Pay Some Tuition in Cash, Get a $2,500 Tax Rebate

Note: This article is part of Morningstar's February 2015 Tax Relief Week special report.

Question: We have a 529 account for our daughter, a college freshman, and were going to use it to pay next year's tuition bill. But a friend says that, for tax purposes, we'd be better off paying a portion in cash. Why would that be?

Answer: It may sound counterintuitive at a time when families are being urged to sock away as much as possible in tax-advantaged college-savings vehicles such as 529s and Coverdell Education Savings Accounts, but for some, paying a portion of tuition and fees from other sources can be a wise move.

The reason: Using money from a taxable account, such as a bank checking account, or with money from a college loan, allows families within certain income parameters to take advantage of federal tax breaks that can provide thousands of dollars in relief each year while paying for college. However, the IRS does not allow taxpayers to take those same tax breaks for costs paid for using assets from a tax-advantaged college-savings vehicle, such as a 529 or Coverdell account. That's why, for eligible families, it often pays to use cash from a taxable account or loans to pay enough costs to qualify for these federal tax breaks and then use assets from tax-advantaged accounts to cover as much of the rest as possible.

Spend $4,000, Get $2,500 Back Here's an example of how this idea works: Let's say Sally attends a college that charges $20,000 per year in tuition and fees. Sally's family has saved diligently and has enough in her 529 account to cover the full $20,000. However, Sally's family also qualifies for a federal tax break called the American Opportunity Tax Credit, in which taxpayers receive a dollar-for-dollar credit for the first $2,000 spent each year on tuition, fees, books, and supplies and a 25% credit on the next $2,000 spent for a total possible credit of $2,500. In essence, by spending $4,000 on qualified college expenses out of pocket, Sally's family later saves $2,500 in taxes for a net cost of just $1,500.

So, even though Sally's family could have paid that same $4,000 in tuition using her 529 account, they would have been forfeiting the chance to get $2,500 back in the form of the tax credit, the equivalent of a 266% return for paying a net $1,500 within the span of a single tax year.

But what if this strategy leaves Sally with an extra $4,000 sitting in her 529 account? Room and board are not considered qualified college expenses for the purposes of using the American Opportunity Tax Credit; however, they are considered qualified expenses for the purposes of withdrawing 529 assets (provided that the student is enrolled at least half-time). So, Sally could use any leftover 529 funds to pay for her housing and meals while at school, or she could hold on to those assets to cover future college costs or even roll them into a 529 account for the benefit of a sibling or other family member.

Income Restrictions and Possibility of Expiration Not all households qualify for the American Opportunity Tax Credit, but the income restrictions are rather generous, at least in comparison to other college-related federal income tax breaks. The full credit is available to students from households with modified adjusted gross income up to $160,000 for taxpayers filing jointly (up to $80,000 for those filing singly) and the credit phases out at incomes above $180,000 for joint filers (and above $90,000 for single filers). The student must be enrolled in college at least half-time, and the credit is available each of the first four years of attendance. Also, if more than one family member is enrolled in college during the same year, the credit can be applied in each case. Thus, if a family has two children in college during the same tax year, they could receive a total of $5,000 in tax credits for spending a total of $8,000 on qualified college expenses. The American Opportunity Tax Credit is also partially refundable, meaning that even if taxpayers owe less in taxes than the credit is worth, they can receive 40% (up to $1,000) of the credit as a refund.

However, while this valuable tax credit is scheduled to continue through 2017, its fate beyond that is unknown. An earlier version, called the Hope Scholarship credit, was more restrictive, with lower income phase outs and a maximum $1,800 credit per year that applied only to the first two years of the student's postsecondary education. In 2009, as part of a federal stimulus package, the credit was expanded and renamed the American Opportunity Tax Credit, but only temporarily. By 2018, we will have a new president and a new Congress, and trying to predict what will happen with regard to this particular tax benefit is foolhardy at best.

Other College-Related Tax Breaks Even if the American Opportunity Tax Credit does eventually expire, there are other federal tax breaks currently in use that can help families manage college costs.

For example, the Lifetime Learning Tax Credit allows households with part-time (less than half-time) students or those who have exhausted their American Opportunity Tax Credit eligibility to receive a credit of up to 20% of qualified college expenses up to $10,000, or a total of $2,000 per year. The Lifetime Learning Tax Credit isn't as broadly applicable as the American Opportunity Tax Credit, but it still amounts to a $2,000 tax break for those willing to shell out $10,000 from their taxable accounts to cover college costs. However, income restrictions on the Lifetime Learning Tax Credit are lower, with only those making $128,000 or less, if filing jointly, or $64,000 or less, if filing singly, qualifying. Here again, double-dipping rules apply, meaning that expenses paid with funds from a 529 or Coverdell account are not eligible for the Lifetime Learning Credit.

Those who don't qualify for the American Opportunity Tax Credit or Lifetime Learning Tax Credit still may qualify for the tuition and fees deduction, although there's no guarantee it will still be in place after it was set to expire in 2014. If it is extended, as has happened in the past, it will offer qualified households the chance to deduct up to $4,000 in tuition and fees per return. However, because a deduction merely lowers the amount of income subject to taxes while a credit represents a dollar-for-dollar reduction in taxes, the college tax credits mentioned above are generally more valuable. For 2014, the tuition and fees deduction begins to phase out at incomes above $130,000 for those filing jointly ($65,000 for those filing singly). To learn more about the college-related tax breaks mentioned here, see this article.

If your family qualifies for the American Opportunity Tax Credit, that's the first of these college-related tax breaks to consider. If you don't qualify, or if your child won't enter college until after 2017, when the credit is set to expire, the decision as to whether to pay cash or use 529 or Coverdell assets may not be quite as obvious. Of course, if you have enough in these tax-advantaged accounts to cover all college costs for you or your child, you may just plan to use those assets and be done with it. But it may well be worth your time, if possible, to use other assets to cover part of the cost of tuition, fees, books, and supplies in order to save on taxes and get a bit more mileage out of your tax-advantaged college-savings accounts.

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