When paying for college, many families tap into investments to cover educational expenses. However, selling stocks, mutual funds, or other assets to fund tuition can have unintended tax consequences—especially when it comes to claiming valuable education-related tax credits. If not handled strategically, capital gains from investment sales may increase a student’s or parent’s adjusted gross income (AGI) and reduce or eliminate tax benefits like the American Opportunity Tax Credit (AOTC) or Lifetime Learning Credit (LLC). In this blog, we’ll explore how to sell investments in a tax-smart way to protect student tax credits and minimize your IRS bill.
Understanding the Education Tax Credits
1. American Opportunity Tax Credit (AOTC)
The AOTC provides a tax credit of up to $2,500 per eligible student per year for the first four years of post-secondary education. Up to 40% of the credit ($1,000) is refundable.
Income limits (2025):
- Single filers: Credit phases out between $80,000–$90,000 MAGI
- Married filing jointly: Phase-out between $160,000–$180,000 MAGI
2. Lifetime Learning Credit (LLC)
The LLC offers a credit of up to $2,000 per return for qualified tuition and related expenses. It is non-refundable and available for an unlimited number of years.
Income limits (2025):
- Single filers: Phase-out begins at $80,000
- Married filing jointly: Phase-out begins at $160,000
Key takeaway: Income from capital gains or dividends can push your modified adjusted gross income (MAGI) beyond these limits, reducing or eliminating your eligibility for education credits.
How Investment Income Affects MAGI
When you sell investments, any profits are counted as capital gains and added to your taxable income. These gains can be short-term (held for one year or less, taxed as ordinary income) or long-term (held longer than one year, taxed at reduced rates).
Here’s how investment income increases your MAGI:
- Long-term capital gains: Taxed at 0%, 15%, or 20% but still counted in MAGI
- Dividends and interest: Fully included in MAGI
- Rental and other passive income: Also added to MAGI
Rising MAGI can trigger a phase-out of education credits, making it critical to carefully plan the timing and size of any investment sales.
Strategy #1: Time Your Sales to Minimize Taxable Income
One of the simplest strategies is to control the year in which you recognize capital gains.
- Consider postponing investment sales until a year when education tax credits are not being claimed.
- If you must sell, consider doing so in a tax year where your income is naturally lower (e.g., one spouse is not working, or a student is not enrolled full-time).
- Coordinate investment sales with tuition payments to spread gains across multiple tax years and avoid crossing MAGI thresholds.
Example: If you’re paying tuition over four years, avoid realizing large capital gains all in one year, which may eliminate eligibility for the AOTC.
Strategy #2: Utilize the Student’s Lower Tax Bracket
If the student is the owner of the investment account (e.g., in a custodial UGMA/UTMA account), gains may be taxed at lower rates. But beware of the Kiddie Tax.
- The first $1,300 of unearned income is tax-free for children (2025 threshold).
- The next $1,300 is taxed at the child’s rate.
- Unearned income above $2,600 may be taxed at the parents’ rate (Kiddie Tax applies to children under age 19 or full-time students under age 24).
Tip: You can have the student realize capital gains in a year when they’re not subject to the Kiddie Tax, keeping the income taxed at 0% and not affecting the parents’ MAGI.
Strategy #3: Offset Gains with Losses
Tax-loss harvesting is a strategy where you sell losing investments to offset gains. If you must sell investments to pay for college, offset gains to reduce their impact on MAGI.
- Capital losses first offset capital gains dollar-for-dollar.
- If losses exceed gains, up to $3,000 can be deducted against ordinary income.
- Unused losses can be carried forward to future tax years.
Example: If you have $10,000 in gains from one mutual fund, sell another investment with a $6,000 loss to reduce the net gain to $4,000, lowering your MAGI and preserving credit eligibility.
Strategy #4: Use Tax-Advantaged Accounts
Roth IRAs and 529 plans offer tax-advantaged ways to pay for college and reduce taxable income:
Roth IRA Withdrawals
- Contributions can be withdrawn at any time tax- and penalty-free.
- Earnings withdrawn for qualified higher education expenses may avoid the 10% penalty but are still taxable.
- Withdrawals do not count as income on the FAFSA but may be included in AGI.
529 College Savings Plans
- Withdrawals for qualified education expenses are tax-free.
- Withdrawals do not impact MAGI and thus preserve tax credit eligibility.
- Consider using 529 funds first before selling taxable investments.
Using tax-free sources of funding instead of generating taxable gains can be a highly effective way to maintain eligibility for student tax credits.
Strategy #5: Structure Asset Ownership Smartly
If parents hold all the taxable investments, any gains are reported on their return and raise their MAGI. One option is to strategically shift ownership of some assets to the student, especially after age 24 (when the Kiddie Tax no longer applies).
- Assets gifted to adult children are taxed at their (likely lower) rate.
- Ensure transfers do not trigger gift tax consequences (under $18,000 per year per person in 2025 is excluded).
- Use this strategy cautiously with help from a tax advisor to avoid triggering FAFSA or IRS issues.
Strategy #6: Apply the “Qualified Scholarship Exclusion”
Scholarships used for qualified expenses are generally tax-free and not included in income. However, if scholarships are used for room and board, they are considered taxable. Some students can make a strategic choice to include scholarships in income (if taxed at 0%) to claim higher education credits instead.
This advanced technique involves careful coordination and may allow more income shifting while preserving credits. Consult a tax advisor for details.
Key Reporting Forms to Understand
- Form 1099-B: Reports sales of stocks and mutual funds (capital gains/losses)
- Schedule D: Used to calculate total capital gains and losses
- Form 8863: Used to claim AOTC or LLC credits
- Form 8615: Calculates Kiddie Tax on child’s unearned income
Make sure these forms align and are accurately prepared to avoid IRS scrutiny and prevent disqualification from credits.
Common Mistakes to Avoid
- Failing to plan ahead before selling investments
- Triggering large capital gains in a single year
- Ignoring the Kiddie Tax rules
- Not coordinating with financial aid strategies (FAFSA and CSS Profile)
- Overlooking the use of tax-advantaged accounts like 529 plans
Final Thoughts
Selling investments to fund higher education is a smart use of resources—but only if done strategically. Because education tax credits like the AOTC and LLC are tied to income limits, increasing your MAGI through poorly timed asset sales can be costly. By planning sales over multiple years, using loss harvesting, leveraging student tax brackets, and prioritizing tax-advantaged accounts, families can reduce or avoid the negative tax impact and preserve eligibility for valuable credits. Consult with a tax professional to develop a personalized plan that fits your investment profile, income level, and education funding timeline.
