There are clear tax benefits to a 529 plan. Though contributions to 529 plans are not tax-beneficial, the assets in these accounts do grow tax-deferred, and qualified withdrawals are tax-free. If this sounds like a Roth IRA, it is. The added benefit of a 529 plan over a Roth IRA is that all qualified withdrawals for education are tax free, unlike a Roth IRA where only withdrawals of contributions (not earnings) are tax-free and penalty-free for any purpose—as long as the five-year rule has been met. Many investors save into the Roth for the flexibility this provides.
For those who qualify (i.e., income is below limitations), there are other education-related tax benefits for student loans. If you take out student loans for your education, the annual interest expense may be deductible up to $2,500. In 2022 for married-filing-jointly taxpayers, the modified adjusted gross income (MAGI) phaseout begins at $145,000 and ends at $175,000. For single taxpayers, the phaseout is $70,000 to $85,000.
There are also credits for education expenses, such as the American opportunity tax credit (AOTC), which allows a qualifying taxpayer to receive a credit of up to $2,500 annually per student for qualifying education expenses at colleges, universities and trade schools. This is a direct credit against your taxes owed, rather than just a deduction on taxable income. A taxpayer can claim this credit for only the first four years of post-secondary education, and it can be used for expenses associated with tuition, books and other equipment needed for school. Even if you don’t have a tax liability in a given year, the credit is refundable up to 40% of what is owed to you. The AOTC is completely phased out for married-filing jointly taxpayers with a MAGI over $180,000, or $90,000 for single taxpayers.
The lifetime learning credit (LLC) is another education expense credit, although it is slightly less favorable than the AOTC in any given year, as it maxes out at a $2,000 credit. However, unlike the AOTC, there is no limit to how many years you can claim it, making it a good option once AOTC has been used up. You can’t claim both the LLC and AOTC in the same year. The LLC is completely phased out at $80,000 for a single taxpayer and $160,000 for those married filing jointly.
What if you are paying school tuition for someone other than yourself or your dependent? If you are a grandparent who’d like to help your grandchild, you can consider funding a 529 plan for them. If the account is in your name, the asset is not considered part of your grandchild’s assets for qualifying for financial aid. However, any distributions used to fund the child’s tuition would be counted as income for the child and so should be delayed until the student’s junior and senior years if qualifying for financial aid is a concern (FAFSA uses prior-year tax data).
Additionally, a grandparent could use his or her own funds to send the tuition payment directly to the school. This has the benefit of not counting as a gift for your lifetime and annual gift exclusion and would not require a gift form on your taxes. Again, this could affect a student’s ability to qualify for financial aid.
Please reach out to your Parsec advisor to discuss your specific situation so that we can determine the best plan for you.
Note: This article appeared in our Q2 2022 newsletter, go here to read it in its entirety: parsecfinancial.com/newsletters/thrive-by-learning-and-growing-edition.