Can I get an education tax credit if I paid with a 529 plan?

Using a 529 plan rather than student loans to cover education expenses can be a savvy move. After all, withdrawals are tax-free if you use them for qualified education expenses. Plus, it’s possible to qualify for educational tax credits that can lower your tax bill.

That said, there are certain rules you have to follow to take advantage of education tax credits while using a 529. For example, the IRS doesn’t allow double dipping — which means you can’t claim an education credit on education expenses covered with 529 funds. Also, you have to meet certain income requirements to qualify for an education tax credit.

One way to claim an education credit without triggering 529 tax consequences is to use most of your 529 funds to pay for education expenses and pay the remaining balance out-of-pocket. For instance, imagine your education expenses are $16,000 and you want to qualify for a $2,000 dollar-for-dollar education tax credit. In that scenario, it could be a smart move to only withdraw $14,000 from your 529 plan to cover qualified education expenses and pay $2,000 from other income sources to qualify for the $2,000 tax credit.

Can you claim other education tax credits with your 529 plan?

You can both pay for qualifying educational expenses with your 529 plan tax-free and take advantage of educational tax credits, as long as you do it wisely. You are not allowed to double up on benefits; in other words, you cannot claim the AOTC or LLC on expenses that were paid for using a 529 plan.

For example, let’s say you withdraw $10,000 from a 529 plan to pay for qualified higher education expenses, consisting of $5,000 for tuition and $5,000 for room and board.

If you claim a $1,000 lifetime learning credit on the $5,000 for tuition, you must reduce the qualified expenses on your 529 plan by $5,000. That leaves you with a “nonqualified” withdrawal of $5,000, the earnings of which you will have to report on your federal tax return. The principal portion of your 529 withdrawal remains tax-free.

One way to claim an education credit without triggering 529 tax consequences is to use most of your 529 funds to pay for education expenses and pay the remaining balance out-of-pocket. For instance, imagine your education expenses are $16,000 and you want to qualify for a $2,000 dollar-for-dollar education tax credit. In that scenario, it could be a smart move to only withdraw $14,000 from your 529 plan to cover qualified education expenses and pay $2,000 from other income sources to qualify for the $2,000 tax credit.

529 plan tax benefits

One of the most appealing parts of a 529 plan is the tax benefits. Earnings in a 529 plan grow tax-free, and as long as the distributions are made for qualifying education expenses, those aren’t taxed either. This matters because compound growth increases your earnings without you paying anything extra in taxes.

Some states also offer tax deductions or credits for 529 plan contributions. In most cases, you’ll need to use your state’s plan in order to claim the deduction, but a few states offer a tax deduction for contributing to any 529 plan, regardless of whether you live in that state.

Types of education tax credits

A 529 plan is not the only way to get tax benefits for paying for college. If you pay out of pocket for education expenses, you might be eligible to recoup some of those costs through tax credits.

American opportunity tax credit

The American opportunity tax credit (AOTC) gives you a maximum annual credit of up to $2,500 per student. You’re eligible to receive up to 100 percent of the first $2,000 you pay for qualifying education expenses and 25 percent of the next $2,000.

You’re eligible for the American opportunity tax credit if your student:

• Is enrolled at least half time for at least one academic period beginning in the tax year.
• Hasn’t finished the first four years of schooling at the beginning of the tax year.
• Hasn’t previously claimed the AOTC for more than four tax years.
• Is pursuing a degree or another recognized education credential.
• Doesn’t have a felony drug conviction at the end of the tax year.

You also must have a modified adjusted gross income (MAGI) of $80,000 or less ($160,000 if you’re married and filing jointly). The amount of the credit is gradually phased out for MAGIs between $80,000 and $90,000 (or $160,000 and $180,000 for married filing jointly).

If you’re attempting to claim the AOTC, you’ll need to receive a Form 1098-T, Tuition Statement, from an eligible educational institution. If your child is enrolled in school right now, they will usually receive this form by Jan. 31 for the previous tax year. To claim the AOTC, complete Form 8863.

Lifetime learning credit

While the AOTC is limited to the first four years of higher education, the lifetime learning credit (LLC) has no restrictions on how many years you can receive the credit. You can receive up to $2,000 per tax return, calculated as 20 percent of the first $10,000 you pay toward educational expenses. Unlike the AOTC, this credit is nonrefundable; you’ll use the credit to pay any tax you owe, but you won’t get any money back on top of it.

To claim an LLC:

• You, your dependent or a third-party must have paid for qualifying education expenses for higher education, whether it’s college or another type of schooling.
• The student must be enrolled at an eligible educational institution.
• The student must be listed on your tax return.

You can’t claim the credit if you earn $90,000 or more ($108,000 for joint filers). The credit is reduced if your MAGI is between $80,000 and $90,000 ($160,000 and $180,000 for joint filers).

As with the AOTC, you’ll need to receive a Form 1098-T, Tuition Statement, and complete Form 8863.

Bottom line

If you want to claim education tax credits, it’s important to do the math and see which one gives you a larger credit. The bigger the tax credit, the less you’ll owe in taxes. No two situations are exactly alike so if you need help navigating the nuances of tax deductions or credits related to your 529 plan, it’s best to speak with a licensed tax professional.