You may have a saving strategy in place for higher education, but do you have a plan for spending that money once those bills start rolling in? The spending decisions you and your student make can affect your broader financial situation, such as financial aid eligibility and tax costs and how much you're able to save for other goals like retirement.
What are your available resources?
Before you can make college spending decisions, you need to take inventory of the financial resources you have available. Although your 529 plan account might be your main source of savings, you'll also want to look at other options, including:
- Savings accounts.
- Uniform Gifts/Transfers to Minors Act (UGMA/UTMA) accounts.
- Contributions from grandparents or other family members.
Understand factors that affect financial aid
How you decide to spend from your various resources can affect your student's eligibility for financial aid and the amount he or she is able to receive.
The FAFSA form asks for financial information, including information from tax forms and balances of savings and checking accounts. The 2024-25 FAFSA form asks for 2022 tax information.* To maximize your student's chance of getting the most aid, consider spending his or her assets first (in the early college years). This might include money from the student's taxable savings and investment accounts or a trust account for which he or she is an owner or beneficiary.
By delaying spending from sources that are considered student income, like distributions from a grandparent's 529 account, you may be able to boost the amount of aid your student is eligible for in later years.
Tax benefits can offset college costs
While you're looking for ways to increase financial aid, you'll also want to decrease taxes. It's important to determine which higher-education expenses qualify for tax-free withdrawals from your 529 account and which can be applied toward tax credits or deductions.
At the federal level, you can use only one education credit or deduction per student in a given tax year. If you qualify, the American Opportunity Tax Credit (AOTC), which provides a credit of up to $2,500 on $4,000 of qualified spending, is generally the most beneficial. Otherwise, depending on your situation, you may be able to apply for the Lifetime Learning Credit (LLC) or the tuition and fees deduction.
Most tax credits and deductions for educational spending are meant to benefit lower- and middle-income families.
- To claim the full credit, your modified adjusted gross income (MAGI) must be $80,000 or less ($160,000 or less for married filing jointly).
- You receive a reduced amount of the credit if your MAGI is over $80,000 but less than $90,000 (over $160,000 but less than $180,000 for married filing jointly). You cannot claim the credit if your MAGI is over $90,000 ($180,000 for joint filers). **
For families with higher incomes, the tax impacts of spending from various account types can be even more significant. If they spend from tax-deferred accounts, they could increase the income that's taxed at ordinary rates. While spending from taxable accounts could mean they'd realize gains that would be subject to capital gains rates and losses that could count toward deductions.
Spend flexibly from 529 savings
It may seem logical to tap your 529 account first when paying tuition and other sizable education expenses. However, if you follow a more flexible approach and spend more regularly from your 529 throughout the student's college years, you'll be able to make the most of the benefits these plans offer, including tax-deferred growth on earnings.
By relying more on 529 assets, you can depend less on other financial resources, such as loans or out-of-pocket spending, in any given year. And, as long as you're contributing to your 529 account, you'll be able to continue taking advantage of other tax savings, for example, possible deductions on your state income tax return.
Here are some additional tips for smart 529 spending:
- Know which higher-education expenses are considered qualified, such as tuition (including k-12), fees, books, computers, and room and board. Your home state may recapture your deduction in certain circumstances used to pay elementary or secondary school tuition, registered apprenticeship program expenses, or qualified education loan repayments.* Check with your tax advisor for your individual circumstances.
- Avoid penalties by withdrawing money in the calendar year that you plan to use it. A common mistake is withdrawing money in the fall for the entire school year. This creates a gap between the withdrawal year and the year in which some of the bills are due. When paying expenses for the spring semester, for example, wait until after January 1 to make a withdrawal.
- Keep good records of your 529 withdrawals so you don't exceed your qualified expenses. You don't want to end up paying taxes—and possibly penalties—on extra withdrawals.
Avoid tapping your retirement savings
As college costs continue to rise, it's possible that your spending plan could fall short. If this happens, you might be tempted to withdraw from your retirement accounts to make up the difference. Avoid it! Instead, consider these other ways to fill the gaps, such as:
- Spending from other available accounts, but be aware of any possible tax consequences.
- Taking advantage of federal student loans, if your student is eligible.
