How to Use Your 529 Plan When It’s Time for College

It’s easy to find advice about saving for college, but what are you supposed to do once your child actually reaches college age and it’s time to spend some of that money you’ve saved?

Specifically, how should you handle the money you have in your various 529 savings accounts?

Is it best to spend as much as you can all at once? Should you withdraw it more evenly over time? What if you have money in other savings and investment accounts as well? And how should other children factor into your decision?

There’s a lot to consider and, potentially, a lot at stake. The right decisions can save you a lot of money and give your children a better opportunity to attend the best schools for them.

As is almost always the case, there is no one approach that’s right for every situation. It’s important to tailor your strategy to your family’s unique goals and circumstances. But there are some general guidelines that are worth following, and this article lays them out.

Focus First on the Net Cost of College

While it’s tempting to use the money in your 529 savings account as the benchmark for the amount of college you can afford, experts caution against sending your child to a higher-cost school just because you can.

“My approach is always to find a quality education at the lowest net price,” says Robert J. Falcon, CFP®, president of College Funding Solutions and Falcon Wealth Managers. “Any 529 money left over can be withdrawn by the student shortly after graduation and they will pay tax, but no penalty, at their relatively low tax rate. Alternatively, they can use the funds for graduate school or a new beneficiary can be named on the account.”

In other words, while a 529 savings account is a great way to save money on the college expenses your child incurs, it’s still smart to try to minimize those expenses, even if it means that you’ll have money leftover. There are plenty of ways to use that money down the line, and in the meantime you can maintain some flexibility to adjust to life’s ever-changing circumstances.

Consider Taking Direct Stafford Loans Before Using 529 Money

Direct Stafford Loans are issued by the U.S. Department of Education and generally offer more favorable terms than just about any other student loans, including:

  • Students who demonstrate financial need can qualify for Direct Subsidized Loans, in which case the government pays your interest while you’re in school.
  • All eligible students can qualify for Direct Unsubsidized Loans, regardless of financial need.
  • Interest rates are fixed and are low compared to other student loans.
  • These loans are eligible for income driven repayment.

“If the student qualifies for subsidized student loans, it would be silly for the family to not take advantage of the “free” loan money and use their 529 proceeds evenly over four years,” says Falcon.

Even if you don’t qualify for Direct Subsidized Loans, it’s still often worth taking advantage of the unsubsidized loans available to you. They’re likely the best student loans you’ll ever have available to you, and they’re subject to annual limits that are use-it-or-lose-it.

“This is a reason why we recommended that the family take the Direct Stafford Loans from the beginning,” says Fred Amrein, the founder of PayForED.com. “If the family runs out of money at some point, they are unable to get the prior Direct loans.”

One downside is that student loan payments do not count as qualified higher education expenses, meaning that you can’t use 529 money to pay off those loans without both paying taxes and incurring a penalty on those 529 withdrawals. There is legislation currently making its way through Congress that could change this, though, so it’s worth keeping an eye on.

Take Advantage of the American Opportunity Tax Credit

The American Opportunity Tax Credit (AOTC) provides a $2,500 tax credit on the first $4,000 of eligible education expenses for the first four years of higher education. That’s a big source of relief, but it comes with two important catches.

The first catch is that you can’t receive two tax breaks for the same expenses, which means that you can’t claim the credit for expenses that were paid with money from your 529 savings account. According to Amrein, that’s typically a good reason to only use your 529 savings for expenses above the amount that’s eligible for the credit.

The second catch is that the credit phases out once your income reaches a certain point. For single filers, the phaseout occurs from $80,000 to $90,000 in modified adjusted gross income (MAGI), and for married couples filing jointly it’s phased out from $160,000 to $180,000.

But as long as you’re eligible, it’s typically worth handling some of your college expenses either from cash flow or from a savings or brokerage account so you can claim the American Opportunity Tax Credit.

Consider the Long-Term Education Needs of All Your Children

While it may be tempting to use as much of your 529 savings account as possible the first time you’re presented with that college tuition bill, it’s important to take the long view on withdrawals.

One big factor to consider is whether your child is likely to attend graduate school, which comes with both big costs and, often, less attractive loan options.

“The sooner a student can determine their career path and understand the amount of education needed, the better the plan,” says Amrein. “Too often I see parents who send their child to that more expensive undergrad and expect their student to pay for grad school. I then get the call asking, ‘How I can I help the child repay the $150,000 of grad school loans?’”

Another big factor is whether you have other children who may also need help paying for college. If your children are close enough in age to eventually be in school at the same time, Falcon says that you may be more likely to qualify for needs-based financial aid down the line, in which case spending your 529 money now might make sense.

If, on the other hand, your children are further apart in age, or you have multiple younger children, you may benefit from holding onto that money a little longer.

“If you can cash flow some of the expense, any 529 money left over would continue to grow tax free for the younger sibling to use,” says Falcon. “And either sibling might be able use the 529 proceeds for grad school.”

Consider Other Savings

A 529 savings accounts certainly isn’t the only way to save for college, and you may have money in a Roth IRA, brokerage account, or savings account available as well. If you do have multiple accounts, the big question is how to manage withdrawals from each one as efficiently as possible.

Roth IRAs can be fantastic college savings accounts and are likely the next best option after a 529 savings account as far as tax benefits go. The catch, of course, is that they’re also incredibly valuable as retirement funds, and since saving for retirement is more important than saving for college, you should generally only use Roth IRA money for college if you’re all set for retirement through other means, like a well-funded 401(k).

“I love Roths for retirement, so I have a bias of not using that Roth for college if the family can pay from elsewhere,” says Falcon. “Of course, if mom and dad have $5 million saved for retirement, my response might be different.”

If you have money in a brokerage account, and if it’s grown significantly since you contributed it, you’ll likely have to pay capital gains tax on those gains if you sell. That’s one of the big downsides of a brokerage account compared to a 529 plan, given that the entire 529 plan balance can be withdrawn tax-free for qualified higher education expenses.

But according to Falcon, you can circumvent at least some of that cost by gifting some of your brokerage holdings to your child, allowing him or her to sell at a lower tax rate. You do have to be wary of gift taxes, the kiddie tax, and the impact on financial aid, but it’s one strategy to consider.

As for a regular savings account, Falcon suggested that as long as you keep a separate emergency fund, it may be smart to use excess savings before withdrawing from a brokerage account given that you wouldn’t face capital gains tax and you aren’t sacrificing as much potential long-term growth.

At the end of the day, 529 plan withdrawals are still typically the most cost-effective way to pay for college from savings. But if you have other savings available to you, a mix-and-match approach could help you accomplish multiple goals along an extended timeline.

Make Sure to Adjust Your Investments as Needed

One other major point to consider is that as you get closer to actually needing the money in your 529 savings account, it’s usually a good idea to dial back your investment risk.

“529 investments should be more conservative as you approach college,” says Stephanie Bacak, CFP® of Capstone Global Advisors. “You don’t want to have to spend a substantial amount of the account in a year that the market is down.”

This should happen automatically if you’re in a target-date or age-based mutual fund, but you should still check to make sure the asset allocation of that fund is in line with your personal goals and preferences. And if you’re not in an age-based fund, you’ll need to make those adjustments yourself.

Taking a Comprehensive Approach

The key to making smart decisions about paying for college is taking a long-term view that includes in all of the options available to you.

By factoring in loans, tax credits, financial aid, and the long-term education needs of all your children – in addition to your 529 savings account – you can save money and give your children the best opportunity possible to reach their goals.

Matt Becker, CFP® is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families.

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