March 31, 2013

Tax Benefits of Education Tax Credits Versus Using 529 Savings

If you're trying to save for your children's college expenses then you may be using a 529 savings plan.   The benefit of a 529 plan is that it gives you tax deferred savings and the gains are tax free if used for college.   In this sense it works like a Roth IRA in that you use post tax money and then you can withdraw the money to pay qualified college expenses without paying taxes.   Sounds good right?

However using a 529  for savings isn't necessarily the best option.  In fact if you use a 529 exclusively then you may be losing money by missing out on better tax savings via tax credits for college expenses.   The key here is that if you use money from a 529 savings plan then it doesn't qualify for other tax benefits like the tax credits.

First I should point out that peoples eligibility for tax credits will vary based on your income and the future of tax credits is unsure since they don't all seem to be permanent laws.  The American Opportunity Tax Credit is valid today but it is set to expire in 2017 I believe and may or may not be renewed.   If your income is too high then you won't qualify for credits at all.    For more details on the tax credits read publication 970

Lets look at an example.   For this example I'm going to assume you have a decent income and some pretty good assets so you generally won't qualify for much if any financial aid.   Your child then decides to go to the local public college so you "only" have to pay $10,000 in tuition and books.   Now lets compare using the 529 versus paying out of pocket.

529 savings :
If you'd saved $1000 a year for 18 years and gotten 8% annual growth then you'd have about $37,450 in the 529 plan.   You can pull that money out and use it for the tuition bill without any taxes. You pull $10,000 out of that plan to pay the tuition bill tax free.  

Out of pocket + tax credits:
Lets now assume that instead of using the 529 you just put the $1000 a year into a taxable account at Vanguard.  You bought a buy and hold index to minimize taxes.   Your money still grew 8% and you've still got $37,450.  However if you sell those investments you'll have to pay taxes on the gains.   The capital gains rate on that would be 15%. 52% of the money in the account is gains.  Lets say you wanted enough after taxes to pay for a year of college.  You could pull out $10,845 and pay $845 in capital gains taxes and be left with $10,000 after the tax bill.   You then use that money to pay for the college tuition.   Because of the current American Opportunity Tax credit you get a $2500 tax credit.

The end result on the two situations is :

529 savings : tax free, so tax bill = $0

Out of pocket + tax credits :  -$845 in capital gains + $2500 tax credit = $1,655 positive net

If you simply avoid a 529 in this situation it allows you to take advantage of the American Opportunity Tax credit which is up to $2500 in tax credit for eligible tax filers.    The 529 plan may be tax free by you're giving up a generous tax credit to save a little bit in capital gains.


Another example :   Lets say you're a single woman working as a teacher in Alabama.   You can get a good pay raise and maybe a promotion if you pursue a Doctorate so you sign up for part time classes on nights.   Your tuition is going to cost you $5000 a year.    You've got a couple years worth of tuition saved up in an account.

529 savings :  You put $5000 into a 529 plan last year in order to pay 2013 tuition.  The $5000 gives you a deduction on your Alabama state taxes so you save $5000 x 5% or $250 in state taxes. There is no federal tax impact.

Tax credits :   If you simply left the $5000 in a savings account and then paid out of pocket you'd qualify for the lifetime learning credit.   That credit pays 20% of your expenses.  In this case thats 20% of $5000 or $1000 in federal tax credit and theres no state tax impact.

For this example the 529 savings plan would save you $250 on your state taxes but using the federal Lifetime Learning Credit would save you $1000 on your federal tax bill.


Bottom Line:   Be careful that using a 529 savings plan for college will make you forfeit even more generous tax benefits available from education tax credits.

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2 comments:

  1. I love your analysis with all of the examples you add to posts on these financial decisions.

    I recently did some research on how best to save for my nephews future, maybe you have done this already in a different post. I'm skeptical of the 529 plan, and it's not without drawback. I can't find the chart that I found most helpful when considering which option to choose, but this chart is contains similar information as much as I can tell.

    http://www.collegeinvest.org/product-comparison

    Apparently, there are a variety of 529 plans and some plans are not recommended for investment.

    http://www.dailyfinance.com/2012/12/13/529-college-savings-plans-morningstar-rankings/

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  2. Enhancethehuman, Yes I think the 529's do have some downsides for sure. I like the idea in general, but in some situations using a 529 can backfire. Also as you point out there are many 529' plans since and they are not all created equal.

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