Just when you thought filing your taxes was the most complicated thing you’d have to figure out financially, along comes a problem like this.
Let’s start at the beginning…
There are a couple of things you don’t know when saving for college:
- Will my children even go to college?
- If so, how much will college cost them?
My wife and I answered these questions many years ago as follows:
- Yes, they will go to college. After all, that’s what we did.
- College will cost them a fortune. We’ll get virtually zero need-based financial aid and even if we get scholarships it will cost a tidy sum.
Saving for College
Given these answers we saved for college in two ways:
- We put in $5,000 each year for several years into a Michigan 529. This also got us the biggest tax break available at the time.
- We gifted my parents money and they put contributions into a Coverdell Education Savings Account.
Over the course of time the savings grew until we ended up with the following:
- $70k in the Michigan 529 for each child — $50k of which we contributed and $20k of growth
- $20k in Coverdell ESAs for each child — $15k of which we contributed and $5k of growth
In other words, we have $90k for each child, $65k of which is money we contributed and $25k of growth.
For background, you can read how we saved in each of our kids’ college accounts as well as our “keep what you don’t spend” incentive.
We Saved Too Much Based on Reality
The problem is, we answered the two questions above incorrectly:
- First of all, it appears that my son may not go to college. He’s not a fan of school and has talents elsewhere. He may go straight into business, take some creative arts classes, or work some and try to figure it out along the way. We’re still working on his plan.
- Second, my daughter will be going to college but her costs will be lower than $90k (or at least it appears that way). She has been homeschooled through high school. Because she was well ahead of her grade level, she started taking local community college courses when she was a sophomore in high school. We used what is called dual enrollment — where she took college classes and they counted as both high school and college credit. Doing this for three years she will have amassed almost 60 college credits before she enters college on campus next fall. BTW, she stayed home an extra year since our agreement was any classes she took in high school/while at home we would pay for ourselves, not out of her college money.
So she’ll enter college on-campus next fall as a junior and have two years at an all-in cost of $34k per year. She also hopes to be part of a summer internship which she’ll get credit for at a rough cost of $15k. That means her two years will cost $83k, $7k less than what we have saved for her.
BTW, for the rest of the article don’t worry about what we pay for versus what she pays for from her college fund. At this point we simply want to get all the money we can out of the college funds with no penalties. We’ll settle on what we owe her at the end out of other funds if need be.
Getting the College Money Out
The issue with my son is a longer term one, so this post will deal with how to pay for my daughter’s college, specifically how can I get all the money we have saved out of the accounts without incurring a penalty. You see if you withdraw money from 529s or Coverdells for amounts over the qualified college expenses, you pay a 10% penalty on the earnings withdrawn. And before you get any bright ideas, you have to take out money earned on your contributions and the money you contributed in equal amounts (based on the percentage of each in the account).
The good news is that you can take out dollars equivalent to scholarships the student receives. My daughter is probably going to get $10k per year in non-need based scholarship money.
If you have extra funds left in accounts you don’t have to withdraw them and take the penalty. According to Saving for College you can:
- Change the beneficiary to another qualifying family member who is planning go to college
- Hold the funds in the account in case the beneficiary wants to attend grad school later
- Make yourself the beneficiary and further your own education
Before we get into specifics, let’s review some advice from my accountant. As I noted in Big Tax Savings due to Early Retirement, I sent an early December email to my CPA asking about tax planning issues for 2017.
I asked my CPA for some guidance in an email as follows:
Hi, Wendy. I hope this email finds you well.
My daughter is a senior in high school and homeschooled. She has taken college classes online as part of her dual enrollment (getting both high school and college credit). I have a 529 for her as well as a Coverdell ESA. I’m wondering:
1. Can I withdraw money from either of the accounts for her college expenses in 2016?
2. If so, does it matter which account I take from first?
3. And what is covered? Both tuition and books?
4. Can I withdraw money for 2015 and 2014 classes and books or did I miss that window? Most of the costs are in 2016 anyway, but if I can take more out, I’d like to.
Anything else I need to think of? For instance, should I take money out with the check made out to her or to me? Or does it matter?
I think that’s it for now. Let me know if you have questions and I’ll get back to you asap.
Thanks,
ESI
She responded:
You can withdraw money from either account for the college expenses. It doesn’t matter which account you use first.
The Coverdell ESA must be used by age 30 …. but I doubt you will need it that long. The 529 has no age limit.
You can take money out to cover tuition, books, and room and board expenses provided your daughter is enrolled at least half time.
It doesn’t matter who the check is made out to. As another option, you can have it sent directly to the college.
You cannot take money out now to cover the previous years’ expenses…you are right, that window is closed.
Let me know if you have additional questions.
Some thoughts on this response:
- The Coverdell is something that’s going to “expire” in 10 years, so I should use that money first.
- I need to deduct as much as I can for 2016’s expenses (which I have done). They added up to $7,000.
- It does matter who the check is made out to if you withdraw money above what you have for education expenses. Details can be seen here.
Our College Savings Situation
Now let’s go through the specific situation. Here’s where we stand money-wise:
- $70k in the Michigan 529 for my son — $50k of which we contributed and $20k of growth
- $70k in the Michigan 529 for my daughter — $50k of which we contributed and $20k of growth
- $20k in Coverdell ESA for my son — $15k of which we contributed and $5k of growth
- $7k in college expenses from my daughter taken in 2016 out of Coverdell ESA
- $13k new balance in Coverdell ESA for my daughter — $11k of which we contributed and $2k of growth
Now, let’s say we incur the following expenses throughout my daughter’s college career:
- $34,000 for college expenses for the 2017-2018 school year
- $15,000 for college expenses for the summer of 2018
- $34,000 for college expenses for the 2018-2019 school year
- This is a grand total of $83,000 costs to complete her degree
Now, how do we pay these costs to maximize the amount we can take out?
The Path to Withdrawing College Savings
In the tax email to my CPA she noted that we could qualify for a college tax credit, but according to this site, that money needs to be paid from other funds. Their quote:
Under the American Opportunity Tax Credit, for example, taxpayers can deduct 100 percent of the first $2,000 and 25 percent of the next $2,000 spent on qualifying education expenses from their tax bill.
But that money can’t come from a tax-qualified distribution from a 529 plan. So the best way to benefit from both the credit and the distribution is to pay the first $4,000 of annual expenses from a checking or savings account, and then take the remaining amount needed from the 529 plan.
Given everything we’ve discussed so far, here’s my thinking on how to pay for my daughter’s education:
- Transfer my son’s Coverdell into my daughter’s name. I want to drain the Coverdells first since they have to be withdrawn at 30 and 529 funds don’t.
- Pay the first $4k of her 2017-2018 expenses in cash (to get the tax credit)
- Pay the rest of her 2017-2018 expenses ($30k) from her Coverdell (now combined with my son’s)
- This leaves a balance of $3,000 in her Coverdell after the second semester in the 2017-2018 school year
- Pay the $15,000 for her summer internship/courses with the rest of the Coverdell and $12k of the 529. This eliminates the two Coverdell accounts.
- Pay the first $4k of her 2018-2019 expenses in cash (to get the tax credit)
- Pay the rest of her 2018-2019 expenses ($30k) with her 529
That leaves $28k in her 529 which breaks down to $20k of which we contributed and $8k of growth.
How to Handle What’s Left in the 529s
So, now what do we do?
My understanding is that I can take the $20k out without taxes or penalty. That is money we contributed post tax and is ours. Whether I can do that without tapping into the $8k I do not know.
If I take the $8k out I will need to pay both tax and a 10% penalty on it. At a 15% tax rate, this would be $1,200 in taxes plus $800 in penalties or $2,000 (leaving me $6k).
Or I could leave the money where it is (even roll it into my son’s 529 plan) and hold it indefinitely — perhaps for our grandchildren.
Same goes with my son’s 529. I could pull it out, pay taxes, and penalties, or leave it be.
As you can see, things are fairly complicated. Who knew saving too much would be such a problem?
I’m still working through these issues (as you can probably tell) and may be for the next several years. For now I’d appreciate your thoughts on what I should do, errors in the law I may have made, and so forth.
photo credit: Fibonacci Blue University of Minnesota students protest hate speech via photopin (license)
I love when you put your emails to a CPA or legal attorney in your posts; it makes the post read much better and allows the reader to have the same experience you did.
Best of luck with the 529s. Maybe you can gift it to another family member, say a niece or nephew?
Go with the legacy – leave the excess money in the 529 and plan to use it for grandchildren. If it is planned well, it might even extend eventually to the next generation. I would love to be able to do that for future generations. (Check out Paul Merriman articles on saving $10,000 for his grandson – great plan to optimize compound interest.)
Even if you take the money out, you really aren’t losing that much. As you said, you still have the money you put in post-tax, and you are losing money you gained on the investment only. Essentially you are getting a lower rate of return.
This is what I’ll probably do. Just let it sit and grow for 30 years or so…
This is quite the conundrum and partly the reason I second guess myself every time I transfer funds into my daughter’s 520 plan. It really is a crap shoot whether or not they will do at 18 years old what we expext them to do. Times change and so does the world of higher education. My daughter is only 7 now – who knows where we’ll be in 11 years.
As for your money – I think I’d leave as much as possible in the 529 after expenses, assuming you don’t need the money. There could be grandchildren in the future who would benefit from it. And who knows, your son could change his mind and go to school or your daughter to continue her education. My vote is with leaving it sit in the account. Awesome post. Thank you for the insight!
Mrs. Mad Money Monster
This is another great suggestion – my daughter went to graduate school, and trying to get scholarships and loans for post-grad work is even more expensive than undergrad.
I am not telling you something you or you accountant don’t know all ready but keeping good documentation of where the money went is important. I received a letter from the IRS stating that I owed $3400 in taxes due to unqualified distributions from my Michigan 529. This is when both were in college and $48k in tuition. I needed to prove and did so in a letter point that 529 money was transferred to my sons checking account to pay this tuition bill with all supporting documents. They dropped the tax when I showed where the money went to a qualified distribution. My taxes were probably looked at closer due to a larger than normal Federal refund.
BTW I there is an option where the money is directly paid to the University which I found out too late. It may have minimized the audit letter.
Did you receive a 1099-T (Tuition statement) from the college? If so, the IRS should have known about your expenses.
Sorry, 1098-T
I was thinking the same thing. I received one for this year and will be forwarding to my accountant.
First off, impressive work by your daughter entering college with 60 credits! I’m sure you’re super proud. 🙂
Secondly, if I overshoot I will use those proceeds as a tax efficient method to passing money on to heirs. I’ll likely change the beneficiary to grandkids. I plan on tucking away $70K for each kiddo in their firs 3 years into a 529 and letting it grow to ~$250K or so. I might be overshooting it, but it could also be used for grad school. Just like you folks, it is hard to predict the future, but worst case changing it to grandkids isn’t a bad deal.
It’s a great “problem” to have, and we have nearly as much saved up for our boys, who are in 1st and 2nd grade, likely using the same TIAA-CREF funds you’re using.
You’re wise to use the AOTC, which doesn’t phase out for a married couple until taxable income exceeds $160,000. Never walk away from free money.
I hope to have “too much” saved. I’ll encourage our boys to try not to use it all up. The leftover money could easily have the better part of three decades to grow and be available for their own children someday.
Cheers!
-PoF
I have a hard time understanding why people use 529 plans. My wife and I can gift a total of $28k to each of our kids tax free every year into a custodial account. When my kids need to use it for educational expenses, the capital gains will be based on their income. At the time they use it, their income will be so low the capital gains rate will probably be 0% (that’s what it currently is for single filers for income less than $38k). The upside is they can use the funds for whatever they wish with no risk of penalty and usually the investments options are greater, including those with less expenses. The downside is that the funds are theirs when they turn 18. I’ve gone over and over this trying to understand why I would use a 529 plan but I always go back to the custodial route. What am I missing?
I think you hit on one of the downsides:
“The downside is that the funds are theirs when they turn 18.”
In addition, if you get a 529 from the state you live in, many states allow you to deduct a percentage of the contributions from your taxes.
I think there are a number of pros for a 529 in your situation.
First, the money in a 529 doesn’t penalize your child as much as child-held assets on the FAFSA.
Also, the “kiddie tax rule” (just google it as I can’t do it justice succinctly) would probably apply in the situation you describe – the capital gains for your kids may be taxed at your marginal tax rate.
Finally, the situation ESI is in IS a nice problem to have, and the ownership and flexibility to change beneficiaries etc. could give you lots of options down the road.
Those are at least some of the arguments for a 529.
The break on state income taxes. My state doesn’t tax 529 contributions, even if they’re made to a 529 plan for another state. We use the Utah 529 plans which are excellent, and it’s like receiving a 3% refund on our contributions each year.
I get paying out the first $2k cash since it’s 100% tax credit. But I’d reconsider the next $2k since it’s at the 25% credit level – I’ll leave the actual math for you or the CPA, but it seems like a net zero (10% penalty plus the 15% in taxes)?
Unless you think she’s going to get a post-grad degree or your son would use it later on (or for the future grandkids)
I’m in the process of doing my 2016 taxes now and we’ll discuss the credit as part of our return/planning.
I’ll keep you informed.
As others noted, having excess funds in a 529 is a great problem.
Great post and interesting as I imagine what my 2 kiddos will do come college age! My plan is to have ~ $250k in 529 and cash flow any additional (could be another $250k+??).
A quick question … when looking at your overall situation and a scenario where you need to access the left over 529 funds ($80k’ish that your son won’t use) for living, was your overall approach to college savings a good move?
Well, there’s a scenario you can come up with that makes almost any financial decision you make a bad one, especially if it’s 20 years down the road. And, of course, hindsight is always 20/20.
The issue here is trying to project what to save when costs, college choices, financial aid, family situations, investment growth, and a whole host of other factors are in play and unknowable two decades in the future.
So, if the question is would I rather have this issue than have too little saved? Yes.
Would I prefer if I had saved the exact amount each child needed for college costs (as if anyone could predict that)? Yes.
If I have to have the money for living (which I don’t — a good argument for making multiple money moves/savings to negate any unforeseen consequences of other moves) then would saving in a 529 be the best move? Of course not.
But I don’t need the money and given the knowledge I had at the time, I think our moves were fine. Not optimal, but not disastrous either.
Of course, I could all have turned out differently — both my kids could have gone to medical school and I’d have saved too little! 😉
Thank you for your post. It certainly makes me think, as my original plan has been to save the amount that my son needs to attend the best 4-year university in our state, and then stop. He’ll reach that amount in 2 years at age 7, so the additional growth could be used for graduate school, or to pay for a better private school, should he choose that route. There are a lot of other things I could divert that savings to, such as paying off a rental property mortgage, but it still feels like the risk of overfunding his education is lower than the risk of underfunding his education. Also, I’ve decided not to buy life insurance because I believe I am “self-insured”, so saving specifically for his college is a higher priority for me than it might be if I was insured. If I have overfunded his 529 plan, I think I’ll use it in retirement to enroll in cooking school in Europe, and take some photography classes, possibly even get a PhD. 🙂
Hmmmm, now you have me thinking….
Perhaps I need to go back to college myself — in St. Thomas. 🙂
Some thoughts:
* boys can change a lot between 18 and 28 – no knowing what might happen in the next few years. He might want to be an electrician or an EMT or a truck driver or a CPF, etc., all of which require training which can be funded from the Coverdells, at least.
* no knowing, even for your daughter, that she’ll need just two years in college. Kids change their majors or, has been mentioned, later want to pursue a master’s
* I’d be very interested in hearing how the process goes for moving Coverdell funds. I have three kids with unused funds which I’d like to eventually move to my grandchildren (from another child who used up her college savings).
I like the idea of hanging on to the money for any grandchild’s education – now that would be a legacy!
But one pro / con to that – as I did research, it seems the assets in a grandparent-owned 529 don’t get included on the FAFSA (which is great).
What’s not so great is that once those funds are distributed / used to pay expenses, they’re then included in the student-owned resources which come in at a much higher rate than parent-owned resources (including a parent-owned 529).
I think the best strategy for grandparents to help via a 529 is to therefore pay for the last year of school.
Complicated stuff, but an excellent problem to have. Congratulations
Some notes, you can use 529 funds against things like a computer for school and room and board.
If you pull out the money for scholarship you will still be subject to income tax but not the 10 percent penalty.
Valuable post, ESI. Congrats to your daughter for earning 60 college credits before she even finishes high school! Also, smart thinking on community college – a good friend of mine’s daughter did the same. Studied for 2 years in community college and transferred on part-financial aid to a name-brand university where she studied only 2 years and got a marketable degree. She ended up paying only about $60K total I think, when it would have cost over $140K for that 4-year degree. For me, the 529 plan wasn’t that great so I stopped investing within a year of starting. I plan to now fund my son’s college through my own taxable accounts instead of any assets on his name (which will count against scholarships as I am told). Any insights you have on this would be great.
I could have written the first half of this article for our situation. Son #1 is not staying in college so it appears we have ‘over saved’ for him too. We will likely transfer some of his 529$ to Son #2 before all bills are said and done and with the leftovers, we are not in a rush to decide. He’s only 18 and may change his mind about going to college after a couple years. We may just keep it invested for the future grandchildren depending on the amount or offer it up for nieces/nephews depending on needs.
The 529 was attractive to us during the saving years due to the state income tax deduction.
Thank you for the post. I’ve been starting to get my head wrapped around similar issues for a future post but I haven’t laid everything out yet and with Son #2 starting this fall, we are not 100% sure what our outlay for 2017-2018 will be until we get the forthcoming tuition bill. But we are also way outside the realm of getting need-based aid due to high incomes. In the end, I think it was better to over-save than under-save.
Cheers!
I’m curious, why did you save in Coverdell accounts in addition to 529? Are there advantages I am not aware of over the 529?
Having your daughter take college classes in high school is a great idea and definitely saves a lot of money. I’ve thought about taking that strategy with my kids, but wondering there is any drawbacks to that vs. taking AP classes. Are the credits for both easily transferrable to most colleges? Were the grades for the college classes weighted on a 5 point scale like APs? So much grade inflation these days…
I will be following closely on how you get money out of your educational accounts as I may be in the same boat – over-saving. My wife works at a major university and if my kids get accepted and decide to attend, it’s a full ride. Too many unknowns prompted me to save enough for tuition elsewhere, just in case.
To be honest, I can’t remember why I had both. I do know I had the Coverdell/ESAs first but can’t recall why.
Our kids were homeschooled, so AP classes were not an option.
For the college classes, they were free at the local community college when we lived in OK.
When we moved to CO, we looked for an online college that was well respected and that my daughter thought she might want to attend on-campus one day. Works out that the college she’s taking classes from online is the one she’ll be going to in August, so things transfer perfectly. (FYI, we asked about the OK classes transferring in advance of making our final decision and all those transfer too.)
Wow! Congratulations on that “problem.” 😉 At this stage of the game, I can’t even imagine being in a situation like yours. I am working hard to get out of student loan debt as soon as possible so we can begin contributing toward our kids’ educations. Hopefully, when they reach college-age, we will be in a similar position, or at least, have enough saved. Well done!
Being in Michigan, did you ever consider MET, where you pay tuition now and it is covered later? I use MET and 529 but am torn of which one is best.
First of all, I don’t live in Michigan any longer.
Second, I’m not sure how portable MET is and how much it would cost to use it for other colleges outside Michigan, but I was sure my kids were not going to a Michigan school and a 529 seemed to offer more flexibility.
I know this is a slightly old thread but I came across this recently as I have been trying to come up with the best strategy for my wife and I plan to start a family. My wife and I are both engineers in our early 30’s, live in a low COL area, and have a couple rental properties that we’re trying to reduce our debt on. It can be a daunting task to balance our own retirement savings, personal goals of paying down debt, and planning to fund their futures. It is important to us that we provide them with a great foundation and the opportunity to attend college without debt. For us, that definitely means providing them with a bachelors degree and some assistance for graduate school. I’m just curious to hear others’ thoughts in this area because while 529’s are a great tool, I also worry about a child that decides not to go to college or that we save too much and miss out on other opportunities.
This is a great article regarding your personal experience but for you and others out there: do you also save money for your kids in other accounts besides a 529? I’m not talking about the daily expenses as they grow, that should be covered in your monthly living expenses. Obviously we will contribute to a 529 plan, but how much?
Should we also contribute to a dedicated savings account / CD’s early for other milestone purchases like a car? I understand there are many views and discussions around cars, but it’s still a valid aspect.
How does the conversation change when you want to contribute $100/month vs $1,000/month? If you’re splitting half with a savings account and half with a 529 then that’s a very different conversation regarding money sitting idle for 18 years.
Does it make sense to front-load the 529 so it can grow and then contribute to the savings / CD?
Just curious to hear others’ thoughts…