From diapers to diplomas, your child is finally ready for college--and you think you are, too, because you've saved for this day in a 529 plan. What you may not realize is that your work isn't finished. Managing higher education expenses isn't simply a matter of paying tuition bills.
"Parents and students must understand that their decisions about spending have implications--for a student's financial aid eligibility in future years, for tax costs and for the family's ability to meet other financial goals, particularly retirement," said Jonathan Kahler, an investment analyst in Vanguard Investment Strategy Group.
Kahler and Maria Bruno, CFP®, senior investment strategist in the Investment Strategy Group, are two of the co-authors of "Tackling the tuition bill: Managing higher education expenses." They offer several important tips for paying higher-education bills.
Take an inventory
What resources are available to help you pay for college? Your 529 savings plan may top the list, but also consider savings in other types of accounts. Include contributions from grandparents and other relatives. Estimate what you can afford to spend from your own income and how much you may have to borrow. You'll also need to understand which expenses qualify for tax-free withdrawals from your 529 account and which can be applied toward tax credits or deductions.
Offset college costs with tax benefits
Tax credits, such as the American Opportunity Tax Credit or lifetime learning credit, and the tuition and fees deduction on income taxes can substantially lower the after-tax cost of college. These incentives generally benefit lower- and middle-income taxpayers.
You'll need to determine which benefit is most advantageous for you and spend from your income or taxable savings to trigger the benefit. Remember that 529 assets already receive favorable tax treatment, so spending from these accounts won't qualify for deductions or credits.
For higher earners, the tax impacts of tapping various account types will be more important than credits. Spending from tax-deferred accounts can increase income taxed at ordinary rates, while spending from taxable accounts can mean realizing gains that are subject to capital gains rates, or losses that may count toward deductions.
Evaluate your financial aid eligibility
Financial aid-grants, scholarships, student loans or work-study programs--can be a key component of financing your student's education. So your spending strategy should maximize your student's chances of getting an aid package.
Keep these points in mind:
Income counts more than assets when colleges reduce need-based financial aid, so it's important to understand the classifications. For example, distributions from a grandparent-owned 529 are considered student income, while 529 savings owned by parents or a dependent student are considered parental assets.
Timing is everything. By spending student assets in the early years of college and delaying spending that will count as income (such as from the grandparent-owned 529 plan), you can boost the amount of aid your student may be eligible for in later years.
Spend strategically from your 529 savings
To make the most of 529 benefits, be flexible in spending from the account. It's logical to want to tap your 529 first since you can only use it for qualified college expenses, but it may be more advantageous to consider a 529 as just one asset in your entire financial picture. By spreading out spending from a 529 over a longer period of time, the account can continue to grow tax-deferred and relieve pressure on other sources, such as loans, in any given year. Other tips for 529 spending:
Know which expenses qualify for tax-free spending, such as tuition, fees, books, computers, and room and board.
Avoid penalties by withdrawing money in the calendar year in which you'll use it. A common mistake is to take out money for the entire school year in the fall, which creates a mismatch between the withdrawal year and the year in which some of the bills are paid. Wait until after January 1 to make the second-semester withdrawal in the same year the payment is due.
Keep good records to make sure your 529 withdrawals don't exceed your qualified expenses or you'll be paying taxes--and possibly penalties--on the extra money you took out.
Fill in the gaps
With ever-rising college costs, you may still find your spending plan falls short. Don't be tempted to withdraw from your retirement accounts. That will only jeopardize your retirement goals. Here are suggestions to pay for the remainder:
Tap other accounts available to you, but be aware of the tax consequences
Take advantage of federally subsidized loans if they're available.
Put it all together
"It's challenging to pay for college today because, next to your house, a college education is one of the most expensive investments a family can make," Bruno said. "Most students receive some type of financial aid, and you want to do everything you can to preserve their eligibility."
She noted that a family's spending decisions can both increase expected financial aid and decrease tax bills by several thousand dollars.
"Be smart about developing your plan," Kahler said. "Spend with an eye toward your student's financial aid eligibility while targeting available tax benefits. If you're feeling stressed, consulting with a financial planner can help."
Your goal is to maximize your benefits and use your assets in a way that meets college-spending needs as efficiently as possible.
Source: Jonathan R. Kahler, Jenna L. McNamee, Maria A. Bruno, 2016. Tackling the tuition bill: Managing higher education expenses. Valley Forge, Pa.: The Vanguard Group.