American Opporturnity Credit and 529

[Super Mom]

We put our college savings in the NC529 plan. The research I have done, says no credit if funds from 529. This is not really fair, I can understand no credit on the tax free earnings, but the after tax money we put in should be available for credit. I saw somewhere about deducting the credit and adding the tax free earnings as taxable??? I also thought about getting the check in my Son's name to pay tuition, and then me claiming the credit since he's my dependant???? Suggestions??????

[Roberts]

Your research is wrong.

[Super Mom]

Your research is wrong.

Wrong about no credit, or credit with adding back interest as income? The Taxbook clearly says no credit for tax free educational assistance. But REALLY the only part that is tax free for federal is the earnings. The savings was with after tax dollars. I did deduct on state when I made, so know no deduction there.

[Bees Knees]

The Taxbook clearly says no credit for tax free educational assistance. But REALLY the only part that is tax free for federal is the earnings. The savings was with after tax dollars..

TTB statement is taken from IRS Pub 970 which says:

Coordination With American Opportunity
and Lifetime Learning Credits

An American opportunity or lifetime learning credit (education credit) can be claimed in the same year the beneficiary takes a tax-free distribution from a QTP, as long as the same expenses are not used for both benefits. This means that after the beneficiary reduces qualified education expenses by tax-free educational assistance, he or she must further reduce them by the expenses taken into account in determining the credit.

That leaves no wiggle room. Those are the rules…reduce expenses by the QTP distributions, then reduce expenses further by the ones used for the credit.

When you think about it, it makes sense. The reason earnings are allowed to accumulate inside the QTP tax free, and then allowed to be distributed tax free is because you are using ALL of the distribution to pay for qualified expenses. THAT is the benefit of the QTP…you put after tax money in and then pay no tax on the earnings when those after tax funds are used for qualified education. If you would rather take the tax credit with those after tax funds, then don’t stick them inside the QTP.

[mactoolsix]

When to use 529 plans vs AOC is critical

It is always best to use the AOC or even LLC (when allowed), however if the qualified expenses exceed the AOC maximum of 4,000 then the balance of the expenses can be paid with 529 funds and you may have a small benefit of tax-free earnings.

Another good use of 529 funds is for Room & Board -allowed to be paid with 529 & Coverdell plans.

The last good use for 529's is when the AGI is too high to allow AOC.

Of course some States also allow a deduction for 529 plan contributions.

I don't know if that is all the benefits, but I'm sure many people use a 529 plan and don't realize the difference.

Mike

[Gary2]

I think there's some confusion here. In Pub. 970, don't just read the text, but work through the examples in the chapter on QTPs.

There's no traceability rule, so it doesn't matter whether the QTP funds were actually sent directly to the school for tuition or sent to grandma to thank her for setting up the QTP. So calculate the AOC first. Then use the numbers to calculate the taxable part of the QTP distribution.

The confusion is that the phrase "tax-free educational assistance", taken in context, is referring to things like tax-free scholarships, not the distribution from the QTP. The term "tax-free" is certainly not intended to apply to the return of investment portion of the QTP distribution. That portion is not tax-free, it's just that the tax on it got paid before the money went in, not when it comes back out. Only the earnings portion of the QTP distribution are potentially tax-free.

[BP.]

…reduce expenses by the QTP distributions, then reduce expenses further by the ones used for the credit.

Do these steps, but in reverse order. First reduce the sum of the Qualified Education Expenses by the amount used for a tax credit, then apply the 529 distribution to the remainder. See TTB 12-6 or Pub 970.

In Pub. 970, don't just read the text, but work through the examples in the chapter on QTPs.

OP, essential that you locate the formula on p. 53 of Pub 970, and use it to work your numbers. Required to get an understanding of how to coordinate the tax credits and the 529 distribution. There is nothing unfair about the benefits available.

[appelman]

I think BP and Gary are saying the same thing.

You're describing the same elephant in slightly different words. The key is Example 2 on p. 53 of Pub. 970. Clients may not realize that they cannot control how much of the distribution is basis. Nor can they allocate the basis portion to purpose a and the income portion to purpose b.

[LCP]

That leaves no wiggle room. Those are the rules…reduce expenses by the QTP distributions, then reduce expenses further by the ones used for the credit.

When you think about it, it makes sense. The reason earnings are allowed to accumulate inside the QTP tax free, and then allowed to be distributed tax free is because you are using ALL of the distribution to pay for qualified expenses. THAT is the benefit of the QTP…you put after tax money in and then pay no tax on the earnings when those after tax funds are used for qualified education. If you would rather take the tax credit with those after tax funds, then don’t stick them inside the QTP.

This quote and comment seems to be addressing what is left of a distribution that is allowed to be taken tax-free after you reduce it by scholarships and the amount used for a credit.

It isn't reducing the expenses by tax-free distributions leaving little if any left for a credit.

Bottom line........ 529 money does not significantly limit credits.

[BP.]

529 money does not significantly limit credits.

The 529 money does not limit credits at all.

It is the other way around. The use of credits might limit how much of the 529 distribution's earnings will be tax free.

[LCP]

The 529 money does not limit credits at all.

It is the other way around. The use of credits might limit how much of the 529 distribution's earnings will be tax free.

Agree! It seems that the TheTaxBook has been "officially" confusing the issue for quite a while. Time for a rewrite perhaps?