A couple goes over their annual taxes and refunds.

Try Planning College Savings With This Year's Tax Refund

Use this year's tax refund as a starting point to set a tax and savings strategy that will maximize your child's college fund.

A couple goes over their annual taxes and refunds.

Understanding how education tax credits and deductions affect tax refunds can help families map out next year's college savings. 

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Don't mistake that tax refund for a gift.

"A tax refund can feel like found money, but it’s been your money all along," says Jason Washo, an Arizona-based certified public accountant and personal financial specialist.

That's why it’s important the money is put to good use, he says. If a tax refund is the result of a family's education tax credits or from state tax deductions for 529 plan contributions – deposits made into tax-advantaged college investment accounts – a logical answer for many parents is to put the money toward paying for education in the following year, he says.

However, families should consider whether they should adjust tax withholdings so they don't get a refund in the future. That can allow parents saving for a child's college education to invest the money – and have it earn more – throughout the year. However, if a taxpayer's withholdings are reduced too much, he or she could be subject to a penalty for underpaying taxes.

Understanding why parents received a tax refund and the role education tax credits play can help them set next year's college savings strategy. Families should weigh how the following tax credits and deductions affected their tax refund this year before setting a savings or distribution strategy for college savings in the next year.

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1. American Opportunity Credit: The American Opportunity Credit can be used for four years per student, says Ted Sarenski, a New York-based certified public accountant and personal financial specialist.

If a family or the independent student has already claimed the credit for four years, changing their withholding based on being able to claim the $2,500 annual tax credit the following year can have expensive consequences. Parents who plan on claiming this credit for a fifth year and adjusting their withholding accordingly could result in a $2,500 tax bill, Sarenski says.

If you're getting a refund because of the credit this year, depositing that money into a 529 plan account is a good option, Washo says.

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2. Lifetime Learning Credits: This tax credit is generally used after the first four years, since the value is lower than the American Opportunity Credit. Provided families or independent students meet income requirements, up to $2,000 of $10,000 could potentially be credited per taxpayer, Sarenski says.

Problems can arise if the total education bill is under $10,000 and 529 plan funding is used for part of that amount. Savings from a 529 plan can’t be used to pay for the same education expense for which a taxpayer claims a credit. For instance, if a family uses a 529 plan to pay for tuition, they can’t claim the Lifetime Learning Credit on the same dollars.

If a family used 529 plan funds this year and wasn't able to take the tax credit, they need to evaluate whether they want to withdraw funds from the account next year, at least on the first $10,000 of expenses, Sarenski says.

The decision could involve factors such as financing education with student loans, whether the 529 plan funds will be needed to pay for education in future years or the number of students in a family. Thus, families may want to consider talking to their accountant or financial advisor when debating options.

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3. State tax deductions and credits: States generally do not have income restrictions on how much a taxpayer can deduct for 529 plan contributions. But the same isn’t necessarily true for credits.

It’s important for families to check their individual state’s requirements to see if any income changes they anticipate in the following year could affect the tax benefit in the future.

Some states will help taxpayers use state tax refunds for education savings by offering an option to transfer refunds directly into college savings accounts, says Roger Michaud, a former chairman of the College Savings Foundation. Two states offering this are Maine and Colorado. However, residents of other states should look for this option on their tax forms.

Paying for college isn't always about what families can spare from their own budgets or scholarships earned by students. Tax credits and deductions can be a big help. 

The American Opportunity Credit alone adds up to $10,000 over four years of college. Once families investigate these various tax credits, estimate their income for the next year and look at how much money they’ll need to spend on education, they can plan how much they’ll save in 529 plans or spend from them.

Trying to fund your education? Get tips and more in the U.S. News Paying for College center.

Corrected on March 31, 2014: A previous version of this article misstated the name of the Lifetime Learning Credit.