Colorado 529 withdrawal income tax recapture and AOTC

Question

In Colorado contributions to the state 529 plan are deductible from State income taxes. These income taxes are recaptured if a non qualified withdrawal from the plan is made.

My husband (the beneficiary of our 529 plan) also appears to be eligible for the AOTC (American Opportunity Tax Credit).

If we pay for his full tuition expenses from the 529 plan, I understand that under the double dipping rules the part of his tuition that is also refunded via the AOTC will not gain preferential capital gains treatment (though will avoid the 10% penalty).

However it is not clear to me if the income tax saved from these deposits is also recaptured on such an unqualified withdrawal, I know for income tax recapture there are some exceptions such where unqualified withdrawals are not eligible for recapture (such as scholarships or disability) but I am not clear if the AOTC double dipping rule is one of these exceptions?

I ask as it appears that otherwise we will likely not be able to make use of all of the 529 funds, so it is preferential to withdraw without the 10% penalty now than end up paying it later. But it is not clear what happens with the income tax recapture for when we file taxes this year.

(Please note before someone suggests, we have (and can have) no children and no other relatives or friends who will go to college so naming a new beneficiary is not feasible.)

Answer 1

Here's the language from the CO Department of Revenue:

Any subtraction claimed for payment or contribution made to a 529 college savings plan is subject to recapture at the time of distribution, refund, or withdrawal unless it is made for a qualifying purpose. Qualifying distributions, refunds, and withdrawals are those made:

• to pay qualified higher education expenses for the designated beneficiary of the account;
• as a result of the beneficiary’s death or disability; or
• as a result of receiving a scholarship during the tax year in an amount equal to or greater than the distribution, refunds, or withdrawals made.

From that, it seems like you'd face no recapture. However, the IRS doesn't allow you to use 529 funds to pay for expenses that qualify for AOTC. Per Publication 970 (note 529 plan = QTP):

You can't do any of the following:
.....
Figure the tax-free portion of a distribution from a Coverdell education savings account (ESA) or qualified tuition program (QTP) using the same expenses you used to figure the American opportunity credit. See Coordination With American Opportunity and Lifetime Learning Credits in chapter 7 and Coordination With American Opportunity and Lifetime Learning Credits in chapter 8.

My understanding based on the above is that you cannot avoid your 529 distributions being considered unqualified by both IRS and CO if you are attempting to use them for the same expenses that qualify for the AOTC, and would therefore face CO recapture.

If you have enough expenses that you can use some for each, then you are set, but there cannot be overlap that is considered qualified. I'd wager taking the AOTC is still the better way to go, but you'd want to run through the numbers to be certain.