529 · Taxes

529 Example Scenarios

[As with anything tax-related, see my disclaimers.]

I jog regularly with two guys who, like me, both have college age kids like me. During our most recent jog, I explained the benefit of paying for college through a Virginia 529, even if you don’t have much time for the contribution to grow. After the run, I realized that a blog post with some examples might help.

Am I Eligible to Claim an Education Credit?

The first thing to consider are the education credits and deductions. Maybe you’re wondering if you are eligible for the AOTC or the Lifetime Learning credits. Look no further. The IRS has an interactive tool that can help you determine if you’re eligible for education deductions or credits on your taxes.

Instead of enumerating the requirements and features of each credit or deduction, here are some links if you want to learn more, ordered roughly in their value/usefulness:

Now for some scenarios.

All of the people are fictitious and happen to be residents of Virginia, allowing them to take the Virginia state tax deduction on 529 contributions.

Scenario One

Denzel and Pauletta have one daughter, Olivia, entering college this fall (2020). They have a combined adjusted gross income (AGI) of $180k. Tuition is $3,000/semester and living on campus will be $800/month for 10 months. In 2020, they’ll be paying $8,000 of the total $14k.

  • Total Tuition: $3,000 in 2020
  • Total Living Expenses: $5,000 in 2020
  • AGI is too high for any of the tax credits or deductions. Lowering their income by maximizing their 401(k) contributions could drop them into the phase out window where they could get a partial credit. Assuming they keep up their AGI in future tax years, they’ll never be able to take the AOTC. Their daughter, Olivia, might if she ceases to be their dependent by paying more than half of her own support (I sense a future blog post!). There’s a good chance this might happen when she graduates. Details here.
  • All $8k paid in 2020 can be paid for using 529 funds. Denzel opens three different Virginia 529 accounts/portfolios with Olivia as the beneficiary. Because the money is needed pretty much immediately, Denzel wants to preserve his capital and chooses to put $4k into both the Total Bond Market Index Portfolio and the Inflation-Protected Securities Portfolio and $4k into the FDIC-Insured Portfolio. 

Because he knows he’ll be paying another $3k in 2021 and another round of college expenses, he puts an additional $4k in the FDIC-Insured Portfolio to increase his state tax deduction for 2020. That’s three separate accounts of $4k each, or $12k. He could open additional accounts with more risky portfolios, or have Pauletta open similar accounts if they want to save more this year.

In April 2021, when they file their 2020 Virginia state tax return, Denzel and Pauletta will get an additional $690 of credit towards their state taxes, simply for passing $12k through the 529 account.

Scenario Two

Tom and Rita have two adult sons, Colin and Truman. Colin was enrolled for summer term and will also be attending full time in the fall and winter. Truman has taken a couple online, independent courses but is planning on taking a gap year (or two!) and has deferred his college entrance to a future date.

Tom and Rita have a combined AGI of $160k. Colin’s tuition is the same as Olivia’s in scenario one: $3,000/semester and $1,500/term. Truman’s classes are $700/each. Colin will have $3,000 of living expenses in 2020.

    • Total Tuition: $5,900
      • $1,500 for Colin’s summer term and $3,000 for his fall semester. 
      • $1,400 for Truman’s two independent study courses.
    • Total Living Expenses: $3,000 for Colin. Truman is living at home.
    • They qualify for the AOTC for Colin but not Truman. They qualify for a $2,500 credit on their 2020 taxes for Colin’s tuition expenses but because Truman isn’t considered enrolled at least half time for at least one academic period, he is not covered. As long as they don’t go above this AGI in the future–maybe by increasing their 401(k) contributions to the limit–they should be able to take it in the future when Truman is done with his gap year(s).
    • Their AGI is too high for the Lifetime Learning and Tuition and Fees Deduction. This would have helped with Truman’s online classes. If they can get their income down below $136k, they start to get in the range of the credits, but that’s not likely unless they weren’t already maxing out their 401(k) contributions and start doing so immediately.
  • $4,900 paid in 2020 can be paid for using 529 funds. They cannot take out more since any funds covered by AOTC can’t be paid for using the 529 funds. That would be double dipping. Unlike the AOTC, 529 funds can cover living expenses.

In this scenario, with two kids, it might make more sense to break down the 529 accounts per student.

Truman’s education expenses are only $1,400. It makes sense for Tom and Rita to open a single account and throw in $1,400. If they throw in more, they can increase their 2020 Virginia state tax deduction, but won’t be able to withdraw the extra contribution until future years when Truman returns from his gap year(s) and resumes school. Assuming they contribute the minimum to cover Truman’s 2020 expenses, they’ll get $80 back on their Virginia state income tax return.

Colin’s expenses not already covered by the AOTC are $500 in tuition and $3,000 in living expenses. Tom opens one Total Bond Market Index Portfolio account with Colin as beneficiary and deposits $4k. By contributing, Tom and Rita will get $230 back on their 2020 Virginia state income tax return.

Note: Colin’s winter tuition is due on December 28th. They could choose to delay paying it until January 1st and pay any late fees, or they could contribute another $3k to another 529 account for Colin, either using Rita as the account owner or as another portfolio with Tom as the account owner. It’s the difference between an additional $172 in tax savings in 2021 or later in 2022.

If Colin pays directly for his own expenses instead of going through Tom and Rita, he likely won’t get as big a tax deduction unless his income is above $17k/year. Even if Tom and Rita expect him to pay for school, it might make sense for Colin to gift the money to Tom, who can set up the 529 and pay for the expenses and then pass on any tax savings to Colin in the form of another gift. Additionally, Colin probably won’t qualify for the AOTC unless he’s a dependent on Tom and Rita’s tax return.

Pay Now, Contribute Later

What if you already paid the college expenses before learning about the value of passing the money through the 529? 

No worries, you can still take advantage of this as long as you make the withdrawal from the 529 in the same tax year that you incurred the college expenses. Clearly you have to make the contribution before Virginia529 will let you withdraw it, but it doesn’t have to be contributed before the education expense.

Assuming all transactions occur the same year, this:

  1. Contribute $4,000 to 529 on January 1st
  2. Withdraw $4,000 in college expenses on January 2nd
  3. Pay $4,000 in college expenses on January 3rd

Is treated the same as:

  1. Pay $4,000 in college expenses on January 3rd
  2. Contribute $4,000 to 529 on December 1st
  3. Withdraw $4,000 in college expenses on December 2nd

The only real constraints here are that (a) “pay” and “withdraw” must be in the same tax year and (b) you have to contribute before you can withdraw–duh!

Conclusion

There are a lot of rules around here and hopefully my examples haven’t muddied the water even more. I’m happy to answer any questions in the comments, if you have any.

Any other tips you have for preparing to pay for college? Put them in the comments.

Hasta luego!

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