You’ve dutifully saved for your child’s college education for years and years in a 529 plan. Now you have to decide how to use the money you’ve saved. Do you spread the money out equally over all four years, or do you spend it all during the first year or two? Which approach is better? Why?
Consider the impact on financial aid eligibility
If the college savings plan is owned by the student or parent, it is reported as an asset on the Free Application for Federal Student Aid (FAFSA). This means that any money that isn’t spent during the first year will count against financial aid eligibility again during the second year, and possibly also during the third and fourth years. There is a similar impact on institutional financial aid for the colleges that require the CSS Profile.
So, a strategy of spending the college savings down to zero as quickly as possible, front-loading the funds, will minimize the impact of college savings on eligibility for need-based financial aid.
Consider the impact on taxes
But, minimizing the impact on financial aid isn’t necessarily the best overall strategy. You also have to consider the impact on taxes.
Now, you may be confused because qualified distributions from a 529 college savings plan are entirely tax-free. So, what’s the problem?
That impact on taxes isn’t the one of concern. Rather, the focus is on tradeoffs with other education tax benefits, such as the American Opportunity Tax Credit (AOTC). The AOTC provides a tax credit of up to $2,500 based on up to $4,000 spent on tuition and textbooks.
The IRS has coordination restrictions that prevent double dipping. In other words, you can’t use the same qualified higher education expenses to justify both a tax-free distribution from a college savings plan and the $2,500 tax credit.
Which education tax benefit is better?
- The financial benefit of the AOTC is 62.5 cents per dollar of qualified expenses.
- The financial benefit of tax-free distributions from a 529 college savings plan is about 11.3 cents per dollar of qualified expenses.
Tax-free distributions from a college savings plan yield tax savings at the taxpayer’s tax bracket and only on the earnings portion of the distribution. The maximum tax bracket consistent with the AOTC income phase-outs is 24%. As much as a third of the distributions from a 529 college savings plan come from earnings. Combining this with the 10% tax penalty on non-qualified distributions, the financial benefit of a tax-free distribution from a 529 college savings plan is as much as (24% + 10%) / 3 = 11.3%.
Thus, if you qualify for the AOTC, you should carve out $4,000 in tuition and textbook expenses each year to qualify for the maximum tax credit. You will need to use cash or student loans to pay for the qualified expenses, not 529 plan money. Qualified distributions from 529 college savings plans can be used to pay for the remaining eligible costs. Luckily, qualified distributions from a 529 plan use a broader definition of qualified expenses than the AOTC.
Preserving access to low-cost loans
There is one additional caveat, and that concerns federal student loans. If you don’t have enough money between the 529 plan, AOTC and other funds to cover the full net price of your child’s college education, your child may need to borrow some student loans to help pay for college. Federal student loans, especially subsidized loans, are the best borrowing option. But, these loans have annual limits in addition to aggregate limits. If you don’t borrow during the first few years because you front-loaded the 529 plan funds, you can’t borrow beyond the subsequent years’ annual limits to compensate.
The sum of the annual loan limits for a dependent student is $27,000 over the first four years. If you need to borrow the full amount, you will need to carve out amounts corresponding to each year’s annual loan limits before using 529 plan funds. If you need to borrow less, then start from the senior year and work your way backward. Working your way backward minimizes both the number of years during an in-school period when unsubsidized loans will accrue interest and the number of years during which the college savings plan money will count against financial need. Of course, one does not need to be concerned about subsidized loans accruing interest during the in-school period. Subsidized loans also have lower annual limits than unsubsidized loans. So, one should allocate them first, before the unsubsidized loans.
Technically, qualified higher education expenses for the purpose of a qualified distribution from a 529 college savings plan are not reduced by the amount of any qualified education loans, so one could use both a qualified distribution from a 529 plan and student loans to pay for the same expenses. That might eliminate the need to carve out a portion of qualified higher education expenses to be paid with qualified education loans instead of a tax-free distribution from a 529 plan. This is one of the few situations in which you can double dip, since the coordination restrictions are one-sided. Likewise, 529 plan distributions do not cause a student to be overawarded from a financial aid perspective when the 529 plan is listed as an asset on the student’s FAFSA. Note, however, that the definition of qualified higher education expenses for a qualified education loan is reduced by qualified distributions from a 529 plan, but only by the earnings portion of such distributions. In practice, the IRS does not reduce the amount of qualified education loans that are eligible for the Student Loan Interest Deduction based on such double dipping because it is not practical to do so, especially since the qualified education loans may have been borrowed in years prior to the current tax year and the education loans will usually still be qualified even after such a reduction in qualified higher education expenses.
If a college savings plan is owned by anyone other than the student or the student’s parent, such as a grandparent, it isn’t reported as an asset on the FAFSA, but it has the same impact on qualified expenses with regard to qualified 529 plan distributions and the AOTC. It is still better to claim the AOTC first. The impact on aid eligibility does not depend on the impact on education tax benefits, so you can think about the two separately. Plus, most people will change the account owner or roll over the money to a parent-owned 529 plan or wait until after January 1 of the sophomore year in college to take a distribution, rather than have half the distribution amount reduce aid eligibility. So, this either has the same impact as a parent-owned 529 plan, or it delays the distributions until later in the student’s college tenure.
- Carve out up to $4,000 in tuition and textbook expenses for the AOTC. Do not use 529 plan funds to pay for these expenses. Claim the maximum AOTC to the extent that you are eligible (up to $2,500), using cash or loans to pay for the tuition and textbook expenses (up to $4,000) that justify the tax credit.
- Carve out up to the annual loan limits for student loans. Estimate the four-year net price. If this exceeds the total tax credits, total 529 plan funds and other resources you will use to pay for college, the student will need to borrow to pay for college. The amount of student loans will depend on the size of the gap. Spread these loans starting from the senior year back to the freshman year, taking annual limits into account.
- Fill in the remaining college costs with qualified distributions from 529 college savings plans.