You can learn about the best practices for developing an efficient college spending strategy in Vanguard’s research paper Tackling the tuition bill: Managing higher education expenses.
What are your available resources?
Before you can make college spending decisions, you need to take inventory of the financial resources you have available. Although your 529 plan account might be your main source of savings, you’ll also want to look at other options, including:
- Savings accounts.
- Uniform Gifts/Transfers to Minors Act (UGMA/UTMA) accounts.
- Contributions from grandparents or other family members.
Understand factors that affect financial aid
How you decide to spend from your various resources can affect your student’s eligibility for financial aid and the amount he or she is able to receive.
Beginning with the 2017–2018 school year, the Free Application for Federal Student Aid (FAFSA) now requires applicants to report income information from two years ago. To maximize your student’s chance of getting the most aid, consider spending his or her assets first (in the early college years). This might include money from the student’s taxable savings and investment accounts or a trust account for which he or she is an owner or beneficiary.
By delaying spending from sources that are considered student income, like distributions from a grandparent’s 529 account, you may be able to boost the amount of aid your student is eligible for in later years.
Tax benefits can offset college costs
While you’re looking for ways to increase financial aid, you’ll also want to decrease taxes. It’s important to determine which higher-education expenses qualify for tax-free withdrawals from your 529 account and which can be applied toward tax credits or deductions.
At the federal level, you can use only one education credit or deduction per student in a given tax year. If you qualify, the American Opportunity Tax Credit (AOTC), which provides a credit of up to $2,500 on $4,000 of qualified spending, is generally the most beneficial. Otherwise, depending on your situation, you may be able to apply for the Lifetime Learning Credit (LLC) or the tuition and fees deduction.
Most tax credits and deductions for educational spending are meant to benefit lower- and middle-income families. For example, to claim the AOTC, your modified adjusted gross income for 2017 must be $80,000 or less ($160,000 or less for married taxpayers filing jointly).
For families with higher incomes, the tax impacts of spending from various account types can be even more significant. If they spend from tax-deferred accounts, they could increase the income that’s taxed at ordinary rates. While spending from taxable accounts could mean they’d realize gains that would be subject to capital gains rates and losses that could count toward deductions.
Spend flexibly from 529 savings
It may seem logical to tap your 529 account first when paying tuition and other sizable education expenses. However, if you follow a more flexible approach and spend more regularly from your 529 throughout the student’s college years, you’ll be able to make the most of the benefits these plans offer, including tax-deferred growth on earnings.
By relying more on 529 assets, you can depend less on other financial resources, such as loans or out-of-pocket spending, in any given year. And, as long as you’re contributing to your 529 account, you’ll be able to continue taking advantage of other tax savings, for example, deductions on your state income tax return.
Here are some additional tips for smart 529 spending:
- Know which higher-education expenses are considered qualified, such as tuition, fees, books, computers, and room and board.
- Avoid penalties by withdrawing money in the calendar year that you plan to use it. A common mistake is withdrawing money in the fall for the entire school year. This creates a gap between the withdrawal year and the year in which some of the bills are due. When paying expenses for the spring semester, for example, wait until after January 1 to make a withdrawal.
- Keep good records of your 529 withdrawals so you don’t exceed your qualified expenses. You don’t want to end up paying taxes—and possibly penalties—on extra withdrawals.
Avoid tapping your retirement savings
As college costs continue to rise, it’s possible that your spending plan could fall short. If this happens, you might be tempted to withdraw from your retirement accounts to make up the difference. Don’t do it! Instead, consider these other ways to fill the gaps, such as:
- Spending from other available accounts, but be aware of any possible tax consequences.
- Taking advantage of federal student loans, if your student is eligible.
A case study in smart spending
The Vanguard Tackling the tuition bill research paper illustrates strategic college spending through a few scenarios that show how a hypothetical family’s spending decisions can increase financial aid and decrease tax bills by several thousand dollars.
Michelle and Chris have a daughter who’s attending a four-year college. The family plans to fill out the FAFSA each year to maintain loan eligibility and take advantage of any grant aid that may be available. Here’s their financial picture:
This study details two possible scenarios for how this family could spend from their assets. The first scenario prioritizes delaying out-of-pocket spending and disregards the possible impacts to taxes and financial aid that such spending may have. The second scenario follows a strategy aligned to the best practices detailed in the paper.
The graph below shows the benefits that Michelle and Chris can expect from a smart spending strategy. Although they’ll spend more out-of-pocket over the four years, they’ll stay within their budget and take full advantage of available tax credits. Here are the details:
- $6,250 in potential taxes saved by not tapping into their traditional IRA.
- $6,000 more in estimated financial aid by spending the student-owned UGMA account early and delaying spending from the grandparent-owned 529.
- $15,000 added to their retirement savings.
Although your resources may differ from those in this case study, the important thing to remember is that no matter where you’re pulling money from, you want to spend it in a way that enables you to take advantage of financial aid as well as any tax benefits.
Smart college spending will allow you to meet the challenges of paying for higher-education expenses without going over your budget or jeopardizing other financial goals, for example saving for retirement.
Source: Jonathan R. Kahler, Jenna L. McNamee, and Maria A. Bruno, 2016. Tackling the tuition bill: Managing higher education expenses. Valley Forge, Pa.: The Vanguard Group.
For more information about any 529 college savings plan, contact the plan provider to obtain a Program Description, which includes investment objectives, risks, charges, expenses, and other information; read and consider it carefully before investing. If you are not a taxpayer of the state offering the plan, consider before investing whether your or the designated beneficiary’s home state offers any state tax or other benefits that are only available for investments in such state’s qualified tuition program. Vanguard Marketing Corporation serves as distributor and underwriter for some 529 plans.
The information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. We recommend that you consult a tax or financial advisor about your individual situation.
Investment returns are not guaranteed, and you could lose money by investing in the plan.