When you have children who are in or about to start college, there is quite a bit of tax planning that can be done to maximize tax and financial aid (FAFSA) benefits. Ideally, college savings planning starts when the child is young so you can maximize tax benefits over a couple decades. However, if this is not the case for you, you can still benefit in the year tuition payments are due.
Taxpayers have a few tools for college tax planning: FAFSA, the 529 education savings plan, and tax credits. Because FAFSA and tax credits are typically accounted for after the fact, the best long-term planning tool for college savings is the 529 plan. Unfortunately, the 529 education savings plan will provide tax-free growth for long-term savings, but no immediate benefits. Follow these tips to facilitate a better discussion with your tax professional.
Tip 1: If you are paying for college and live in a state with income taxes, make sure you contribute enough each year to maximize the 529 state tax benefits. This strategy can also be used for K–12 in some states, if you pay for private school tuition. Although there is no federal tax benefit for contributing to a 529, there are many states with tax deduction or tax credits for doing so. For example, if you have a college tuition bill for $5,000, you can make a $5,000 contribution to a 529 plan and immediately pay the bill from the 529 plan. This will still get you the state tax benefits even though there is no money left in the account.
Tip 2: The tax-free growth is the most tax advantageous part of the 529 plan. This requires long-term planning, however, and not everyone can start to save for college right away. If your state offers tax benefits for contributions, you should try to maximize those each year. Beyond that, you’ll only receive the tax-free growth, which will provide the highest long-term benefits if you are saving early.
Tip 3: The maximum dollar contribution to a 529 can be in the hundreds of thousands, depending on your state. But there are other limitations to consider. You can donate up to the annual gift tax exclusion ($17,000 for 2023) without any additional paperwork. This doubles for married couples, since a $17,000 donation can be made from each parent. And if you want to donate more, there are other options, such as using the lifetime gift and estate tax exemption. The limit that matters for most is the contribution that will yield the maximum state tax benefit, which will usually be less than the annual gift tax limit.
Tip 4: You can use 529 funds and, at the same time, get education tax credits, such as the lifetime learning credit or the American opportunity credit. However, you can’t use the same dollars for both; so if you withdraw from the 529 to cover the payments you use for tax credits, the withdrawn amounts will be taxable. It’s only an issue if you exclusively use 529 funds for college expenses.
Tip 5: If using FAFSA, know how to shield your assets and income. There are many legal ways to do this, such as keeping assets in a business, harvesting investment losses, reducing or postponing any retirement distributions, reducing liquid assets by paying down a mortgage, etc. Keep in mind, however, that what might be beneficial for FAFSA won’t necessarily be for taxes. Be sure to weigh the pros and cons of competing strategies.
There are many tax benefits that can be harvested for college savings. The earlier you start the more you can get out of college savings tax planning, so make sure to have this discussion with your tax professional. A good time to start is as soon as you have money to save for college or before you spend any money for college expenses or K–12 tuition.
This article originally appeared on Forbes