4 Secrets to Getting More From Your 529 Account

Note: This article is part of Morningstar's October 2014 College Planning Report Card special report.

Question: I've been investing in a 529 college-savings plan for my daughter and want to make sure I'm not missing anything when it comes to the tax advantages. Got any tips?

Answer: The 529 college-savings plan is generally a pretty good deal for college savers. Not only do assets invested in such plans grow tax-free and not only are distributions for qualified college expenses tax-free, but savers in many states can reap state income tax deductions or credits if they contribute to an in-state plan. These benefits alone can save 529 plan users thousands of dollars in taxes, but additional, less-well-known rules can help put even more money back into their pockets or help them avoid paying penalties. Of course, there's no substitute for saving early and often when it comes to using a 529 plan. The earlier you begin making contributions, the longer your money has to grow and the more you are likely to have when the beneficiary eventually goes to college and you begin making withdrawals. None of the suggestions below is a substitute for doing so. However, the following tips may help you stretch your 529 savings a bit further.

Route short-term money through the account: Even if you plan to pay part of your child's college bills out of pocket--from your taxable brokerage account, for example-- consider sending it to the student's 529 plan first. Many states have no waiting period regarding when 529 assets can be withdrawn (other than the time it takes for your check to clear). That means you may very well be able to deduct the contribution amount on your state income taxes even if the money doesn't stay in the account for long.

For example, let's say your son or daughter is already in college and you live in a state in which the maximum 529 deduction for married couples is $10,000. Assuming you haven't made any contributions to the account this year (and even if you have, it's no big deal--all contributions count toward the annual deduction limit), you could contribute up to $10,000, wait for the money to show up in the account, and then immediately withdraw it to pay for tuition or other qualified college expenses. (Technically, you could pay the tuition and other expenses out of pocket and then reimburse yourself using the 529 funds, but be sure to make the contribution and withdrawal in the same calendar year and to save paperwork showing how the money was used for tax purposes.) If you're in a 5% state income tax bracket, that $10,000 deduction for your 529 contribution would be worth an extra $500 to you and your spouse. And all for a few minutes of extra paperwork.

This strategy won't work for all 529 account owners, however. Only those living in the more than 30 states that offer state income tax breaks for 529 contributions and whose 529 plans impose short or no waiting periods before funds can be withdrawn are able to use it. Some states impose waiting periods of a year or longer before 529 contributions can be withdrawn or only allow tax deductions equal to the amount of annual contributions minus annual withdrawals. But if your state offers the full tax break and its 529 plan has a minimal waiting period, it's a relatively easy way to save some extra money. Read more about this strategy here.

Roll in out-of-state 529 assets: Another useful but lesser-known tip involves 529 assets held in out-of-state plans. Some states allow 529 account owners to deduct the contribution portion of any 529 assets rolled from an out-of-state plan to an in-state plan. So, if you have contributed $5,000 to another state's 529 plan over the years and that investment has grown to $7,000, you might be able to transfer the assets to your in-state plan and deduct $5,000 on your state income taxes, just as if you had made a fresh contribution to your state's plan (note that the earnings portion of the rollover is not deductible). And you won't have to pay any taxes on the rollover as long as the money is transferred directly from the out-of-state 529 plan to the in-state plan.

Each state imposes its own limit on the amount of 529 contributions that may be deducted each year, so check this first, as it might make more sense to spread out the rollover over a few years in order get the maximum tax benefit. Also, before requesting a rollover, ask each plan whether there are any fees associated with doing so, as this could make the move less appealing.

However, don't compromise on the quality of your 529 plan just to get the tax break. If your in-state plan is not particularly good--meaning it isn't rated Gold, Silver, or Bronze by Morningstar's 529 analyst team--it may pay to keep your assets out of state and forego the state income tax benefit of a rollover. For more on this approach, click here, and you can check Morningstar's ratings for various plans by using our 529 Plan Center and clicking on any state on the map.

Coordinate to maximize federal tax breaks: Yet another way to stretch your 529 savings dollars is to carefully coordinate distributions with federal tax breaks for education. The main point here: Paying for some college expenses out of pocket rather than with 529 assets may net you significant savings on your federal income taxes.

For example, the American Opportunity Tax Credit (formerly known as the Hope scholarship credit) may be used to offset up to $2,500 per student in tuition, fees, and course materials per year and is available to families with modified adjusted gross incomes of up to $180,000 (or $90,000 for single filers). Those who qualify get a dollar-for-dollar tax credit on the first $2,000 in qualified expenses and a 25% credit on the next $2,000 (for another $500 in credit). That's a net cost to the taxpayer of $1,500 for $4,000 worth of college expenses paid for. Plus, since the credit applies to each eligible student in the household, those with more than one family member in college at the same time can conceivably save up to $2,500 in taxes per student.

However, households with 529 accounts need to be aware that the IRS has rules against double-dipping--in other words, you may not take the tax credit to cover expenses that are paid for using 529 assets. Therefore, for families who qualify for the credit, it may make sense to pay $4,000 worth of tuition, fees, and/or materials out of pocket in order to get the full tax benefit and then to pay additional qualified expenses using 529 assets.

Aside from the income restrictions, there are other requirements for using the American Opportunity Tax Credit. Only full-time students or their families are eligible, and the credit may only be applied to the first four years of a student's post-secondary education. Even more importantly, the credit is currently set to expire after 2017, so there's no guarantee it will still be in place for beneficiaries who are still several years away from college.

Even if you don't qualify for the American Opportunity Tax Credit, there are other federal tax breaks that can help lower your tax bill and which may require coordination with your 529 distributions. Among these is the Lifetime Learning Tax Credit, which applies to families with modified adjusted gross incomes below $124,000 for joint filers ($62,000 for single filers). This is a good option for part-time students or those who have exhausted their American Opportunity Tax Credit eligibility. The Lifetime Learning Tax credit can be used to offset 20% of qualified college expenses up to $10,000 for a maximum benefit of $2,000 per year per family. For more information on these and other federal tax breaks for higher education click here, or check out the IRS rules for education-related tax breaks here. 

Coordinating your 529 distributions and tax deductions can be tricky, and if you feel you're in over your head, it may pay to consult a tax professional. It will cost you money, of course, but the potential savings on your tax bill may more than offset the added expense.

Hold on to unused 529 assets: If somehow you end up with money left over in a 529 account after the beneficiary graduates, or perhaps because he or she drops out or decides not to attend college, avoid the temptation to cash it out. Withdrawing 529 funds for nonqualified expenses means not only paying ordinary income tax rates on the earning portion of the withdrawal (as opposed to the lower long-term capital gains rates you would normally pay for investment gains) but a 10% penalty on top of that. (For more on the tax penalties associated with 529 accounts, see "Don't Get Sent to the 529 Penalty Box.")

To avoid paying the penalty, one option is simply to keep the money where it is. Most 529 plans allow assets to remain in the account indefinitely, and by keeping the money there, it will continue to grow tax-free. That may come in handy if the beneficiary later decides to return to school and/or to attend graduate school (and yes, 529 assets can be used for post-graduate education). But even if he or she doesn't, the leftover 529 assets can eventually be transferred to a new beneficiary, such as the current beneficiary's son or daughter. 

Speaking of familial transfers, another option is to roll the assets into a 529 account set up for a relative of the beneficiary. As discussed in this Short Answer article, this can include siblings, cousins, aunts and uncles, and even parents and grandparents. Transferring the assets may require a family conversation about who gets the money and whether it should be repaid in some form. But that's probably a better option than paying taxes and a penalty on the money.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.