An Education in Spending

Money: Best ways to spend college education savings

By Mark Helm
Published on August 26, 2004, 12:00am | Comments

It's back to school time, and around the country, young men and women are heading off to college -- that's why some of you may be here in D.C. reading this right now. And going to college, for parents and families, it's a proud -- and expensive -- moment.

Luckily, many families have put away some money to help pay for the student's college education. But if you thought saving the money was the hard part, think again. Spending the funds stashed away for college expenses also takes some careful planning.

Most families have their college savings in a combination of places: mutual funds, a 529 plan, savings bonds and an education IRA. If you don't want to lose financial aid and valuable tax savings for which you could qualify, the order in which you tap these funds can really matter.

The first thing to understand is that most families won't be able to pay for the student's entire college costs. That means dealing with financial aid packages.

Almost all students are eligible for some kind of student loan, the most common form of aid. But the federal government and individual schools determine how much aid or how large a loan a student can receive based on both parent and student earnings and savings.

Financial aid officers evaluate student need and student and parent finances each year. Students are expected to contribute 35 percent of their money toward college costs, while parents are only expected to contribute 5.6 percent of their assets each year.

The more money in a student's name, the less financial aid is possible. If you want to get the maximum aid, spend any and all student money first. Coverdell education savings accounts, formerly known as education IRAs, and custodial accounts are both considered student assets. When the parent is the account holder, 529 plan accounts are considered the assets of the parent.

Also, you can't talk college funding without mentioning taxes -- and I know everyone loves taxes.

Many families, with moderate to above average incomes, will qualify for tax credits and tax deductions when they spend money on tuition and fees for education.

For instance, the Hope credit allows you to claim a tax credit of $1,500 when you pay $2,000 in tuition and fees.

Another option for couples earning under $130,000 or singles under $65,000 is the tuition and fees adjustment to income, which allows you to reduce your income by up to $3,000 of education expenses even if you don't qualify to itemize deductions.

Unfortunately, the IRS prohibits "double dipping" -- claiming tax credits or deductions for the same education expenses paid for with tax-free withdrawals or exempt interest from certain college savings investments or accounts.

So that $2,000 in college expenses has to be paid with money in a taxable account. Investment earnings in a 529 plan, for instance, are tax-free when withdrawn, but if you used $2,000 from a 529 plan to pay your college bills, you're not allowed to claim the same $2,000 of expenses for the education tax credit or deductions.

FinAid
www.finaid.org
A non-profit Web site that provide information to parents and students on the financial aid process

FAFSA
www.fafsa.ed.gov
The Department of Education's Web site for filing financial aid. The site provides the forms needed and explanation on how the process works.

Simple, right?

So what money should you spend first?

Coverdell Education Savings Accounts are a good place to start. Coverdells are similar to the Roth IRA. Money withdrawn from a Coverdell account to pay qualified education expenses is tax-free. As mentioned before, the money in a Coverdell is considered the child's assets and will count against you for financial aid, so it's best to use it as quickly as possible.

Savings bonds are another good place to start. Thanks to low interest rates, savings bonds have a low return right now. It might be smart to spend this money and allow other investments to grow. Since the earnings on savings bonds purchased after 1989 are tax-free when used to pay for education expenses (income restrictions apply), you can't claim the same expenses for the education tax credit or deduction.

What funds should you tap later?

College-saving 529 plans have become popular: parents have amassed $34.6 billion in them overall. Like the Coverdell, tuition and fee expenses paid for with tax-free earnings withdrawn from the 529 can't be claimed toward the education tax credit or deduction. It may make more sense to allow this money to grow as long as possible before spending it.

Finally, spend your savings that are in generic/general accounts, also called taxable accounts. Remember, stock intended to be sold to finance college should be gifted to the student, who may pay capital gains tax at five percent versus the fifteen percent rate for higher-income parents.

Even as a last resort, avoid dipping into any 401(k) or other retirement plan to pay for college. That might entail early-withdrawal tax penalty, and it may not be easy to replace those funds.

Mark Helm is a personal finance writer and financial planner. He can be reached at HelmFinancial@aol.com.


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