College isn’t cheap. Anybody who is in college, was in college or is currently saving for college already knows that. What you might not know, however, is how fast the costs are rising. The accepted rule of thumb is that the cost of college increases at about twice the rate of inflation. That means that each year, you can expect to pay at least 5% more.
If you’re a parent of a future college student, you have to save now, but tucking money away in a savings account isn’t going to work. You have to invest it to stay ahead of inflation. Most people turn to a 529 savings plan to make their money grow. That will help a lot, but what parents may not know is that how they later spend the money is just as important as how they save.
In the best possible scenario, you would combine 529 funds with help from the government to cover the complete cost of college for you or your child, but government help is often income-based and that's where handling those 529s strategically comes in.
When and How to Spend 529 Funds
Recently, a Wall Street Journal columnist advised that once a child reaches college, it might work to the family’s advantage to spend all 529 funds in the first two years in the hopes of getting financial aid in the third and fourth years – if the parents expect a high-expense or low-income year. Good advice? We decided to check it out with other experts. The variety of advice we found made it clear that parents should consult a college loan expert for the correct advice for their situation.
Cash out quickly, if you're a student or parent. Gretchen Cliburn, CFP, director at BKD Wealth Advisors in Springfield, MO, says, “Money held in 529 accounts owned by the student or one of their parents is considered to be parental assets on the FAFSA. If you know your education costs will exceed your 529 savings, I would recommend spending the 529 balance first before borrowing any money.”
But not if you think you might have trouble getting a loan later on. Running through 529 funds in the first two years – instead of taking advantage of available loans – can backfire, says Joseph Orsolini of College Aid Partners. “Families really need to budget out the four years of college to determine the best course of action with spending savings and borrowing. I have seen a number of families spend down their 529 accounts in the first couple of years, but later run out of money and not be able to borrow (due to bad credit) in the final years,” he warns. “These students are left without resources to finish college.”
Orsolini agrees. “Low income is a relative term for people. Dropping from $150k to $100k is a huge reduction, but in most cases it will not result in any additional financial aid,” he says. “If your child is at an elite college that matches 100% of need, it might be worth relying on this strategy, but most colleges will not increase an aid package simply for spending down your 529 fund.”
Hold back, if you're a grandparent. There are circumstances when it might be best to refrain from using the money until the student’s later years, according to Ryan Kay, a certified financial planner. “One important aspect to remember while considering when to spend the 529 money is who owns the plan,” Kay says. “If a grandparent is the owner, for example, and he or she distributes funds from the 529 plan, the money will count as student income for next year’s FAFSA and could negatively impact the student’s ability to qualify for financial aid. So when the grandparent is the owner, often times it’s best to leave the money in the 529 plan until the student has filed the final FAFSA (January 1 of their junior year of college).”
Factor in the Tax Credit
The American Opportunity Tax Credit offers a tax credit of up to $2,500 when you have spent $4,000 on tuition, fees, textbooks and other course materials. However, it phases out at certain income levels ($180,000 for married couples filing jointly in 2015, for example). Also, you can’t use the same expenses to justify both a tax-free distribution from a 529 plan and take the tax credit – there’s no double dipping.
“The tax credit is worth more per dollar of qualified expenses than the tax-free 529 plan distribution, even considering the 10% tax penalty and ordinary income taxes on non-qualified distributions,” says Mark Kantrowitz, publisher and VP of Strategy, Cappex.com. “Families should prioritize $4,000 in tuition and textbook expenses to be paid for using cash or loans before relying on the 529 plan. Otherwise, [it’s preferable] to spend down the 529 plan balance as quickly as possible, so that the assets do not persist year after year to reduce aid eligibility by 5.64% of the asset value.”
The Bottom Line
Like most financial questions, there are a lot of what-ifs, but in general, our experts recommend other practices rather than spending all the 529 money now and betting on the future. However, for some people, they note, the strategy could represent a cost savings.