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As laws change and the tax codes are updated, I’m always looking for planning opportunities for our clients. The most recent opportunity will impact only a small subset of our clients, but can save a family approximately $8,000 per college student. This strategy revolves around college planning and specifically focuses on college tuition funding, 529 college savings plan distributions, and the American Opportunity Tax Credit (AOTC).

The AOTC is a tax credit for qualified education expenses for the first four years of a qualified student’s higher education. The maximum annual credit is $2,500 per eligible student. For the purpose of this example, you’ll only claim $2,000 of the available $2,500. Read more about the AOTC here.

Two elements must be existing for this planning opportunity to work:

1. You have a fully funded 529, which means that you have assets at, or in excess of, the expected college tuition payments for all four years of school. If you expect tuition to be $100,000 for four years, you have saved at least $100,000 in the 529.

2. You have a modified adjusted gross income of $80,000 or less ($160,000 or less for joint filers) which allows you to claim the American Opportunity Tax Credit for an eligible student’s qualified expenses.

This strategy could be a fit in these situations:

1. Generous family/grandparents – Sometimes it takes a family to put a child through college. We frequently see grandparents funding a large part of their grandchild’s 529. I’ve also seen an increase in other family members making contributions. Close family and friends can give monetary gifts toward the child’s 529 instead of, or in conjunction with, a gift at birthdays and holidays.

2. High-income earners who are in transition years – We work with many high-income clients who expect to have a life transition well before they retire. This could be a less demanding job, starting their own business, or taking a sabbatical from work, i.e. a mini retirement

3. Divorce – In a divorce situation, if one spouse has a much higher income than the other, the spouse with the lower income may be able to execute this strategy

4. Scholarships – Out- of-pocket expenses will be lower if a child receives a scholarship. You may not have been able to fully fund the 529, but when you include the award it’s possible you may now have a fully funded 529

In each of previous four situations, you’ll take out a small student loan each year to pay for a portion of the annual college tuition. This may sound counterintuitive at first glance because I just said a prerequisite is a fully funded 529. I’ll explain why the loan is needed in short order.

As an example, I’ll use Bridgewater State University’s annual tuition rate. Outside of the University of Massachusetts system, Bridgewater State is the largest public college in Massachusetts. The cost for in-state students is roughly $27,000 a year including tuition, and room and board, making the cost of a four-year degree around $108,000.

How to Implement the Strategy

In year one of college, you’ll take out a $2,000 student loan. With household income under the AOTC limit, you’ll receive a $2,000 tax credit. By taking the loan and receiving the tax credit’ you’ll essentially get $2,000 of “free money,” which reduces the tuition bill from $27,000 to $25,000. You’ll then use $25,000 of the money in the 529 to cover the remaining tuition for the year. You’ll repeat this process for years two, three, and four.

Without taking the $2,000 loan and applying it to qualified educational expenses, you wouldn’t be eligible for the AOTC. Over four years, you’ll receive $8,000 in tax credits and now have $8,000 in student loans plus any interest accrued over that time.

The SECURE Act allows up to $10,000 of 529 plan money to be used to pay off student loan debt. The $10,000 is a lifetime amount NOT an annual limit. In the final year of school, you can make a distribution to pay off the $8,000 plus the interest you incurred over the previous four years.

Final Thoughts

What hasn’t changed was the amount of money it cost to send the child to school. You still paid $108,000 for the four-year degree. What you gained by implementing this concept is $8,000 in tax credits that you otherwise would not have received.

Since this can be a complex strategy to implement, you should work with a team of professionals to help navigate the nuances. You have to make sure the loans are used to pay for qualified expenses, time the payments correctly to receive the American Opportunity Tax Credit, and confirm that your state has adopted the provision in the SECURE Act that relates to 529 distributions for student loans. All said, if you’re willing to put in a little bit of work and meet the two requirements for this planning process, $8,000 in tax credits may be available to you