From Vanguard

As parents prepare to send their children off to college, distinct financial challenges may arise. Although many families take advantage of 529 plans and other education-specific savings accounts, most will finance college using a variety of sources and account types. It’s important for parents and students to understand how their spending decisions will affect their broader financial situation and to plan strategically. Those spending decisions will have implications for financial aid eligibility in future years, for tax costs, and for the ability to meet other financial goals, particularly retirement.

Three actions to take when considering college spending options:

  1. Evaluate factors for financial aid eligibility. When seeking financial aid, parental and student income and assets can significantly influence eligibility. Identify the income sources and assets that most affect eligibility and create a spending strategy that maximizes the student’s chances of obtaining aid. Spending student assets early and delaying spending that will count as income can boost the amount of aid a student may be eligible for in later years.
  2. Use tax benefits to offset college costs. Various tax credits and deductions are available for most families as they pay higher education expenses. Understand what tax benefits are available and create a spending plan that takes full advantage of them. This can substantially lower the after-tax cost of college. Be aware, too, of tax implications when tapping various account types. Spending from tax-deferred accounts can increase taxable income, and spending from taxable accounts can mean realizing gains or losses.
  3. Spend strategically from 529 savings. Plan to spend flexibly from 529 savings throughout a student’s college years to ensure that the benefits these accounts provide are maximized. Understand which expenses qualify for tax-free 529 spending, and plan to deplete the account over the student’s college career if the assets can’t be used by another eligible beneficiary. Smart spending from 529 accounts can also help take the most advantage of tax benefits and aid opportunities.


Understand the factors that affect financial aid

A college education is one of the most expensive investments most families will make. Fortunately, significant financial aid packages are often available. Aid can come in various forms, with some types more valuable than others. Grants and scholarships, for example, do not have to be repaid. Student loans or work-study programs can be helpful but are obviously less attractive than outright grants.

According to Sallie Mae, the vast majority of college students report receiving some type of financial aid, and 70% receive it in grants or scholarships.1 The College Board estimates that for the 2014–2015 school year, the average full-time undergraduate student received $14,210 in financial aid, 66% of it in grants, scholarships, or tax benefits.2

Because financial aid can be such a key component of college financing, it’s important that families understand how their savings and spending decisions can affect the availability and amount of aid. There are two main financial aid applications: the Free Application for Federal Student Aid (FAFSA) and the CSS/Financial Aid PROFILE®, which is administered by the College Board and required by some institutions and scholarship programs. Each application uses a formula to evaluate a student’s and parents’ financial situation to determine the expected family contribution for each year of higher education.

Although some classifications of income and assets are straightforward, others are not. For example, distributions from a grandparent-owned 529 are considered student income, while 529 savings owned by a dependent student are considered parental assets.


Explore tax incentives—and be mindful of tax-sensitive withdrawals

It might seem ideal to accumulate 529 assets that fully cover the costs of a student’s education, but for most families, this won’t be realistic. The upside of this likely deficit is the potential for more tax savings. Because 529 assets already receive favorable tax treatment, spending from these accounts will not qualify for potentially valuable deductions or credits. At the federal level, taxpayers can use only one education credit or deduction per student in a given tax year. Generally, for those who qualify, the American Opportunity Tax Credit (AOTC) is the most beneficial, providing a credit of up to $2,500 on $4,000 of qualified spending. Otherwise, depending on the situation, the Lifetime Learning Credit (LLC) or the tuition and fees deduction may apply.

Tax credits and deductions for educational spending generally target lower- and middleincome taxpayers. The 2016 limits on modified adjustable gross income to take advantage of the AOTC, for example, are $90,000 for single filers and $180,000 for married taxpayers filing jointly. For higher earners, the tax impacts of spending from various account types will be more important. Spending from tax-deferred retirement accounts is taxed at ordinary income rates, and gains realized from taxable investment accounts are subject to capital gains rates.

Care should be taken when selling assets from taxable accounts. If there are positions that can be sold at a loss, the realized loss can offset gains elsewhere or can partly offset taxable income. Realized gains, beyond being subject to taxes, can also affect financial aid eligibility, because the sales of these investments will not only reduce assets (a positive factor for aid eligibility) but also increase income (a negative factor for aid eligibility).


Craft a plan for college spending

Once the costs of education for the coming year are known, it’s important to make a plan that will meet the liability as efficiently as possible. The following framework for creating a college spending plan takes into account financial aid impacts and tax efficiency.

  • Take inventory. Take stock of savings that are available for college spending. These may include education-specific accounts, such as 529s, or savings in other account types. Include expected contributions from grandparents and other relatives. Estimate what you can afford to spend from current income each year and to what extent loans will be used to finance college costs. Understand which expenses qualify to offset 529 withdrawals and which can be applied toward tax credits.
  • Financial aid: Do no harm. It’s important to understand how the timing of certain spending can affect financial aid in subsequent years. Beginning with the 2017–2018 school year, applicants will use two years’ prior tax return information when filling out the FAFSA.3 Aid status can be maintained—and possibly improved—by spending from sources such as student assets in the early years of college, and by delaying spending that would count as student income (such as from grandparent-owned 529s) until the last two years of school, when it will no longer count against the student from an aid standpoint. Even if there is no expectation of need-based aid, the FAFSA should be submitted each year to maintain eligibility for federally subsidized student loans.
  • Evaluate available tax credits or deductions. Tax benefits can offset a significant portion of out-of-pocket education spending. Determine which benefit is the most advantageous, and plan to spend from current income or taxable savings to the extent that the spending will qualify for the targeted benefit.
  • Spend flexibly from 529s. Because 529 accounts are set up explicitly for college savings, it’s logical to tap them first when paying tuition and other qualifying expenses. Although that may make sense for some, it’s useful to consider 529 accounts as just one asset in the larger context of college funding. Spreading out spending from 529s will allow for continued tax-deferred growth and will relieve pressure on other sources, such as loans or out-of-pocket spending, that may be required in a given year. Continued contributions to 529s throughout a student’s college years may be beneficial as well, especially in states that offer tax savings for these contributions. Plan to deplete 529 assets over a student’s school years, or transfer assets to another beneficiary to avoid taxes and penalties on earnings. Although 529s may be used to pay for graduate studies, keep in mind that assets in 529 accounts cannot be used to pay down student loans.
  • Fill in the gaps. After spending to qualify for targeted tax benefits and spending as planned from 529 accounts, a family may need additional funds. When spending from other accounts, be mindful of associated taxes. Determine as early as possible what loans will be needed, and take advantage of federally subsidized loans if available. Avoid spending from accounts dedicated to retirement goals.



Although the challenges of meeting college expenses can be daunting, proper planning— and, perhaps for some, consulting with a financial planner—can ease this often financially stressful period. Spending with an eye toward financial aid eligibility while targeting available tax benefits can result in substantial savings over a student’s college years. The role of traditional college savings accounts, such as 529s, should be considered in the broader context of a family’s financial situation. A smart, holistic plan can maximize the benefits unique to these accounts and ensure that these assets are deployed in a way that meets college spending needs as efficiently as possible.

  1. Sallie Mae, How America Pays for College 2016, available at
  2. College Board, Trends in Student Aid 2015, available at
  3. For example, applicants in early 2017 could use tax return information from 2015.


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