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Off to College – The Tax Mistake to Avoid

It was one thing to start writing about Social Security and Retirement when I was still over a decade away, and quite another to write as a retiree with Social Security just a few years away. College is in that same category and my topic today.

I started saving for my daughter’s college the month she was born. We started to save all we could, as I had a forecast, from a spreadsheet I pulled up from then – the cost then was $20,000, as listed on one of the college planning sites, and with a 5% annual increase, this year would cost $48,000, and the 4 year bill, $208K. The cost I tracked was for private, out of state, schools. Better to plan for the high end than to assume a closer state school and come up short.

In the back of my mind, I knew that I was planning to retire early, but looking nearly 20 years out, I made the assumption that we’d both be working until college graduation. This assumption meant we shouldn’t plan to get any aid. In hindsight, we hit a bit of a Catch-22. By saving for college, we pushed ourselves into a situation where we wouldn’t qualify for aid. To be clear, had we planning for the “retirement before college” we might have paid off the mortgage and lined up an equity line for some of our spending over the 4 years. This is the irony to how aid is given. You can own a home with a $200K mortgage, and have $200K in the bank. In this case, that $200K is fair game, you’re paying tuition. But, no mortgage, no savings, you’re likely to get some aid. I’m not advocating this approach, but I am certain there are many who manage to game the system this way.

I do want to look at two things that can snag you, no matter how good your intentions. Both are related to the American Opportunity Credit (AOC). This is a credit of $2500 against college expenses. Not a tax deduction, a credit. It’s calculated as 100% of the first $2000, and then 25% of the next $2000 of college cost. The first potential snag is related to the 529 College Savings Account. This account allows you to save money post tax, and then use the money for college with no tax on the gains. A bit similar to the Roth IRA as far as tax treatment goes. But, here’s the rub. If you take the money for all college expenses from the 529 account, you have no expenses left to claim the AOC. What if you have the exact amount saved? You are still better off using $4000 cash to pay for school. You get back $2500, and can easily afford the tax if you withdraw from the 529 after school is over. In my case, I came very close to using money from a tax-favored Coverdell Education Savings Account (which is pretty similar to the 529) for the full first semester tuition, until I realized this. It would be awful to hit this issue and lose $2500 due to this.

The other AOC issue has to do with MAGA MAGI, Modified Adjusted Gross Income. The ability to take this credit is phased out over the MAGI between $80K-$90K if filing single or $160K-$180K if joint. If you are nowhere near this range, either low or high, you may not have any decision to make. On the other hand, say you were going to be at exactly $90K and filing single. Consider, you are in the 25% bracket, but with the loss of the AOC, the last $10K really cost you $5K. If you can plan ahead and bump your 401(k) or IRA deduction by $10K, your tax bill will be $5K less. Even a stock loss of up to $3K will help you along. For joint filers, the range is $20K wide, so the impact is a bit less dramatic. The $2500 difference over $20K of income feels like a phantom 12.5% vs the 25% for a single filer.

For further reading IRS Publication 970 is a great read to end your exciting summer.

Any questions or comments? Feel free to leave them below.

  • Mrs. Adventure Rich August 21, 2017, 7:49 am

    This is fascinating! We have a 2 year old and are just beginning to figure out the world of planning for college/how to proceed. I honestly didn’t know about the AOC… but the AOC problem for those right on the border of a tax bracket makes a lot of sense. I have no idea where my husband and I will be in 16 years when our son graduates high school, but I hope to have a solid plan in place by then!

  • Joe August 21, 2017, 9:24 am

    Much thanks for the visit and the comments! 2 years old? I remember driving home from the hospital like it was yesterday, ‘time flies’ is no lie.

    For you, I can only suggest that you watch the tax laws change over the years. There are a number of college credits/deductions, and knowledge is power. After 18 years of doing it right, one mistake can cost you a chunk of money.

  • Honolulu Aunty August 21, 2017, 3:30 pm

    Aloha Joe,

    With 4 kids in Hawaii, I was like an ostrich with head in sand, so we didn’t save up for their college even though the family rule was that they had to go away for school, which meant they HAD to get some break in tuition or we would be eating pork and beans for over a decade.
    The first one was the easiest – University of Washington, and he worked internships during the summer and could pay for his own tuition after the first year. Number 2 only went to college for a year. The last 2 were tough – $40k+ each per year, with an overlap of one being a senior and one being a freshman. Not sure how we did it, but we did. So, weirdly enough, not scrimping and saving worked out for us.
    One strategy that we learned during a real estate investing seminar was to buy a property when the child(ren) were young . A cash flowing rental property. After 18 years of positive (and pretty good) cash flow, money was saved up, but even better, the ongoing cash flow can be used monthly for college expenses while they are in college. We didn’t learn of this strategy until the kids were older, but it has great potential. The key factor is a good rental property. That was it can also be sold (with long term capital gains tax vs. short term), most likely for a good appreciated profit if the rental cash flow is too low.

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