What's the best way to use a 529 plan to pay for college?

Question:

We have a 529 college savings plan with about $20,000 for our son who will be starting college this coming fall. What is the best way to use the money in this account?

Answer:

There are several possible strategies for how to use a 529 college savings plan to pay for college. One strategy involves using as much of the available funds as possible during the student’s first year in college and the rest, if any, during the second year. Another strategy involves spending the money in equal increments over the student’s college career. For example, this strategy would spend one-quarter of the money each year for a student enrolled in a four-year degree program. Which of these strategies is better?

There are several principles that can influence the strategy used to spend the money in a 529 plan.

  • If the family is potentially eligible for the American Opportunity Tax Credit (AOTC), it should carve out $4,000 in qualified expenses (tuition and textbooks) to be paid for with cash or loans. The same qualified expenses cannot be used to justify both the tax credit and the tax-free distribution from a 529 plan. IRS coordination restrictions prevent double-dipping. The financial value of the AOTC per dollar of qualified expenses exceeds the financial value of a tax-free distribution from a 529 plan. So, the family should reserve $4,000 in qualified expenses to qualify for the AOTC each year, potentially reducing the amount of the 529 plan distribution.
  • To the extent that savings replaces unsubsidized loans, taking a 529 plan distribution earlier can reduce the amount of interest that accrues on the unsubsidized loan and is capitalized over the in-school and grace periods. Note that 529 plan distributions should not be used to replace subsidized loans, since the federal government pays the interest on subsidized loans during the in-school and grace periods. For example, suppose a student takes a $5,000 Direct Unsubsidized Loan in two installments as a college freshman. Assuming a 6% interest rate, this loan will accumulate $1,275 in interest by the time the loan enters repayment. That compares with the $375 in interest that will accumulate on a $5,000 Direct Unsubsidized Loan borrowed as a college senior. With the added impact on compound interest during a 10-year repayment term, the timing of the loan adds nearly $1,200 in interest over the life of the loan.
  • The Direct Unsubsidized Loan is subject to annual loan limits. If the student decides to not borrow unsubsidized loans during one year, the student cannot borrow that money during a subsequent year. So, if spending all of the 529 plan assets during the freshman year will leave the student with insufficient borrowing capacity in a subsequent year, the student may wish to reduce the 529 plan distributions during his or her freshman year in order to borrow more that year, as needed. For example, suppose the college’s net price is $10,000 during the freshman year, $11,000 during the sophomore year, $12,000 during the junior year and $14,000 during the senior year. Annual loan limits for the Direct Unsubsidized Loan are $5,500, $6,500, $7,500 and $7,500, respectively. If the student spends the $20,000 in 529 plan assets during the freshman and sophomore years, he will have a shortfall of $4,500 during the junior year and $6,500 during the senior year after borrowing to the limit. If the student takes distributions of $4,500 during the freshman, sophomore and junior years and $6,500 during the senior year, the annual loan limits can cover the gap.
  • Money in a 529 plan that is owned by a dependent student or the dependent student’s custodial parent will be treated as a parent asset on the FAFSA (Free Application for Federal Student Aid). This can reduce eligibility for need-based aid by as much as 5.64% of the asset value. So, spending down the 529 plan assets to zero as quickly as possible can increase the student’s eligibility for need-based aid by preventing the 529 plan assets from reducing aid eligibility in subsequent years.  (This is in contrast with a grandparent-owned 529 plan, where the asset value does not affect eligibility for need-based aid, but rather only distributions are counted against need-based aid eligibility in a subsequent academic year. In such a circumstance the grandparents may wish to wait until the senior year in college to take a distribution, when there is no subsequent year’s FAFSA to be affected by the distribution.)

Note that contributions to a 529 plan can continue during the college years, potentially qualifying for a state income tax deduction or credit based on contributions to the state’s 529 plan. If the income tax benefit is based just on the contributions during the tax year, the taxpayer can claim the state income tax deduction or credit every year. If the income tax benefit is based on contributions net of distributions, however, the taxpayer can claim the state income tax deduction or credit every other year.