If possible, avoid taking Qualified Tuition Plan distributions that will be used to pay for expenses that may be used either for the American Opportunity Credit or Lifetime Learning Credit. This especially applies for the American Opportunity Credit credit since that credit equals 100% of the first $2,000 of eligible expenses and 25% of the next $2,000. While there is usually more benefit to a credit than the Qualified Tuition Plan tax-free treatment of earnings, structuring distributions can help maximize tax savings.
A parent has a Qualified Tuition Plan account for a child that has $40,000 ($28,000 in contributions and $12,000 in earnings). Tuition is $10,000 for the year with room and board of $6,000. The parents or the child use $4,000 of the $10,000 tuition to claim the maximum American Opportunity Credit Credit. If the parents withdraw the entire qualified expense amount of $16,000 (tuition and room & board), only $12,000 will be tax-free. $1,200 or the pro-rata portion of the earnings withdrawn will be taxable. The $1,200 is calculated by $12,000 divided by $40,000 = 30% (earnings ratio). The 30% earnings ration is applied to $4,000 (taxable portion) to arrive at the $1,200. The 10% penalty on the taxable earnings does not apply in this situation.
By structuring distributions from Qualified Tuition Plan to avoid conflict with education credits, you may save $2,000 or the amount of the education credit applicable to qualified education expenses in question.