In about a month, our kids will head back to school. For some parents, that means new lunchboxes and character backpacks. For the more seasoned parents, it means there’s a rather large college tuition bill looming, perhaps the first (of many!). It’s time to figure out how to spend 529 college funds that were so diligently saved.
Paying for college is a hot topic, and it certainly isn’t new for us. What I want to focus on today, however, is something that too often gets missed in the college finance discussion: how to spend what you’ve saved in a 529 plan. Do you spread the money out equally over all four years, or do you spend it all in the first year or two? And, how will that decision impact your taxes and your child’s eligibility for future financial aid?
How we answer those questions requires a deep dive into all the types of funds you’ll be accessing to pay for your child’s education -- 529 funds, need-based aid, tax credits, and loans.
Let’s look at need-based financial aid first. If the 529 is owned by the student or parent, you must report it as an asset on the Free Application for Federal Student Aid (FAFSA). Once you do that, any money that isn’t spent during the first year will count against the student’s financial aid eligibility again during the second year, and possibly beyond. For colleges that require the CSS Profile, there’s a similar impact.
So, for families relying on need-based financial aid in future years, the strategy of spending the college savings down to zero as quickly as possible makes perfect sense. If there’s no money left to report, you won’t have to report it on the FAFSA. Front-loading your 529 funds in the early year(s) of college minimizes the impact of college savings on eligibility for need-based financial aid.
As far as the impact to your taxes, it’s sort of there and it’s not. Qualified distributions from a 529 college savings plan are tax-free, so you won’t see any tax bill from withdrawing them. The issue here is the tradeoffs with other education tax benefits that you may experience when you withdraw money from a 529. The IRS has coordination restrictions that prevent “double-dipping”. In other words, you can’t use the same qualified education expenses to justify both a tax-free distribution (your 529) and another federal tax credit.
Here’s just one example: The American Opportunity Tax Credit (AOTC) provides a potential tax credit of up to $2,500 based on up to $4,000 spent on tuition and textbooks for those who qualify. Using 529 funds for those expenses would disqualify you for the AOTC in the same year.
Is there a workaround? Yes. Assuming you qualify for the AOTC, you would carve out $4,000 in tuition and textbook expenses each year to qualify for the maximum tax credit. You would then need to use cash or student loans to pay for the qualified expenses, not 529 plan money. Again, how you spend 529 funds is critical.
If there’s not 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 a strong option due to their historically low-interest rates and flexible payback schedules. 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 your child will need to borrow the full amount, then a good strategy would be to carve out amounts corresponding to each year's annual loan limits before using 529 plan funds. If less is needed, then you could start from the senior year and work your way backward to minimize 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, you do 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.
Welcome to the craziness that is college financing! You can see already why we recommend discussing college financing with an accountant who is well-versed in college spending strategies (not just saving).
Now, if your 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 if you qualify for it. 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.
Optimizing the use of 529 plan funds is more complicated than it first appears to be. We look forward to guiding through the process.