"You can't use the same higher education expenses to qualify for both a tax-free distribution from a 529 plan and the American opportunity tax credit," says Mark Kantrowitz, publisher of the financial aid website FinAid.org. Because the American opportunity credit amounts to a free $2,500 off of your taxes each year through 2012 (provided that you spend at least $4,000 on college expenses), Kantrowitz advises parents to use savings or student loans to cover the first $4,000 in tuition, fees and course materials, then 529 plan distributions for all other expenses.
Income phaseouts for the credit start for single filer households earning more than $80,000 and joint filer households earning more than $160,000.
Use it for college
"Pulling 529 contributions out early for nonqualified expenses counts as a distribution, and therefore counts as income and can subtract from the student's financial aid package if taken the year before the student attends school," says Alisa LeSueur, a former certified college planning specialist and owner of ICS College Funding in San Antonio.
While families can withdraw 529 cash tax-free for qualified education expenses, those who pull out funds for nonqualified expenses will pay taxes on the withdrawal and a 10 percent penalty on earnings.
"It's especially devastating if the 529 plan is in the student's name because then it counts as student income," LeSueur says.
According to the U.S. Department of Education, parents can earn up to $31,000 for the 2011-2012 school year without their income detracting from their children's federal financial aid package. For every dollar earned above that mark, the federal government will subtract up to 47 cents from the student's need-based award. For students, the income threshold is much lower. Students can earn up to $5,250 per year with every dollar above that mark taking 50 cents away from their need-based award.
Tap the grandparents
"(529 plans) are a (financial) asset, and any asset is going to count against you in the (federal) financial aid formula," says Mark Mauro, a Certified Public Accountant and head of Mark Mauro Financial in Somerville, N.J.