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Costly Tax Errors to Avoid When Funding College Education

Posted on Edited on
Don James
Don James

With the cost of financing a college education rising twice as fast as inflation, the dream of sending a child to college is becoming more like a nightmare. The increase in college costs is out-pacing both inflation and the increase in family income. A family just can’t afford to make any costly errors.  Here are three to avoid:

1-  Paying for college from a grandparent’s 529 plan– A 529 plan can be an excellent way for grandparents to contribute to a grandchild’s college education while simultaneously paring down their own estate. A big advantage of 529 plans is that under special rules, grandparents can make a joint lump-sum gift of up to $130,000 ($65,000 for individual gifts) to a 529 account and completely avoid federal gift tax…and the assets in the plan do not have to be included on the  FAFSA completed by the grandchild and his/her parents.

This strategy works great for families that will not qualify for financial aid…no harm, no foul.   However, for families that will qualify for financial aid, the amount withdrawn from the 529 plan is considered as untaxed income to the student on the FAFSA and reduces need-based financial aid by 50 cents for every 529 Plan dollar withdrawn. 

2-  Grandparents that pay college bills directly to the institution– Another excellent way for grandparents to help their grandchildren with college costs is to pay the college directly. Under federal law, tuition payments made directly to a college aren’t considered taxable gifts, no matter how large the payment.  Plus, it removes the money from the grandparent's estate.

Again, this strategy continues to works well for families that will not qualify for financial aid.  However, for families that will qualify for financial aid, the amount paid by the grandparent is considered as a “resource” to the student for financial aid purposes, and reduces need-based financial aid dollar for dollar. 

3-  Using 529 Plan money to pay for Lifetime Learning Credit expenses– Families with incomes of $100,000, or less, can claim 20% of the first $10,000 tuition and fees as a tax credit.  However, if they use 529 Plan distributions to pay for those same tuition and fees, they lose the tax-free status of the withdrawn earnings.  Furthermore, 529 Plan distributions subject to income tax will be counted as untaxed income in the determination of financial aid eligibility.

The “Net Qualified Education Expenses” must be determined to figure what portion, if any, of earnings withdrawals from a 529 Plan are truly tax-free.  Before earnings can be considered to be tax-free, certain non-taxable items need to be deducted from the withdrawals including tax-free scholarships, Pell grants, and expenses used to claim the education tax credits.

For example, assume a family withdraws $25,000 from their 529 Plan which includes $6,000 of earnings.  The student has also received a $5,000 scholarship and claims the $2,000 Lifetime Learning Credit.  Therefore, we calculate the Net Qualified Education Expenses (NQE) as follows:

          529 Plan withdrawal                           $25,000

          Scholarship                                          -5,000

          Tuition & fees used for credit               -10,000

              NQE                                              $10,000   

Since the $10,000 NQE represents 40% ($10,000/$25,000) of the 529 Plan withdrawal, we apply the same percentage to determine the amount of earnings that are tax exempt.  Therefore, $2,400 ($6,000 x 40%) of the earnings is exempt and the other $3,600 is taxable.


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