529 Plan Coordination with American Opportunity Credit

[dopps]

Joe: I think you mean, "If Bucket 3 is more than Bucket 1..." (not "more than Bucket 2"). At least that is what your ealier step analysis leads me to conclude.

Also, I want to fully inderstand what TurboTax says about claiming the AOTC: "You cannot claim expenses that you paid with tax-free money from an education savings account (ESA) or qualified tuition program (QTP), such as a Section 529 Plan. When you take a distribution form an ESA or QTP, part of it is from your original contribution and part of it is from earnings on the account. You cannot claim expenses paid with the tax-free earnings." I think we can all agree on this so far. But, the next line seems to contradict your bucket/step analysis: "But you can claim expenses paid with money from your original contribution."

Example: I take a qualified distribution from my child's 529 this year of $20,000, which is also the amount of qualified college expenses for the year. Let's say my contribution basis of this $20,000 is $12,000, so 60% of every dollar of this distribution is return of basis.

Assume, of the $20,000 taken from the 529, that $10,000 is for tuition and books. So 60%, or $6,000, of that is return of basis. Therefore, I can say I incurred $4,000 (the maximum for AOTC use) of qualified AOTC expenses that came from return of my basis when I claim my maximum $2,500 AOTC for the year. So this should not subject any part of my 529 withdrawal to tax.

Under your bucket analysis, my Bucket 1 started out at $20,000, but then got reduced by $10,000 (the amount in Bucket 2) to $10,000. Bucket 3 is $20,000, which is more than Bucket 2 (which, again, I don't think is relevant) and greater than the reduced Bucket 1 (if one is matching expenses with distributions and taking their AOTC credit, how can Bucket 3 ever be less than Bucket 1?). So, using your method, I have some taxes to pay from my 529 withdrawal.

So, which is correct? Sorry to get so wordy, but this is probably way more complicated than the legislative authors intended. You are right that one does need a drink.

[Joseph_Hurley_SFC]

Your example application of my bucket analysis is correct: bucket 3 does not get compared to bucket 2, and yes you will have to pay from your 529 withdrawal. Whatever TurboTax is saying sounds incorrect to me, but I suspect that its calculations are correct when you enter the info it asks for. It is I who needs the drink, good thing it's St. Patrick's Day.

Joe

[1baldeagle]

Just a question on clarification. Does it make any difference with the ability to claim the American Opportunity Credit if the payment from the 529 plan went directly to the school vs. going to the beneficiary who then paid the school?
Thanks,

[scottyusn]

I believe you are in better shape than you think. AOTC CAN be claimed on the portion of your qualified 529 withdrawal, used for tuition and books only (not room and board), that represents the return of your (already-taxed) contribution basis (so any "growth" component, which is tax-free, is not eligible for the AOTC). The Florida pre-paid plan should provide this figure to you as part of their 1099 (I am assuming that even a pre-paid 529 can separate out the return of basis and growth components of each disbursement). So, if this return of basis number is at least $4,000, you should thus earn the full AOTC.

So to make sure I understand you, I will read this back in my own terms.

My (sons) 529 has grown in value to double my contributions.

If a years worth of tuition is say $10,000. Of that, my taxed contributions over the years is valued a $5000 taxed dollars contributed to 2010 school year. The 1099 from Florida prepaid should show I've paid $5000 taxed dollars towards 2010 college expenses. (This I need to confirm with Florida prepaid.)

As result, I can claim that $5000 amount toward the AOTC?

The bucket thing made me dizzy without alcohol! :crazy:

Regards, Scotty

[dopps]

I believe your example is right, Scotty.

But, I stand corrected from my prior assumptions and examples. It appears that you must reduce the amount of qualified AOTC expenses by the amount of tax-free benefits you received during the tax year for education expenses to arrive at the net amount of taxed education expenses that can be used to claim the AOTC. Example:

I took a qualified 529 withdrawal of $20,000 for the year, of which:
-$12,000 was my contribution basis (so already taxed)
-$8,000 was tax-free growth
-$10,000 was for tuition and books (the AOTC qualified expenses)
So, on my taxes, I can only claim $2,000 ($10,000-$8,000) of taxed education expenses for the AOTC. Thus, my AOTC is only $2,000 and I miss out on the remaining $500 available AOTC maximum.

Caveat: I think this is correct, but I am not completely sure--this is based on my reading of Publication 970, and this is very complicated stuff. I am also not an accountant, so check with one (although a CPA I recently mentioned this to did not know nearly this much detail about the AOTC, since it is so new). Furthermore, it may be possible that part of the 529 withdrawal may now be taxable because of the AOTC, but I am not about to tackle how to calculate that--even more complicated. Joe, am I finally getting this right?

[Joseph_Hurley_SFC]

Sorry I knew I was taking a chance with that analogy.

Scotty, I can't tell if you are paying 10K or 5K of tuition this year. It doesn't really matter, because either way you, or your son, will claim AOTC on maximum $4,000 of tuition (equals $2,500 credit). It also doesn't matter where the tuition was paid from, Florida prepaid or anywhere else.

Then simply reduce your total qualified higher education expenses (tuition, fees, r&b, books, supplies, computer) by $4,000 to come up with your ADJUSTED qualified higher education expenses (AQHEE). If your Florida prepaid distributions plus any other 529 plan withdrawals total up to be more than your AQHEE, then you will report SOME or ALL of the 529 earnings (from 1099-Q) on your or your son's tax return. If the total distributions/withdrawals are less than AQHEE, then you will report NONE of the 529 earnings on your or your son's tax return.

baldeagle, no it does not matter.

Joe

[ndrumm]

This is the best info I have found on 529 and AOTC. Thank you!
I think I understand all of the previous posts, but I don't see my situation in any of them.
My son had $7700 in 529 eligible expenses,
$4300 of these are AOTC eligible expenses (bucket 2),
leaving $3400 non-AOTC qualified expenses (bucket 1).
He received $2500 in 529 money (bucket 3 - from his grandmother) and
$4200 in scholarships (from his school).

In addition, I should note that, the school applied the scholarship to $3600 of the bucket 2 expenses, but the other AOTC eligible expenses were paid out-of-pocket. Can I report the $600 excess scholarship money on my son's taxes and take the AOTC for that $600 on my taxes? Is there any way I can pay taxes on some or all of the 529 and scholarship money in order to claim the full AOTC credit? If not, how can I maximize the amount of AOTC credit I can take?

[Joseph_Hurley_SFC]

Great question, even though I can't follow all your numbers. The interesting thing is: if your son simply claims the scholarship as income, then those expenses become eligible for the AOTC. (But please check with your own tax adviser on this because it is not black and white.) You may very well end up much better off by treating a "tax-free" scholarship as "taxable."

Joe

[ndrumm]

Thanks for the info. I was probably getting too bogged down in all the numbers and not fully seeing the big picture!
If my son (who is my dependent) claims the entire scholarship as income, can I then claim the AOTC even though I didn't actually pay the college the money?
Could he, alternatively, claim the 529 money as income so we can get the AOTC? I believe this would be better since the earnings portion of the 529 is actually very small.

[gatorgogo]

Joe - Thanks for answering all these questions...this is sure a hot topic for a lot of people...

[ndrumm]

Just an update on what I ended up doing.
Thanks to Joe's suggestion and a lot of reading on my part, I claimed $4000 of my son's scholarship as taxable on his return. Since he didn't make much last year, this didn't increase his federal taxes at all and only increased his state taxes by about $100. By applying that $4000 to tuition and fees on my return, I was able to claim the full American Opportunity Tax Credit and get an extra $2500 back! Pretty cool!

[Joseph_Hurley_SFC]

Nice to hear about a positive outcome. However, I have never heard of anyone claiming a scholarship that qualifies as tax-free to be partly tax-free. I doubt the IRS would go along with you picking just a portion of the scholarship to be taxable. You may still be in good shape if your child claims the entire scholarship as taxable?

Disclaimer: this is not tax advice. Seek the advice of your own tax professional.

Joe

[troutman]

Just to clarify, are the scholarship $$ (non-taxable) a student receives used to offset the educational expenses considered for the AOTC? For example, if tuition and other qualified expenses were $15,000 and scholarships amounted to $9,500 the $5,500 paid from 529 plan and out of pocket would NOT qualify for AOTC since the scholarship $$ > payments made.

[cheese21]

I have a GA 529 plan for my son(full time college student/dependent). For 2009, total college expenses were $3148. He received the Georgia Hope scholarship - $2454, leaving $694 in qualified expenses. I took a $324 withdrawl from the GA 529 plan. Can I claim the full $694 as qualified education expenses on Form 8863? Or do I need to reduce it by the 529 withdrawl amount? Thank you.

[dopps]

You reduce it by the portion of the 529 withdrawal that represents any tax-free growth (so NOT reduced by the entire 529 withdrawal).

[Joseph_Hurley_SFC]

Sorry to disagree with Dopps but you do not reduce your $694 in AOTC expenses. Instead, your $324 withdrawal from the 529 becomes a nonqualified withdrawal and you/son report the earnings as taxable. You do not pay a 10 percent penalty.

Joe

[dopps]

Joe: Can you please explain why the $324 withdrawal from the 529 is taxable? Does it have to do with the scholarship?

[cheese21]

Joe, I also want to ask you why you said that the $324 distribution was a nonqualified withdrawl (it was used for textbooks)? The earnings on the 1099-Q were $8.37. Where on my 1040 would I report it?

[Joseph_Hurley_SFC]

You have $694 in qualified higher education expenses after the scholarship. I presume you will use that $694 to generate a $694 American Opportunity Tax Credit. This leaves you with $0 in ADJUSTED qualified higher education expenses, which means that your $324 distribution is a nonqualified distribution. You or your child (who received the 1099-Q?) will report the $8.37 as 'other income' on your tax return. You will also file Form 5329 Part II to indicate waiver of the 10 percent penalty (which would only by $0.84 anyway).

Joe

[dopps]

I think I get, so let me try to recap: In order to abide by the prohibition against "double dipping" (where the same tax-free gain withdrawn from a 529 is also used for the AOTC), a taxpayer apparently has two choices:
1. Do not deduct the growth portion of the 529 withdrawal from one's eligible AOTC expenses, by changing said gain from tax-free to taxable income (in this case, Junebug pays tax on $8, which is a mere fraction of the full $8 AO tax credit she gets from this).
2. OR, retain the tax-free treatment of the 529 gain, but then deduct that from your AOTC eligible expenses.

In Junebug's case, #1 is clearly better, as Joe recommends. However, in some cases, especially with much larger dollars involved, #2 is better--for example: Withdraw $20,000 from 529, of which $5,000 is tax-free gain. $10,000 of the 529 withdrawal is for tuition and books and thus eligible for the AOTC (the other $10,00 went to room & board, which is NOT eligibile for AOTC) . Subtract the $5,000 tax free gain, and one can claim $5,000 in AOTC expenses, which earns them the maximum $2,500 tax credit for the year. So, this person preserved all of their 529 gains as tax-free AND got to receive the maximum AOTC. Joe, is this right? Very confusing stuff--thanks, Federal lawmakers!