 (for 2019) for “adjusted qualified education expenses” paid for each student who qualifies. The LLC can create a credit for up to 20% of the first $10,000 of qualified education expenses paid for each student who qualifies. The Tuition and Fees Deduction can provide an above the line Adjustment to lower Adjusted Gross Income by up to $4,000. The expenses used for these credits/deduction cannot come from a tax-free source such as scholarships, grants, or a qualified tuition program (QTP). 529 Plans fall under the classification of a QTP. They also are mutually exclusive so you can’t double-dip. What this means is that you have to pick which you want to use and for which student and at which time. Any expenses paid by student loans are considered as being paid by the borrower since those funds will have to be paid back. The credits are not lost when using student loan proceeds to pay for them.
Education Expense Savings Trifecta
When planning for college, it’s not so easy as pay for it and figure it out later. You have to consider a variety of moving parts, including the parents’ and student’s expected income and asset levels, what expenses will be required, other sources of aid/funding, and the overall educational plan, to name a few of the big ones. It’s often a good idea to keep your options open. Consider what income and assets are going to be available to the student when college starts. Will either their income level or the parents’ income level be such that it eliminates or limits financial aid options? Are there other family members to hold 529 plan assets for use at the appropriate time? What expenses will count towards the education credits but don’t count for the 529 plans and vice versa? One potential option is using student loan proceeds to pay for the expenses and then take a distribution from the 529 plan to pay off the student loan in a subsequent year once the student graduates. Another could be over-funding one of the parent’s Individual Retirement Account to pay for the expenses. Since those assets are considered parental assets, they don’t factor in as high as 529 plans used for the student. There are many possible combinations of tools to solve this problem. Each solution is also likely to be unique to each family as what worked well for your neighbor/friend/family member might not work as well or in the same way for you.
It can be beneficial to work with a Certified Student Loan Professional (CSLP) to help address these issues. The CSLA Board of Standards certifies these individuals. These individuals have passed a rigorous exam testing their knowledge of the student loan repayment and forgiveness processes. These individuals focus on the tools to solve this need not some financial product to try an end-run around the rules that may or may not work.
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