Higher education is expensive—frighteningly expensive. But with proper planning, parents can approach college costs in an organized and financially sound way.

Recently, I explored the factors that affect financial aid eligibility in a blog post. Today, I’ll provide tax-smart tips that parents can follow to ensure they’re maximizing tax benefits. (Our new research, Tackling the tuition bill, has all the details on both topics.)

While it may seem intuitive to first tap into the qualified education savings accounts when the bills come, there are a few things you need to consider before doing so.

Educate yourself on potential tax perks before tapping 529 accounts

Consider the AOTC for you, or your child. Don’t rush to deplete your 529 account right away as there may be some beneficial tax credits available to you each year. For example, the American Opportunity Tax Credit (AOTC) is available to taxpayers who meet income eligibility requirements. The credit amounts to the first $2,000 spent on qualified education expenses and 25% of the next $2,000, for a total of $2,500. Funds counted toward this credit must come from current parental income or parental-owned assets held in taxable accounts. In other words, they can’t be funds from qualified savings plans, such as 529 plans. This tax credit can be taken each year in which qualified education expenses are incurred, for a maximum of four years per student. Because of this potential total benefit of $10,000 over the student’s educational career, it may be smart for eligible parents to first take advantage of this credit before spending from 529 accounts.[1]

See if you qualify for the LLC or other deductions. Some taxpayers, such as those who have already exhausted the AOTC, may qualify for the Lifetime Learning Credit (LLC). This credit is worth up to $2,000 for tuition and other qualified expenses for students enrolled at an eligible financial institution.[2] The credit can be used each tax year and applies to undergraduate and graduate school, as well as programs geared toward professional degrees or expanding job skills.

If you don’t qualify for the AOTC or the LLC, the Tuition and Fees Deduction may be another option. For the 2016 tax year, this deduction can reduce taxable income by up to $4,000 .[3] See irs.gov for more information on education tax credits and deductions. The figure below provides a brief summary of the most basic information.

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Be mindful of tax-sensitive withdrawals

Aside from the potential tax benefits you can receive from paying for college expenses out of pocket, there are tax implications to be aware of when withdrawing from retirement accounts and taxable savings accounts. Withdrawals from parent-owned and student-owned tax-deferred retirement accounts (such as traditional IRA and 401(k) accounts) are taxed as ordinary income.[4]  Withdrawals from parent-owned and student-owned Roth IRAs, on the other hand, can be taken tax-free as long as the distribution is composed of the contributions made into the account on an after-tax basis. Withdrawals that represent earnings will be taxed as ordinary income.[5]

You should be careful when selling assets from taxable accounts, whether parent-owned or student-owned. Realized gains will be subject to capital gains tax, but they may be offset with realized losses elsewhere.

Although the challenges of paying for college expenses may seem overwhelming, proper planning is critical to a successful outcome. So put away the smelling salts! Remember that balancing financial aid and grant considerations with tax-efficient spending strategies is a good way to start facing your college financing fears.

* Special thanks to my colleagues Jonathan Kahler and Jenna McNamee for their research contributions.

 

[1] If your income exceeds the AOTC limits, but your child is reporting income for that tax year, your child may have the option to claim the AOTC. This would require your child to file as an independent, rather than as a dependent on your tax return. Although this is possible, it’s best to consult with your financial advisor as there may be other financial implications. The AOTC is refundable up to $1,000.

[2] For the 2016 and 2017 tax years, the Lifetime Learning Credit is worth 20% of up to $10,000 in qualified college expenses. The LLC isn’t refundable.

[3] Only one tax credit or deduction (AOTC, LLC, or Tuition and Fees deduction) may be claimed per tax year.

[4] Withdrawals that meet the criteria of qualified education expenses are not subject to the 10% penalty tax.

[5] Roth withdrawals in excess of contributions are not subject to the 10% penalty tax if used for qualified education expenses.