08 July 2015

For Virginia residents, Virginia 529 plans are a great way to save for college. Your contributions get you a break on your Virginia state income taxes. Earnings and growth within the account escape both state and federal income taxes, as do qualified distributions from the account when it is time to pay for college. That's a whole lot of good things stacked up in one account - what could go wrong?  In a word: plenty.

The federal government offers some very valuable tax credits to help make college more affordable. The American Opportunity Credit (AOC) pays you back dollar-for-dollar on the first $2,000 you spend on tuition and required fees, plus 25% on the next $2,000. Spend $2,000 on tuition, get $2,000 back in tax credits. Spend $4,000 on tuition, get $2,500 back in tax credits. AOC can only be used for undergrad education, and can only be used 4 times per student.

If you run out of AOC eligibility the Lifetime Learning Credit (LLC) kicks in. You can get 20% back on the first $10,000 you spend on tuition and required fees. Spend $10,000 on tuition, get $2,000 back in tax credits. The LLC can be used for any accredited post-secondary education, and as many times as you want. You just can't use AOC and LLC for the same expenses.

The AOC and LLC are very valuable - more valuable than having a 529 plan. Fortunately, you can have your federal tax credits and a 529 plan, too. You just have to be careful. If executed poorly the 529 plan could cancel your eligibility for the federal tax credits, potentially costing you thousands of dollars annually. Tax break fratricide - one tax break killing another.

The way the 529 can interfere with eligibility for the federal tax credits is a little complex, which is probably why the mistake is easy to make. Essentially, you cannot claim the tax benefits of the 529 and a federal tax credit for the same education expenses. It makes sense, but the sequence of events can trip you up on this. Tuition is due in the year before you file for the federal tax credits. You would naturally think to use your available 529 money when the tuition comes due. This would be a mistake. Since the federal tax credits can only be used for tuition, if you pay the tuition with 529 money you cannot claim either of the (more valuable) federal tax credits when you file your tax return the following year.

In my opinion this makes the prePAID 529 plan especially risky. The prePAID plan is designed specifically to pay for tuition at some point in the future. This virtually guarantees you can't get the federal tax credits because you are using 529 money to pay the tuition. (You can take the money out of a Virginia 529 prePAID plan in cash and use it for other 529 qualifying expenses such as room and board, but you only get the original contributions back plus money market interest - not a great investment.)

Higher income families won't qualify for the federal tax credits. In 2014 AOC was completely phased out at $180K modified AGI for joint filers, half that for everyone else. LLC was completely phased out at $128K modified AGI for joint filers, half that for everyone else. Additionally, if you're married filing separately you are not eligible for the AOC or LLC. If you're not going to be eligible for the federal tax credits, then use the heck out of the 529 plans, even the prePAID plan. They can't interfere with the federal credits if you don't qualify for them. Just don't forget that your child will be filing separately from you at some point. Don't wreck his/her eligibility for AOC or LLC with a 529 plan.

The Virginia 529 Plans are fantastic. No one should think I am telling you to avoid them. (I have several Virginia 529 accounts!) It's the only way to get a tax break for room and board - which can be a significant portion of the college expenses. The 529 Plans just need to be part of an overall integrated college financing strategy so that you don't end up with one tax break cancelling another. You can get both if you prepare properly.

If you have any questions, please contact me: Paul @ PIM.