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.