Financial Planning for September 2013

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Late-Stage College Planning

Saving for higher education isn’t just about tuition – there’s housing, books, computers, lab fees, student meal cards, travel expenses – and the list goes on and on. You may have saved for your child’s college education, but you might not have saved enough. Furthermore, you could find that your earnings are too high for your student to qualify for substantial financial aid. If your backup plan is simply to pay for excess expenses out of your current income, the following are tips to help you manage your funding options more efficiently.

Although your strategy might be to spread out the amount in your college savings 529 plan over your student’s four-year (hopefully) college career, it’s generally more tax-efficient to go ahead and withdraw the maximum annual amount. You are permitted to withdraw as much as 100 percent of the student’s qualified expenses in each year. Instead of supplementing a smaller amount with current income, use that income to make additional contributions to the plan each year. If your state allows a tax deduction, this will reduce your state income taxes. Even if you don’t benefit from a state tax deduction, your money will have the opportunity to grow while it’s invested in the 529 plan, and any earnings can be used to pay for future college expenses tax free.

One thing to be aware of, however, is that you might need to adjust the amount you withdraw from your 529 on your annual tax return. Many filers will need to attribute $4,000 of the amount withdrawn to the American Opportunity Tax Credit (AOTC), or it could be considered a nonqualified distribution and the earnings portion will be subject to income taxes (10 percent penalty will not apply). If your modified adjusted gross income is too high to qualify for the AOTC (more than $90,000 for an individual or $180,000 for married filing jointly), you won’t need to make this adjustment when you file.

Distributions from your 529 plan are tax free when used for qualified higher education expenses. To ensure that you are properly credited, it might be better for distributions to be paid directly to the student or to the college, rather than to you as the account owner. The plan sends out Form 1099-Q to the actual recipients of the funds, so the IRS could consider the withdrawal unqualified if the form is sent to you. If that happens, you’ll have to pay income taxes and a 10 percent penalty on the earnings portion of the money distributed – or resolve the issue with the IRS.

Although it means you’ll have to ensure the money is spent correctly, it might be more beneficial to have 529 distributions sent to your student rather than the school, as these checks are frequently processed as scholarship money received for the student. The college financial aid office could decide to reduce the financial aid available to the student as a result.

Be aware that if your student does receive scholarship money that reduces your expenses, you can withdraw an amount equaling that scholarship without being subject to the 10 percent penalty tax for a nonqualified withdrawal. Note, however, that any earnings portion of your withdrawal will still be subject to income taxes. All distributions are allocated between principal and earnings on a pro-rata basis. One way to minimize your taxes is to have this money distributed directly to the student, who is likely in a lower tax bracket. You could even consider this money a gift to the student as a reward for qualifying for the scholarship – as long as he or she pays the taxes due on it.

If the student’s grandparents are of a mind to help out with college expenses, the 529 plan is a great way for them to remove assets from their estate without losing complete control over them. By establishing their own 529 plan, the assets they contribute will not be considered part of their estate and therefore not subject to estate taxes upon their death. If the student doesn’t need the money for whatever reason, the grandparents can get it back – but the money will be subject to estate taxes again.


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