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COLLEGE SAVINGS 101

How to spend from varied college savings plans

Amy Buttell is a freelance writer based in Pennsylvania

by Amy E. Buttell

It's easy to spend money you've saved for your child's college education, the trick is in deciding from which of your various savings vehicles you spend it from first.

After all, 529 plans weren't created until 1997, long after many grandparents and parents of today's college-age kids started saving for college through other types of accounts -- like taxable investment accounts and other accounts opened under the Uniform Gifts to Minors Act (UGMA/UGTM) and the Uniform Transfer to Minors Act (UTMA).

UGMA was designed to provide an easy way to give money and securities to minors. UTMA later expanded the types of property you can give to minors and allows for other transfers besides gifts. Although they apply differently in various states, the terms are often used synonymously.

When the 529s came along, many parents and grandparents opened the new accounts but kept the ones they already had. If you have savings earmarked for college spread in more than one account, you've got to think strategically about how to spend those funds over your child's college career, considering issues such as taxes, financial aid eligibility and the overall tab.

Here are four steps you can take to maximize your savings to get through the college years:

  1. Count your blessings. Figure out how much money you have in which of these accounts:

    • 529 savings accounts
    • 529 prepaid accounts
    • Coverdell Education Savings Accounts
    • UGMA/UTMA
    • Taxable investment accounts

    While you're taking inventory of your accounts, consider any restrictions that will play into how you spend the money. For example, many of the benefits of Coverdell Education Savings Accounts may sunset in 2010 if Congress doesn't renew them, says Joseph Smith, CPA, managing director of Smith, Jackson, Boyer & Bovard in Dallas. Also, you must spend Coverdell funds by the time the beneficiary turns 30 years old, which means you can't potentially save it for graduate school at a later date or for another beneficiary, according to Beth Walker, a certified college planning specialist with The Wealth Consulting Group in Las Vegas.

    Divide the total amount available by four to get an approximate yearly spending amount. Don't forget to add in estimated earnings.

  2. Quantify projected expenses. Next, calculate the amount of expenses over the next four years, including inflation. According to the College Board, inflation in tuition and fees during the past 10 years has exceeded general inflation by an average of 4.2 percent annually at public four-year colleges, 1.4 percent at community colleges and 2.4 percent at private-four year colleges.

    Also, consider whether your child will actually complete school in four years. Budget cuts at many colleges mean fewer instructors and courses, making it more difficult for students to graduate on time.

    When considering the total bill, make sure to include all of the potential expenses, such as:

    • Tuition
    • Room and board
    • Fees
    • Books
    • Travel and commuting
    • Entertainment and incidentals
  3. Consider tax issues. The biggest tax issue to remember regarding college savings accounts is that those funds can only be spent for qualified educational purposes, says Joe Hurley, CPA, founder of Savingforcollege.com. "If you have 529 plan or Coverdell funds, make sure you will get them spent for their intended purpose somewhere along the way," he says.

    In most cases, this isn't a problem, because so many expenses qualify under these two plans. Another reason to spend 529 and Coverdell funds early on in the process is that any capital gains you have in those accounts are tax-free if used for qualified expenses, Hurley adds.

    As far as UGMA and other custodial accounts, you want to avoid triggering "kiddie tax" issues, which are taxes your child will have to pay on investment income at your tax rate. Under the "kiddie tax" children between the ages of 14 and 24 (who are in school full time) must pay taxes at their parent's higher tax rate -- rather than their lower rate -- on unearned income of more than $1,900.

    "Try to avoid a situation where you'll be paying kiddie tax," Hurley says. "You can have up to $1,900 in investment income without being subject to the kiddie tax, so it's only when you are talking about a more substantial amount of gains that you'd run into that situation."

    If your child has a UGMA or other custodial account with more than the $1,900 in investment income, you can employ some strategies to minimize your tax. You could select investments that are likely to yield less than $1,900 in dividends, income or capital gains on a yearly basis. Or, you could withdraw money from the account that either has investment losses or gains of less than $1,900 and use that to fund college expenses.

    Another alternative is to withdraw money in increments over a few years with gains below the $1,900, which could help reduce the total income from the account to less than $1,900 a year. While you might have to pay some kiddie tax in the year that you make those withdrawals, if you also have income from the account, you'll be in a better tax position in later years so you can eliminate or at least minimize the amount of kiddie tax you'll have to pay.

    Another tax issue to consider involves the connection between a Coverdell account and two higher-education tax credits, the Hope and Lifetime Learning Credits, says Smith. If you don't spend the money in your Coverdell account prior to the end of 2010 -- and assuming Congress doesn't extend the Coverdell's tax benefits -- you will not be able to claim either of those tax credits the same year that you take a Coverdell distribution, so you should try to spend your Coverdell funds, if you think you'll qualify for these credits, before that date.

  4. Analyze financial aid situation. Financial aid eligibility is another important consideration. In general, assets belonging to a child, such as UGMA accounts, are assessed more heavily against financial aid awards than are assets held by the parents. Section 529 plan accounts and Coverdell accounts are considered assets of the parents for financial aid purposes.

    "UGMA accounts are assets of the child and that will work against you in financial aid formulas," says Walker. "If you can spend this money before college, say on private school tuition, I would do that." Alternatively, you could spend it on freshman year expenses or on other things that your child may need for college, such as a car, for which you can't use 529 or Coverdell funds. There are no educational-related restrictions on UGTM account spending.

    When taxable investments are part of your college fund, be careful how you liquidate those accounts to pay for college expenses, Hurley says, especially if you have significant investment gains attached to those accounts. "It can affect the financial aid picture if you liquidate taxable investments and recognize gains, because any gains will increase your income, which can decrease your financial aid eligibility," he continues.

    If you don't have enough in savings to pay for all four years of college, consider spending all of your education-related assets as early in the process as possible, because that might help your child's financial aid eligibility down the road, Hurley says. For example, if you have $20,000 in Section 529 funds available for four years, you could spend that on the first two years and your child may qualify for more aid in his or her junior or senior year.

    Before you take any major financial steps that potentially could affect your child's financial aid eligibility, make sure you understand exactly how your child's college calculates financial aid eligibility, Hurley says. Most colleges are pretty clear how they calculate eligibility and may have formulas on their website. Private college and public colleges calculate eligibility very differently, so don't assume that all schools apply the same formulas in the same ways.

Posted October 23, 2009