I know most families aren’t doing this, but I hope you will after reading this! No matter whether you have saved a lot or nothing at all to pay for college, you’ll want to map out how to pay for all four years before your student gets the bill for freshman year, and bonus points for those that do this by the end of Junior year!
You’ll want to make the most of all of the college funding sources you have access to so you don’t miss out on opportunities. There are tax reasons, federal student loan caps, and scholarship considerations to take into account. Most families will be paying for college in layers - a little bit from here and a little bit from there.
How To Build Your Payment Layers
Scholarships, Grants, and Qualified Tuition Reduction
Clearly, if you get free money from schools and/or the Department of Education, you’ll be 100% sure you use it! The same goes for any private scholarships you are awarded.
Federal Student Loans
Well, I hate to give such preference to the student loan monster, but I must. If you have added up all of your payment sources and have decided that student loans are inevitable after you’ve planned for getting outside scholarships, you’ve got to factor them in up front. The reason? The amount you can get each year of college from the Department of Education is limited. In general, it goes like this:
Year 1 - $5,500
Year 2 - $6,500
Year 3 - $7,500
Year 4 - $7,500
In typical government fashion, there are special cases for which you can borrow more, so take a look at the official webpage for all the details.
Tax Preferential Sources
The American Opportunity Tax Credit
The Lifetime Learning Credit
Tax free 529 withdrawals
Tax free Coverdell withdrawals
The tax-free portion of scholarships
Early IRA distributions
Qualified Tuition Reduction
Employer provided educational assistance
Education Savings Bonds
What you should do is add up all eligible expenses and then start assigning them to sources that benefit you the most. Your order may look something like this:
The Tax-Free Portion of Scholarships, Grants and Qualified Tuition Reduction
This was covered above in terms of sources to use for college, but you need to make sure you add the tax-free portion here to make sure you have enough eligible expenses to offset the other tax free sources below.
So how do you know which portion is tax free? This IRS webpage will help.
American Opportunity Tax Credit (AOTC)
If your family income is below certain limits, you may qualify for the AOTC, which is good for a credit of up to $10,000 over four years. If you can get this credit and plan to build it into your payment plan, you need to be super deliberate about actually putting the money aside at tax time to save it until you get a school bill to pay. If this money is likely to be absorbed into your regular family cash flow, you shouldn’t count on it to help pay for college. You know yourself best, so act accordingly.
There are special tax considerations you need to have in place to be able to claim the credit. Namely, you must be able to identify expenses against which you are claiming the credit. You need $4,000 in eligible expenses in order to claim the full $2,500 per tax year. You can not use expenses paid for with a 529 withdrawal, the tax free portion of a scholarship or grant, or just about any other tax free source of money. You can, however, use expenses paid for with a loan.
The tricky thing about using a tax credit to help pay for college in year one is that you normally won’t see the benefit of it until the school year is almost over. To mitigate this difficulty, you can either change your W-4 for the entire year to get the credit back gradually throughout the year, which takes a considerable amount of discipline as you’d need to automate the savings of those funds with each paycheck to make sure they were, in fact, available when needed. You could also just choose to restructure your payment plan and not use the credit until year 2 of college.
The Lifetime Learning Credit (LLC)
If you cannot claim the AOTC, you may be able to qualify for the LLC. You cannot claim both in the same year for the same student. The LLC is worth up to $2,000 per year, but it is worth 20% of eligible expenses, so it takes $10,000 of qualified expenses to support a $2,000 credit.
As with the AOTC, if you are using the LLC as part of your college funding strategy, be deliberate about setting the money aside someplace safe until you’re ready to send it to the school in payment of a bill.
Employer Provided Education Assistance
An employer can pay up to $5,250 per year in education expenses tax free. This is the amount that reduces your qualified education expenses. In most cases, if they give you a benefit larger than that, it will be included in your income for tax purposes and thus would not be a reduction to your qualified education expense calculation.
Education Savings Bonds
If you cash in Series EE or Series I Government Bonds, you may be able to avoid paying tax on the interest if your income falls within the applicable limits and you have enough qualified expenses. In this case, qualifying expenses do not include room and board but do include contributions to a 529.
To get the benefit from your 529 savings, you’ll need to make sure you use it on eligible expenses for college which you haven’t used for your AOTC credit (if applicable) or other tax advantaged sources. Otherwise, you have a few limited options for taking the money out penalty free and you would have to change the beneficiary to a close family member and then use it on eligible expenses to take the funds out tax and penalty free.
For the freshman year, this means taking funds out of a 529 in the parent’s or student’s name with the student listed as the designated beneficiary. As the law is currently written, a 529 in a grandparent’s name should be used in years 3 and 4 if you need to avoid the negative effect that untaxed income has on your family’s EFC or Expected Family Contribution as calculated by the FAFSA. If your family EFC is already too high for you to qualify for any aid, then there is no need to distinguish between a 529 held in a grandparent’s or parent’s name. Also, changes are coming to the FAFSA over the next few years, and this treatment of grandparent 529 contributions to pay for college will no longer be a cause for concern when it comes to the FAFSA and EFC calculation.
I think in all my experience working with people on college savings I’ve only encountered one family who had been making Coverdell contributions, so if you need to know more on that, find it here.
Penalty-Free Early IRA Distributions
Distributions from an IRA typically incur a 10% penalty if taken before age 59 ½. One exception to this rule is when the money is used to pay for Qualified Education Expenses, in which case, you may be able to take advantage of penalty free withdrawals.
Keep in mind that you can withdraw your contributions from a Roth IRA anytime both tax and penalty free. Contributions are the amount you contributed and, thus, do not include any earnings. Therefore, if you are taking from a Roth IRA in an amount equal to or less than the amount you have contributed, you don’t have to worry about the double dipping rules and qualified education expenses.
If you need to choose between taking money penalty-free from a Traditional IRA or tax and penalty-free from a Roth IRA, go with the Roth option first.
Non Tax Preferred Sources
This would be the next place to take funds for college because it can have the most positive effect on your family’s EFC. If your EFC is too high already, then it doesn’t matter in what order you use the student’s savings versus the parent’s savings.
Using the parent savings will decrease your EFC all else being equal.
As with the Grandparent 529, assuming that you care about keeping your EFC as low as possible, this should be used for the 3rd and 4th year of school under today’s laws. This will be changing in a couple of years, and at that time it won’t matter any more.
If your family has been making monthly contributions to a 529 plan or other savings vehicle for college, plan to continue that habit if needed during the college years. This is especially true if your state gives a state tax deduction for 529 contributions.
You also may be able to use some on-going cash flow towards college that you would have otherwise used to pay for the student’s food or extracurricular activities in times past.
Your student may need to work during school and put aside some earnings to pay for college expenses, so this is where you would add that in.
Roth IRA Contributions
As stated above, the amount you contribute to a Roth IRA is taxed in the year of contribution, so that amount can always be taken back out penalty and tax free. The same does not apply to the earnings on Roth contributions, however.
You can find three examples of how to plan out your payment strategy here.