According to the most recent data provided by the College Savings Plans Network, 529 balances for the average family currently hover just over $26,000, just about enough to pay for one year of public college in most states.
As few families are able to save enough money to finance college in its entirety out of their college savings accounts, most parents are faced with the quandary of how to spend the limited college savings that they do have. If you have a 529 account for your child—maybe enough to cover about one year of college—what is the most beneficial strategy for spending down those funds? Should you spend it all on the first year? Save it all for the last year? Divide it evenly across the four years of college? While there is no definitive answer to this question, here are the primary considerations parents should keep in mind:
- Tax-Free Growth: The benefit to any tax-deferred (tax-free, when properly used) account increases the longer the funds are allowed to grow. Funds grow without taxation, and that tax-free growth accrues more growth without taxation, and so on. Earnings increase exponentially, arguing for leaving the money in the account as long as possible. Wait until senior year to use it.
- Misuse Penalty: On the other hand, 529 investors face significant misuse penalties should they use the account for anything other than college. The earnings portion of unqualified 529 withdrawals is subject to taxation at the payee’s ordinary income tax rate, plus a 10% penalty. If you decide to maximize the tax benefit of your 529 by saving it until senior year of college, and your child drops out of school after freshman year, you’ve missed the opportunity to spend your 529 tax-free on qualified college expenses and will face taxes and penalties to get your money out to spend on something else. The misuse penalty argues for using your 529 as soon as possible, especially if you only have one child. Spend it on freshman year.
- American Opportunity Credit (AOC): The American Opportunity Credit allows families meeting certain income and enrollment qualifications to claim a tax break on up to $4,000 in payments made for college tuition, fees, and books. The federal government doesn’t allow families to double-dip when it comes to education tax breaks, claiming two tax breaks for the same college payment, however, so you cannot make a tax-free withdrawal from a 529 and claim the AOC for the same college payment. If otherwise eligible for the AOC, you should make sure to pay at least $4,000 in qualified costs from a non-tax-advantaged account, so that you can claim the maximum $2,500 tax credit and still get your 529-withdrawal tax-free. Save that $4,000 in your 529 to apply to next year’s college bill.
- Student Loan Eligibility: If student loans are going to be part of your college payment plan, families should know that the Federal Direct Student Loans (also known as Stafford Loans) are subject to annual borrowing limits of $5,500 for freshman year, $6,500 for sophomore year, and $7,500 for both junior and senior years. If the student doesn’t take his $5,500 allotment for freshman year, for example, he cannot simply add it to his sophomore year amount. That amount is lost to him. As the Stafford Loans are likely the best deal you can get in the student loan market if you think your family will need to borrow to cover educational costs at some point in your child’s college career, you probably want to take advantage of your child’s Stafford Loan eligibility each year and perhaps hold back some in your 529 to cover the future years.
- Loan Payback: Speaking of loans, think about when you will be able to start repaying any college loans you borrow. Some education loan programs allow for the deferral of payments until the student graduates (or ceases half-time attendance), while others require (or encourage with a lower interest rate) immediate repayment. Many people assume that it’s always best to spend down your 529 first in order to delay borrowing as long as possible. While this assumption is correct if you plan on deferring payments until graduation (you accrue less interest over 11 years than 14 years, so borrowing a loan for senior year instead of freshman year is beneficial), if you plan to start repaying college loans right away, it makes no difference at what point in your child’s college career that you borrow. You’re repaying the loan and accruing interest over the same amount of time (usually 10 years with a federal loan), so it doesn’t matter if that 10-year clock starts freshman year of college or senior year. You still accrue 10-year’s worth of interest.
- Available Cash Flow: Also consider what cash flow you may be able to devote to college on a monthly or yearly basis. If dividing your 529 equally across the four years of college covers enough of your tuition bill that you can afford the remainder by paying out of your paycheck on a monthly payment plan to the college, that may be the wisest course of action for your family, as opposed to spending the entire 529 on one year, and leaving too high a bill in other years to be covered out-of-pocket. If stretching your 529 across four years allows you to eliminate, or at least minimize education loan borrowing, this apportionment may be the best financial strategy for your family.
As you can see, as with most aspects of the college planning process, there is not a one-size-fits-all approach to spending your 529. Your spending strategy may vary based on your child, family situation, financial situation, and priorities. Consideration of the above factors, however, should ensure that you spend your 529 in a way that makes the most sense for your family and your finances.