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Consider These Tax Moves Before Paying for College

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  • As the fall semester approaches, parents have a few tax-efficient options to pay for college.
  • Families may need a strategy for using 529 money while claiming an education tax credit. 
  • Parents might also consider long-term taxes, along with college funding from other sources.

As the fall semester approaches, some parents may be opening their checkbooks or making 529 savings plan withdrawals to pay for college. However, a few strategic moves may both reduce taxes and help with those costs, financial experts say. 

"The more time you give yourself, the more flexible you can be," said Dennis Nolte, certified financial planner and vice president at Seacoast Bank in Winter Park, Florida.

Before making payments, parents may consider how they use 529 plans, tax credits and other strategies to ease the burden of high education costs. Here's what every family with college-bound students needs to know. 

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529 plan strategies

Those with a 529 college savings plan may finally have the chance to tap those tax-deferred funds. However, to avoid levies, they must use it for so-called qualified education expenses — such as tuition, fees, books, room and board, computers and more.

Families should start by adding up qualified expenses and subtracting tax-free education assistance, said Jim Shagawat, CFP and partner advisor at AdvicePeriod in Paramus, New Jersey.

For example, let's say a student has $20,000 in qualified expenses. They may receive a scholarship for $2,000 and employer assistance for $3,000, leaving $15,000 to pay.

But before forking over the $15,000, families should see if they qualify for the American Opportunity Tax Credit or the Lifetime Learning Credit, both subject to income limits. 

Here's why: Families may use 529 money and still receive a tax credit, but not for the same expenses.

"The IRS considers that double-dipping," said Shagawat.

The bigger write-off, the American Opportunity Tax Credit, is 100% of the first $2,000 and 25% of the next $2,000 per student. To claim the full $2,500 credit, families may pay $4,000 of expenses out of pocket and use the 529 for costs above that, he said. Families may receive the credit up to four tax years per student.   

"That's the best way to make sure you're getting the most from these 529 distributions," Shagawat added.

While the American Opportunity Tax Credit only applies to the first four years of higher education, the Lifetime Learning Credit may pay for undergraduate, graduate or professional degrees. There's a comparison of the two here.

Other college funding options

Families with more than one source of money for college may consider their long-term tax plans, said Nolte. 

While the future of President Joe Biden's tax proposals is unclear, those worried about future tax hikes may choose to sell stocks with gains sooner, he said. 

"Maybe you want to pay the capital gains now at a lower tax rate," said Nolte. 

With the flexibility to change 529 beneficiaries, families may opt to use their savings for another child or family member. But the ability to easily make changes isn't always a good thing, he said.

If grandparents set up a 529 plan for their children, families may want to use that money first, in case the owner decides to use it elsewhere, said Nolte.

"You want assets you can control, and you can't control your parents," he said.

There is one downside of using non-parental 529 money, however. The withdrawals may count as the student's income on next year's Free Application for Federal Student Aid, or FAFSA, which may affect financial aid.

The Consolidated Appropriations Act of 2021 made changes to the FAFSA, simplifying the form and removing this penalty. However, the Department of Education has delayed the FAFSA revisions, and non-parental 529 payments may still impact future aid in the meantime.

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