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By Ingrid Case
April 30, 2021
A person is taking a slide out of a Pizza pie with 529 on it.
Jade Schulz for Money

You worked hard to save money for your child’s college education, and now you’re ready to send the kid off to school. An effort to spend the money strategically lets you finish off the job in style by helping you get the biggest benefit from your 529 plan.

529 college savings plans let parents, grandparents and other relatives invest after-tax dollars, then spend the investment earnings tax-free on qualified educational expenses. How you spend that money — specifically when and on what — will determine whether you can claim certain tax credits and even qualify for financial aid.

Maybe you’re in the fortunate position of being able to pay for all or most college expenses from your child’s 529 plan. Or maybe you’ll need to mix some savings with some borrowing and scholarships. Regardless, planning how you will spend down your 529 ahead of time can help you get the best bang for those bucks. Here’s what to consider as you craft a strategic spending plan.

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Time your 529 withdrawals to minimize loan interest

If you’ll need student loans to pay some college costs, consider whether the loans will be subsidized or unsubsidized. The federal government pays interest on subsidized loans while students are still in school, but unsubsidized loans start accruing interest as soon as they’re disbursed.

Subsidized loans are given out based on financial need, so if you qualify, feel free to take them whenever you need them during the college years. If subsidized loans aren’t an option, then you’ll want to delay taking unsubsidized loans as long as possible to minimize the total interest you’ll pay on the loan. That probably means paying for the early years from your 529 plan.

“Figure out your budget for all four years, remembering that college costs tend to go up by about 3% a year,” advises Mark Kantrowitz, the Chicago-based former publisher of savingforcollege.com. “Push unsubsidized loans as close to the end of your kid’s college career as you can.”

Pay some college bills with cash to earn tax benefits

There are two ways to get a tax break on the money you pay for your child’s college expenses.

If you earn up to $90,000 a year, you’re eligible for the American Opportunity Tax Credit, worth up to $2,500 a year per eligible student for up to four years.

Earning up to $69,000 a year makes you eligible for the Lifetime Learning Credit, which is worth up to $2,000 a year per return, with no limit to the number of years you can claim it. (Those earning limits are for single parents. Double them to get the limits for couples filing together.)

You can use just one of these options in a given tax year. Generally, the American Opportunity Tax Credit is the best deal, Kantrowitz says, adding that this credit benefits most people even more than the tax savings a 529 plan generates.

Here’s the catch. The IRS will not let you double-dip by getting a tax credit for using money that wasn’t taxed in the first place. That means you can’t claim these tax breaks with expenses covered by money in your 529 plan. If you want any of these tax advantages, you need to spend the amount the IRS stipulates from after-tax dollars on tuition, fees and other qualified educational expenses.

As an example, let’s say you’re spending $30,000 a year on college expenses. You want to use the American Opportunity Tax Credit, which gives a credit of 100% of the first $2,000 you spend on college bills, then a quarter of the next $2,000.

Of your total $30,000 bill, you can pay $26,000 from your child’s 529 plan. The remaining $4,000 must come from after-tax money — your checking or taxable brokerage account both qualify — in order for you to take the American Opportunity Tax Credit. The same logic (but different numbers) applies to the Lifetime Learning Credit.

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Strategize your 529 spending to maximize financial aid

Maybe you’ve done your best to save for college, but you don’t have enough to pay most of the costs. You’ll rely on financial aid to make up the difference. How you handle your 529 plan can also help determine how much financial aid your student qualifies for.

Most U.S. schools use the federal aid application known as the FAFSA to help determine what a family can afford to pay for college. Some other schools, typically at the more expensive end of the educational market, also use a form called the CSS profile for the same purpose.

These two college aid calculations take differently sized bites of a family’s assets, depending on who holds the legal title to those assets. It’s better to have assets in the parents’ names, rather than the child’s, because aid calculators take a much smaller piece of parental assets. That’s why 529 plans are considered more favorably in financial aid formulas. Unlike other assets that are counted as belonging to the child, parents typically own the 529 and simply name the child as the beneficiary.

In some families, grandparents own the 529 plans and list grandchildren as the beneficiaries. That keeps the plan completely off the aid calculator’s radar. However, whatever money eventually does come out of a grandparent-owned 529 plan counts as income to the child during the year of the withdrawal. The aid calculators notice that income and reduce financial aid accordingly.

There are two ways around this problem, says Chris Lyman, a financial planner at Allied Financial Advisors in Newtown, Pennsylvania.

“Remember that the FAFSA has a two-year look back for income, and it’s ruled by the calendar year, not the academic year,” he says. “If you have a traditional four-year school, wait until January 1 of the year the kid becomes a junior to start tapping the 529 that’s owned by someone who isn’t a parent.”

In other words, wait until after you have filed your last FAFSA to use money from a grandparent-owned 529.

If you’re already using a grandparent-owned 529 to send a child to a private high school but hope to get financial aid for college, stop using that 529 plan on Jan. 1 of the year the child enters the junior year of high school. That will ensure the grandparent’s college savings plan isn’t captured in the FAFSA you file for your child’s freshman year.

The second method for sidestepping this issue is to roll a year’s worth of money from the grandparent-owned 529 plan to a parent-owned 529 plan, then spend it before filing the next FAFSA or CSS, Kantrowitz says.

The catch here is that not every state lets you roll over funds to a different 529 plan, and those that do say the second plan needs to be in the same state. Your accountant or financial planner can help you decide if this strategy is worth the (minimal) hassle of starting a new 529 plan in whatever state the grandparent has chosen.

More from Money:

Almost No One Saves for College. Can New 529 Apps Help?

What’s the Best Way to Save for College? The Pros and Cons of 529s vs. UTMA Accounts

How Much Should Parents Really Pay for College? An Expert Explains in a New Book