A wrong decision on paying for college can cost you in taxes or lost aid.

    In recent years Section 529 plans, Coverdell Education Savings Accounts and penalty-free IRA withdrawals for higher-education expenses have eased the pain of paying for college. But problems often arise when people unknowingly tap these tax-favored plans in ways that eliminate valuable education tax credits or deductions, make distributions taxable or jeopardize chances for obtaining financial aid.
    While financial advisors are often well-versed in ways to save for college, experts say many could probably use a solid 101 course on how to take money out of savings plans when the bills start rolling in. "A lot of advisors don't understand the tax and financial aid ramifications of taking money out of tax-advantaged college savings plans, and they're giving advice that could be costing their clients thousands of dollars," says Ron Them, a college planning consultant in Columbus, Ohio. "There are a lot more pitfalls than people think." With the cost of four years at some prestigious private colleges now approaching $200,000, the confusion comes at a time when the stakes are extraordinarily high and maximizing every dollar counts.

The Aid Game
    Deciding how and when to tap assets earmarked for college involves taking into account someone's total financial profile, including their income, assets and whether or not they are likely to qualify for financial aid. Don't assume that financial aid is out of the question, even for fairly well-heeled clients. "With total college costs at some pricier private schools approaching $50,000 a year, the income numbers for financial aid qualification are getting higher, particularly for families that have more than one child attending college," says Fred Amrein of Amrein Financial in Wynewood, Pa.
    Other clients may qualify because they have most of their wealth in qualified retirement plans, which are nonassessable assets. And families have become more sophisticated in using techniques that shore up financial aid eligibility, such as juggling income, putting money into a business or paying down or paying off a mortgage. (Financial advisors or their clients can access a financial aid calculator that determines the expected family contribution for college costs at www.finaid.org/calculators. The free federal application for student aid is available at www.fafsa.ed.gov.)
    Asset ownership is critical in determining how much financial aid a student receives. The federal methodology expects students to contribute 35% of their assets and parents to contribute 5.6% of their assessable assets, excluding home equity. "If assets held in a child's name are a financial aid stumbling block for a family that might otherwise be eligible, it's probably a good idea to pay college costs by spending those assets first for college in order to qualify for aid in later years," advises Marc Minker, managing director at Mahoney Cohen Private Client & Family Office Services in New York.
    If possible, he says, spend student assets before college on things like summer camp, private high school, or a computer. To minimize student income, which counts even more heavily in than student assets in aid calculations Minker recommends selling appreciated assets that are in a child's name before the senior year of high school, and selling capital assets that generate losses in the year before filing the federal financial aid form to reduce adjusted gross income.
    On the parental side of the equation, common tactics include putting extra savings into annuities, insurance contracts and Roth IRAs to reduce assessable assets, or using reportable assets to pay down credit card debt and automobile loans. Shift income such as bonuses or capital gains to the years prior to or after a student is in college. Reduce adjusted gross income by up to $3,000 by selling any capital assets that will generate losses in the year before the federal application is filed. If possible, avoid selling a personal residence at a nontaxable gain during college years because the gain is classified as untaxed income and benefits.
    Try not to withdraw from tax-deferred retirement accounts for college expenses. Even though penalty-free withdrawals are now possible for higher-education costs, using a traditional or Roth IRA to pay bills works against parents who are eligible for need-based financial aid. Although amounts in these plans are not counted as assessable assets in aid calculations, the entire withdrawal is treated as income in determining the family's expected contribution. And if you use a penalty-free withdrawal from an individual retirement account to pay for college, you can't use the same expenses to justify a Hope or Lifetime Learning tax credit.

    Preserving Education Tax Breaks
    For middle-class families that fall within income eligibility guidelines, withdrawals from 529 plans, IRAs and Coverdell ESAs need to be coordinated with the education tax breaks. The IRS says that taxpayers may not "double dip" by claiming multiple tax breaks for the same expense. This restriction means that if you pay for college expenses entirely from tax-advantaged savings plans, you risk losing significant tax breaks when you take the money out.
    Them cites an example of how this rule can get sticky, and how to deal with it. A family could pull the entire amount of their qualified higher education expenses tax-free out of a Coverdell or 529 to cover bills, but the double dipping restriction could eliminate their ability to claim the Hope Scholarship Credit or Lifetime Learning Credit for that year. They could preserve the ability to use the credit by treating the earnings portion of the withdrawal as a nonqualifying expense, but they would have to pay ordinary income taxes and penalties and interest on that amount. A better option, he says, would be to write out a check for an amount sufficient to match against the tax credit they wish to claim, then pay the remainder from the tax-advantaged plan. This strategy would preserve both the ability to use the tax credit and the tax-free status of the entire withdrawal.
    The amount of the expenses used for determining the Hope or Lifetime Learning credit are different, a factor that can also influence the decision about timing withdrawals from tax-advantaged college savings plans. Because the Hope credit calculation is based on a maximum of $2,000 in qualified expenses, compared to $10,000 in expenses used for the Lifetime Learning credit, it may be advantageous to plan for larger 529 or Coverdell withdrawals during the Hope credit years. If income is too high to take advantage of a tax credit or deduction for higher-education expenses in one year, deferring a bonus or other income until January of the following year could make sense in some situations.
    Of course, none of this planning is relevant to higher-income clients who don't qualify for tax breaks anyway. But even wealthier families can benefit by using payment strategies that go beyond peeling off checks. For example, a married couple that has saved outside a tax-advantaged account could gift appreciated assets of up to $22,000 to each son or daughter in school, says Them. The child would then sell the securities, recognize the tax on any gains, and if the child had enough income he or she could then use the Hope or Lifetime Learning credit to effectively wipe out the tax. "In effect, the parents are getting the same tax benefits as they would in a 529 plan without the expenses or restrictions," he says.