Monthly Archives: February 2014

529 plan distributions for application expenses

A reader asked the question, “Can I use funds in my 529 plan to pay for college application fees, tests or test preparation?”

Unfortunately the answer is no. Though all of those are both costly and necessary, they are not “qualified education expenses” that are eligible to be paid for by 529 plan funds. In Publication 970, the IRS spells out that qualified expenses are limited to “expenses related to enrollment or attendance at an Eligible educational institution.”  (emphasis mine.)

Student Loan Interest Deduction

One piece of good news with student loans: The interest you pay on them may be deductible. The Student Loan Interest Deduction gives eligible taxpayers a deduction for interest paid on qualified student loans. That’s pretty straightforward, but there are a couple of nuances:

–          A “qualified student loan” is one that’s used exclusively to pay for qualified higher educational expenses. Mixed-use debt is not deductible. For example, if you put tuition on a credit card and pay interest on the card, the interest is deductible as long as you don’t pay for anything else with that card. On the other hand, if you use some of your student loan funds to buy suits for job interviews, the interest is not deductible.

–          You can take the AOTC or LLC for expenses paid with a qualified student loan and still deduct the loan interest.

–          The maximum deduction is $2,500 and it starts to phases out for incomes above $60,000 (single) or $125,000 (joint).

–          The deduction is for the named borrower only. If both students and parents have loans, each can take the deduction for the loan(s) for which they are the named borrower as long as they are eligible.

Student loan interest is an “above the line” deduction, which means various things, the most important of which—for student borrowers—is that you can take the deduction even if you don’t itemize on your return. That’s another good reason to start your borrowing with federal Stafford Loans.

Education Tax Credits

Tax time is as good a time as any to discuss education tax credits. The federal tax code provides two primary tax credits, the American Opportunity tax credit (formerly the Hope Scholarship) and the Lifetime Learning Credit. There are slight differences in each, and depending on a family’s circumstances, one or the other may be more beneficial. You can claim both credits on the same tax return, but not for the same student. And you can’t take a tax credit for expenses that were paid with qualified withdrawals from a 529 plan. I’ll get to that shortly.

The American Opportunity credit is for undergraduate studies only, for a maximum of 4 years per student. Up to $2,500 per student can be claimed on eligible returns (there is a phaseout for MAGI between $80,000 and $90,000 for single filers or $160,000 and $180,000 for joint returns). Let’s say you have two children: Roger, a college freshman, and Sharon, a college senior. If you are eligible for the AOTC based on MAGI, you can claim up to $5,000 in tax credit. If Sharon were in her first year of graduate school after completing a four-year undergraduate degree, however, you could only claim the credit for Roger, not for her.

The Lifetime Learning Credit, on the other hand, is available for all years of post-secondary education, including “courses to acquire or improve job skills.” ( However, the credit is limited to $2,000 per return and it phases out at much lower income thresholds: between $53,000-$63,000 for single filers and between $107,000 and $127,000 for joint filers. In the same example above, in either case, Roger’s and Sharon’s parents could claim up to $2,000 on their return if they are eligible based on their MAGI. Or they could claim the AOTC for Roger and the LLC for Sharon in the graduate school case.

The LLC and AOTC can be combined with student loans and/or 529 plan funds, but you need to coordinate how you use them together. You cannot, for example, claim the AOTC or LLC for expenses that were paid with a tax-free distribution from your 529 plan. You can, however, claim the AOTC or LLC for expenses that were paid with a student loan. But you cannot claim your student loan interest for the AOTC.

Qualified expenses for the LLC and AOTC are also somewhat more limited than for 529 plans. The credits can only be used for tuition, fees, and some required books and supplies. 529 plans, in contrast, can also be used for room and board. Also, the credits only apply to the first $10,000 of tuition, fees, books and supplies. Here is a simplified example: Let’s say your total education expense for the year was $25,000, of which $18,000 was tuition and $7,000 room, board and supplies. You could claim the tax credit for the first $10,000 of tuition and then use 529 plan funds for the remaining $15,000.

And just to make sure: we are talking here about tax credits, not tax deductions. You know the difference, right? But someone else doesn’t, so here goes: a tax credit reduces amount of tax you owe. A tax deduction reduces your taxable income. The Dependent Care credit is a tax credit. The mortgage interest deduction is, as the name implies, a deduction.  There are also some education tax deductions, which I’ll discuss in another post.

The “E” in EFC

So you’ve calculated your EFC and are breathing a sigh of relief, telling yourself, “We can do this.” Hold on a second. “E” is “Expected,” not “maximum” or “guaranteed” or anything like that. There is no requirement that your school of choice meets your financial need, or if it does, that loans aren’t part of the aid package. That’s why it’s important to apply to some schools that meet 100% of need, and to some where your student is in the top quartile of applicants (based on GPA and SAT/ACT scores).

Expected Family Contribution is just that: an expectation. Not a guarantee. Many students will receive packages that generous enough that their actual contribution is less than their EFC; others will not have their need met or have it met primarily through loans. When you receive your SAR or complete the FAFSA4caster, use that as number as a ballpark estimate, not a carved-in-stone number.

In the meantime, here is a list of schools that met 100% of need for full-time undergrads in 2012-2013.

Lucky You: Grandparents Want to Help

If you are among those fortunate individuals whose parents want to help pay for their grandchild’s education, it’s worth figuring out the best way for them to do so in order to avoid the law of unintended consequences. In the college world, unintended consequences include losing financial aid as a result of a grandparent’s gift.

First, you need to know how grandparent (or other extended family) assets are treated by the aid formulas. Good news: Grandparent-owned 529 or other savings accounts do not need to be reported as assets on either the FAFSA or CSS PROFILE. Bad news: Once that money gets spent, it is treated as student income which needs to be reported on next year’s FAFSA or CSS PROFILE. This could lead to an increase in your EFC and a reduction in any need-based aid that your student is receiving, because student income is assessed at 50% in the aid formulas. So Grandma’s $10,000 tuition payment could cost the student $5,000 in lost aid.

What’s a generous grandparent to do? Several possibilities:

  • Grandparents who want to have their own 529 plan accounts—whether for the tax advantages, to maintain control of the funds, or for whatever reason—should coordinate use of those funds with parents. Grandparent 529 plans are great for the last year of college. Why? Because you won’t fill out a FAFSA form the next year, so your student’s income in their last year of school doesn’t matter.
  • Grandparents can also gift money that parents can put in parent-owned 529 accounts. These funds then get the favorable parental asset treatment, assessed at 5.65%.
  • Grandparents who want to pay for more of the cost of college, net of aid received, can also gift money to the student after graduation that the student can use to repay their own student loans. Each grandparent can gift an inflation-adjusted $14,000 annually to the student (or recent college graduate), either to the grandchild or directly to the lender to pay off the loan.

Extremely generous grandparents should know this: Tuition payments made directly to a college are exempt from gift tax, no matter the amount, as long as the payments go directly to the educational institution. Note that only tuition payments count; money given for room, board, books and other fees would be subject to the annual exclusion or lifetime exemption.