The smart way to spend your college fund

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After years of saving, it’s finally time to start spending for all those college-related expenses. There’s a smart way to do it.

If you want to get an “A” in spending that college fund, you’ll need to watch the order in which you tap accounts if you want to maximize financial aid and scoop up federal tax credits.

Let’s start by looking at strategies for maximizing financial aid. Some savings plans for college can really eat up a student’s eligibility for financial aid. The colleges use formulas that look at how much money students have set aside through such means as Coverdell education savings account or state-based, prepaid tuition plans. More saved money means less student aid.

To maximize aid, you’ll want to spend down the money in these accounts — and spend them in the right order.

Spend the student’s money first You’ll also want to spend any money in a student’s name before tapping any account in a parent’s name. This simple move can make a difference in a student’s eligibility for future aid.

Here’s why. If a student has assets, financial aid officers expect students to contribute 35 percent of the money toward college expenses each year. Parents are expected to contribute only 5.6 percent of their assets toward college expenses each year.

So the less money saved in a student’s name, the better your child’s chances of scooping up some financial aid.

Aid officers consider a Coverdell education savings account, formerly known as an education IRA, an asset of the student. The best advice for families with money stashed in Coverdells? Spend that money ASAP.

That won’t be hard to do. The cash in a Coverdell account can be applied to a wide range of educational expenses from kindergarten through high school and on through college and graduate school. The money can be used to pay for everything from tuition, books and fees to academic tutoring and personal computers.

Many financial advisers encourage parents to tap Coverdell accounts while students are still in high school.

Using up the savings in Coverdell accounts prior to college will help boost students’ eligibility for financial aid in their freshman year. To maximize aid, you’ll want to spend as much Coverdell money as you can through December of a high school student’s senior year. Financial aid forms for college can be filed as early as January of student’s senior year.

Another option for families with a Coverdell account is to roll the money over to a younger sibling. This will free up more financial aid for the older brother or sister who is heading off to college and make more money available for the current educational expenses of the younger sibling.

Next up: prepaid tuition If you have any money stashed in a prepaid tuition plan you’ll want to use this money right off the bat as well.

To participate in a state’s prepaid tuition program, the contributor, typically a parent or grandparent, or the beneficiary, the future college student, must be a resident of the state.

A year’s worth of prepaid tuition is guaranteed to pay for a year’s worth of classes at any state college or university.

You might as well use a year’s worth of prepaid tuition for a student’s first year of college. Doing so will improve a student’s chances of receiving financial aid later on. The longer you hold on to the money in a prepaid tuition plan the more it will hinder a student’s ability to qualify for financial aid.

“If we’re talking about aid, it’s the worst because it’s a dollar-per-dollar reduction in aid,” says Vickie Hampton, a certified financial planner and associate professor at Texas Tech University in Lubbock.

“What it’s really going to affect is the grants and work-study programs because those things are the primary needs-based programs.”

You may be able to transfer the money in a prepaid tuition plan to the prepaid tuition plan of another family member. Be sure to check with your state’s plan for details.

Finally, the 529 plan money Money stashed in a state-sponsored 529 college savings plan also affects financial aid but not as severely. A family with a 529 plan will see their eligibility for aid decrease by as much as 5.6 percent of the account’s value.

Because of this, some financial planners advise parents to hold off on tapping a 529 plan for as long as possible. Doing so will give the money in a 529 plan more time to grow tax-free.

“If you qualify for financial aid, I would delay withdrawing from a 529 plan until after you’ve filled out your final financial aid form,” says Rick Darvis, president of College Funding Inc.

A college student would file their final financial aid form in January of their junior year. After the form is filed, you could use the money in the 529 plan to pay for a student’s final 1 1/2 years of college. Any leftover money could be rolled into a 529 plan for another family member.

“You can roll it over to a younger sibling, so that does give you some flexibility,” Darvis says.

Making the most of tax credits
Educational expenses: Tax breaks allow you to deduct the amount of regular education expenses (tuition, books and fees) up to $4,000. This can easily be claimed using form 1040 and 1040A but is limited by your income: A single filer must make less than $65,000 yearly and married couples must earn less than $130,000.

If your income exceeds that limit you can still claim up to $2,000 for tuition and fees, provided that your income is still under $80,000 as a single filer ($160,000 if you’re married and file jointly).

Tax Credits: Two popular tax credits — the Hope Credit and the Lifetime Learning Credit — can help defray education expenses for your family. A credit, which is subtracted directly from the final tax you owe, can take a big bite out of your tax bill.

If you’re footing the bill for your child’s college education, a Hope Credit may be for you. It applies for the first two years of post-secondary education — such as college or vocational school — and it can be worth up to $1,500 per student, per year. Graduate and professional-level programs are not eligible.

The Lifetime Learning Credit can be used for undergraduate, graduate and professional degree courses for anyone. If you meet Internal Revenue Service guidelines, you could get a maximum $2,000 credit per year.

To qualify for either credit, you must pay post-secondary tuition and fees for yourself, your spouse or your dependent, but you can only claim one credit per student each tax year. The credit may be claimed by the parent or the student but not by both. If the student was claimed as a dependent, he or she cannot file for the credit.

Married taxpayers must file a joint return to get these tax breaks.

Both the Hope and Lifetime Learning credits are phased out for higher-income taxpayers. If your adjusted gross income is between $42,000 and $52,000 on a single return, you will qualify for reduced credit. Income over $52,000 will disqualify you. When filing jointly, income between $85,000 and $105,000 will get you reduced credit, and in excess of that a disqualification. In each category, if your income is below the minimum, you’ll qualify for the full credit.

Detailed eligibility guidelines and earning limits can be found in “IRS Publication 970, Tax Benefits for Higher Education.”

With a Hope Credit, you can claim the full $1,500 for each eligible student for whom you paid at least $2,000 of qualified expenses.

The maximum amount of a Lifetime Learning Credit is $2,000 per year. That $2,000 credit is equal to 20 percent of the first $10,000 of qualified tuition and education expenses you paid for all eligible students in a year. Someone who paid $4,000 of qualified tuition and education expenses could claim an $800 credit on their next tax return.

Credits and savings don’t mix Here’s the tricky thing about these credits. Money from Coverdell education savings accounts, 529 college savings plans and prepaid tuition plans cannot be applied to these credits.

The reason? You’re already getting tax-free withdrawals from these accounts when you use the money to pay for college.

You can’t have your tax-free withdrawal and a tax credit, too — not on the same dollar anyway.

To claim a Hope Credit, you’d have to pay for at least $2,000 of qualifying education expenses with money from an account other than a Coverdell, 529 savings plan or prepaid tuition plan.

To claim a full Lifetime Learning Credit, you’d have to pay for at least $10,000 of qualifying education expenses with money from an account other than a Coverdell, 529 savings plan or prepaid tuition plan.

By doing so, you can enjoy tax-free withdrawals from these accounts plus a hefty tax credit to boot.

Cash a bond, get a tax break Parents who cash in qualified U.S. savings bonds to pay college tuition bills may qualify for a tax break as well.

The interest on the bonds is tax-free if your 2005 income is less than $121,850 (projected at the time of this update) on a joint return and $76,200 (projected) on a single return.

Be sure to keep good records. You’ll want to make note of when the bonds are cashed and when the money from the bonds is spent on college tuition and fees.

You won’t qualify for this tax break if the savings bonds are in the student’s name. And you can’t claim a Hope or Lifetime Learning Credit on money cashed from these bonds if you’re already getting a tax break on the bonds.

— Updated: Aug. 11, 2005