15 September 2016
My daughter, a senior in college, recently asked me a reasonable question about whether or not printer cartridges were eligible expenses under the 529 program. This led to a broader discussion of the process I use to keep track of her qualified higher education expenses and their corresponding tax breaks. It occurred to me that might be good information for other taxpayers to have as well. I’ll use our specific situation to illustrate my method, but with generic numbers.
The big picture is that I have to keep track of three things with respect to my daughter’s college:
1. Tax Break 1 - Daughter qualifies for the American Opportunity Tax Credit (AOC).
2. Tax Break 2 - We have money in a Virginia 529 account that remains tax free as long as it is used for her education.
3. Expenses - Tracking qualified higher education expenses (QHEE) and matching them with the correct tax break of the two listed above.
Qualified Higher Education Expenses
There are a lot of different expenses when it comes to college. It should come as no surprise the IRS has rules regarding the expenses you can use to get tax breaks for education. They refer to them as qualified higher education expenses (QHEE), meaning they qualify for the tax break. What might come as a surprise is the rules are not the same for the two tax breaks that concern me most (AOC and 529). The list of qualified higher education expenses for the AOC is more restrictive than the list of QHEE for the 529 plan. (You can’t really blame the IRS for that. Congress legislates this stuff.)
The chart below lists the most common higher education expenses and whether or not they are qualified for the AOC and/or the 529 plan. (Costs to commute to and from campus and parking permits are not qualified under either tax break, but I included them because I often get asked about the eligibility of those two expenses.)
Like most taxpayers, the AOC is more valuable to us than the 529 tax break. Therefore, I am careful to make sure the AOC is accounted for first. In our situation this is not a problem because my daughter is a full-time student at a four-year university. Tuition each year is over $9,000. Tuition is also a QHEE for the AOC.
The maximum amount of QHEE needed to get maximum benefit from the AOC is $4,000. (At $4,000 the AOC is 'maxed out'.) Therefore, I count the first $4,000 of tuition against the AOC and that valuable tax credit is taken care of.
Remember: Double-dipping is not allowed. I can’t claim all $9,000 of the tuition against the 529 money and then also claim $4,000 of it for the AOC. That would be claiming the same expense against two different tax breaks, and it is not allowed. That $4,000 of tuition money that gives us the maximum AOC benefit must come from some place other than the 529 account.
This is where it gets a little tricky. We have non-qualified money in a savings account that is used to fund the college expenses, which is then reimbursed from the 529 plan money. Tuition gets paid right before the start of each semester. Other QHEE for books, room & board, etc. get paid throughout the semester. At the end of the semester I pull money out of the 529 account to reimburse the savings account for all of the expenses EXCEPT for the first $4,000 of tuition, which is reserved to qualify for the AOC. I made a graphic to help explain my method.
The graphic is essentially 3 stacked timelines showing the order of the money flow over the course of a calendar (tax) year from the 529 account to the savings account to the expenses associated with college. Reading from left to right, tuition and other expenses get paid from the savings account and then at the end of the semester the savings account gets reimbursed from the 529 plan.
While the tuition gets paid in a lump sum just before the start of each semester the “Other QHEE” is a number of payments throughout the semester. My daughter has elected to live off campus, so she pays rent and utilities and buys groceries. She can claim all of these as QHEE (against 529 money) as long as the total does not exceed what the university would have charged for on-campus room and board. She has a roommate, so this has never been an issue. If she were living a lavish lifestyle in a penthouse condo and her actual expenses exceeded what the university charges for room and board, her QHEE (for room and board) would be limited to the amount the university charges.
There are other ways to manage this process, but this works for me. I can be sure I will not take too much from the 529 account because I already know what the expenses were for the previous semester. I protect the AOC in the spring by withdrawing $4,000 less from the 529 than the actual qualified expenses were for the spring. That ensures I used non-qualified money for $4,000 of the tuition, which means I can apply that toward the AOC when I am filing tax returns the next year.
We are fortunate to be able to pay out-of-pocket each semester and reimburse ourselves from the 529 plan. (Fortunate because we made a plan and nothing derailed that plan.) We started saving for our children’s education when they were very young. Daughter did her first two years of school at the local community college and then transferred to the university, significantly reducing the overall bill for a bachelor’s degree. She has also worked full time during her schooling and contributes financially to her own education. I’ll be there when she graduates from the Strome College of Business at Old Dominion University next spring. I’ll be the one beaming.
This is a complex issue, which is probably why I write so often about 529 plans. If you have questions about the American Opportunity Tax Credit, qualified higher education expenses, your 529 plan, or any other tax breaks for college, please contact me.
