17 Apr A primer on spending college savings accounts
Q. My son is going to college next year and we have money in a 529 plan, a Coverdell and an UGMA. Which should I use first? And can I use any of them for supplies like a new laptop?
A. Congrats on becoming a college parent, and also for having saved for your son’s education.
If we assume the college expenses will be greater than the value of the combined accounts, you’ll also take funding for college from the income of the student or parent, said Peter McKenna, a certified financial planner with Highland Financial in Riverdale.
And if your balances are large, the tax implications could be meaningful and it may be worth consulting with your accountant.
“Qualified education expenses paid from the UGMA or taxable earnings can be included on the parent’s or student’s tax return as deductions or tax credits,” McKenna said. ” The tax deduction or tax credit can be very valuable if you, or the student, meet the criteria.”
If eligible, the American Opportunity Tax Credit can result in a refundable tax credit of up to $1,000, meaning even if no taxes are due, you may be able to get $1,000 from the IRS, McKenna said.
You can take tax-free withdrawals from the 529 or Coverdell accounts as long as they are used to pay qualified education expenses.
And complicating matters further, there are different lists of what qualifies for the tax deductions/credits and for tax-free withdrawals.
“It is critical to keep good records and to use each expense for either a tax deduction/credit or for a tax-free withdrawal,” he said. “Put differently, in order to use the tax deduction or tax credit the expense must be paid from a taxable account or taxable earnings, not from the 529 or Coverdell account.”
The laptop may or may not qualify.
McKenna said, for example, room and board outlays do not qualify for the tax deduction or education tax credits, but they are eligible expenses for a tax-free withdrawal from a 529 account as long as certain criteria are met.
“A new laptop may or may not qualify depending on whether it is an explicit requirement of the school or course of study, e.g., my daughter’s laptop is eligible because her school had a specific laptop that was required for all engineering majors,” McKenna said.
He recommends you review in detail the financial aid award letter that your school provided for your son. There should be a reasonably accurate estimate of the cost of attendance included in that package. If there isn’t much detail, the college’s website or financial aid office should be able to provide a more detailed estimate.
Then, determine which expenses are qualified for the tax deduction/credit and which ones are qualified for tax-free withdrawals from the 529/Coverdell accounts.
Next, look at the income and tax implications of a withdrawal from the UGMA (Uniform Grant for Minor Account).
“This account does not have any preferential tax treatment and significant gains may cause earnings to be taxed at the parent’s tax rates,” McKenna said. “If the account is invested, quantify the income that would be recognized to liquidate the investments.:
That gain will be considered income to the student owner of the account and student income has a big impact on the need-based aid calculation, he said. Use these funds or taxable earnings for the expenses that qualify for the tax deduction or credit.
Then determine if the remaining expenses are eligible for tax-free withdrawal from the Coverdell or 529 accounts and pay them from those accounts, McKenna said.
“When possible, have the funds go directly from the account to the school so that there is a clear fact pattern should anyone question this, i.e. an audit,” McKenna said.
The message here? The good news is that the IRS provides an opportunity for us to save and pay for college in tax-advantaged ways. The bad news is that it is the IRS and nothing is ever simple or straight forward when they are involved, McKenna said.
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This story was first posted in April 2015.NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.