Once your child starts college, you'll want to use funds set aside for college to maximize tax advantages as well as your financial aid awards.
Which investments should you withdraw first - money from personal savings, Section 529 plan assets, or funds from Coverdell education savings accounts (ESAs)?
How will those withdrawals affect education deductions and credits for tax purposes? And then, what impact will all of this have on your financial aid award?
From a financial aid standpoint, you typically want to use your child's assets first. In financial aid calculations, 35% of your child's assets are expected to be used for college purposes, while only a maximum of 5.6% of your assets are considered. Thus, if your child has money set aside for college in a custodial or personal savings account, spend that money first, possibly even before your child enters college. For instance, you could use those funds for a computer or a car.
ESA assets can be either your assets or your child's assets, depending on how the account was set up. If they are your child's assets, realize that they can be used to pay many education expenses while your child is in high school. You may even want to roll that child's ESA over to a younger sibling, so the funds won't be considered that child's asset.
Payments for prepaid tuition plans reduce financial aid on a dollar-for-dollar basis. If permitted by the plan, you may want to transfer the funds to a Section 529 savings plan, since tax-free distributions are not considered at all in financial aid calculations.
You also need to consider the impact of withdrawals on tax deductions and credits. The deductions and credits available include:
- In 2005, a maximum above-the-line deduction of $4,000 of qualified higher-education expenses is available for single taxpayers with adjusted gross income (AGI) not exceeding $65,000 and for married taxpayers filing jointly with AGI not exceeding $130,000. Single taxpayers with AGI between $65,000 and $80,000 and married taxpayers with AGI between $130,000 and $160,000 are entitled to a maximum deduction of $2,000.
- The Hope scholarship credit is a nonrefundable tax credit equal to 100% of the first $1,000 of tuition and fees and 50% of the next $1,000 of tuition and fees (for a maximum credit of $1,500) paid for a taxpayer, spouse, or dependent for the first two years of post-secondary education. The credit can be claimed for more than one student in a given year. The credit is phased out for single taxpayers with modified AGI between $43,000 and $53,000 and for married taxpayers filing jointly with modified AGI between $87,000 and $107,000.
- The lifetime learning credit is a nonrefundable tax credit equal to 20% of up to $10,000 of tuition and fees (for a maximum credit of $2,000) for post-secondary education, including courses to acquire or improve job skills. The credit can be claimed for an unlimited number of years. The credit is phased out based on the same modified AGI limits as the Hope scholarship credit.
The deduction cannot be claimed in the same year for the same student as the Hope scholarship or lifetime learning credit. Also, these credits and deductions cannot be claimed for amounts paid with tax-free distributions from Section 529 plans and ESAs.