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Balance Tax Credits, 529 Plan Savings for Community College

Using college savings to pay for community college might mean families miss out on valuable education tax credits.

Calculating home finances

Families paying for community college may get greater tax benefits if they use a tuition payment plan and money saved in an account other than a 529 plan.

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Experts often advise families to use tax-advantaged college investment accounts known as 529 plans to save for future education expenses. But for students planning to attend community college, using a 529 plan could mean missing out on education tax credits that could save them more money.

The federal government generally doesn’t allow two tax benefits on the same money. Earnings on money saved in 529 plans and distributed for education isn't taxed by the federal government, which is a tax benefit. Federal tax credits for education are also considered tax benefits.

If tuition, fees, books and supplies total less than the amount of the tax credit, which is more likely to be the case for a community college student, then families may be better off choosing the tax credit over using 529 plan funds, says Gregg Wind, a California-based certified public accountant and personal financial specialist.

[Check out college savings tips for community college students.]

For example, the American Opportunity Tax Credit can give families up to a $2,500 refund on their taxes. Families who qualify have to spend over $4,000 on an individual student to receive the full credit, before 529 plans make sense to be used. The breakdown of the credit is: The first $2,000 of tuition and fees are refundable. Then the other $500 of the credit is based on 25 percent of the next $2,000 spent on tuition, fees, books and supplies.

Families must also meet income restrictions. According to the IRS, the full tax credit is available to individual taxpayers with a modified adjusted gross income up to $80,000 or married couples filing jointly with income up to $160,000.

Families would still have to pay for tuition with money outside of what’s saved for college in a 529 plan in order to take full advantage of the tax credit.

If families are still saving for a community college, they should only save 50 to 60 percent of college expenses within 529 plans, says Gina Chironis, a California-based certified public accountant and personal financial specialist.

[Know how to access money saved in 529 plans.]

If a child is ready to go to community college and families don’t have the funds available outside of a 529 plan account, Chironis recommends families use a payment plan. "Most college payment plans will credit the student’s account in full as soon as the payment plan is in place, but the actual monthly payments are due later," she says.

Delayed payment doesn't prevent families from taking advantage of the American Opportunity Tax Credit. "Take the credit based on when the student’s account is credited, not when the payments are made to the payment plan lender," she says.

Then it’s just a matter of how to use the funds from the 529 plan. Money withdrawn from 529 accounts may be able to pay for some expenses that wouldn’t qualify for reimbursement under the American Opportunity Tax Credit.

"The cost of purchasing computer equipment, including peripherals and software, and related Internet services used by the student and the student’s family while in college are considered qualified expenses for reimbursement from a 529 plan," Chironis says by email. "The good news is that money can be withdrawn from a 529 plan to purchase these items, and that distribution will not reduce the amount of eligible education expenses – tuition, fees, supplies – that qualify for the AOTC."

Experts say that if families withdraw money from 529 plans for computers or other technology needs, to keep receipts and be able to explain why it was needed for the student's course work.

[Avoid the financial aid mistakes that cost community college students money.]

What should families do with the remaining 529 plan funds?

Students who are planning to transfer to a four-year school will likely be able to use 529 plans there without penalty because tuition is generally higher at universities than at community colleges, experts say.

The bonus is they’ll have more time for their 529 plan investments to grow, Chironis says. She recommends families wait to use 529 plans in later years for that reason.

If families plan well, they’ll be able to get the full benefit of both their 529 plans and the tax credits for which they are eligible.

Trying to save for college? Get tips and more in the U.S. News College Savings 101 center.