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Pay for college and get a tax break, too

Make the right moves and boost your child's aid eligibility

Consumer Reports Money Adviser: July 2013

College costs have gone through the roof. Total charges at private, nonprofit four-year institutions averaged almost $40,000 for the 2012-13 school year, according to the College Board. Saving for that giant tab is difficult enough; choosing the most tax-efficient ways to pay the bills–through tax-deferred savings in 529 plans, taxable accounts, loans, and other means–adds a whole other level of complexity.

The goal is to reduce your tax bill while making sure your child qualifies for as much financial aid as possible. Assuming that she's your dependent–and her income and assets are small–her eligibility mainly hinges on your income and assets as reported on the Free Application for Federal Student Aid, or FAFSA. Fill out the form early each calendar year at fafsa.ed.gov.

Bank accounts, investments, trust funds, and real estate other than your principal residence generally must be reported on the application. Exclusions include pensions, individual retirement accounts, 401(k)s, and the value of autos and family small-business interests. Assets don't need to be reported on the application if the parents have an adjusted gross income of less than $50,000 and are eligible to file Internal Revenue Service form 1040A or 1040EZ.

If your income is high: Tap a 529

Households with relatively high incomes should dip into 529 savings accounts to pay for college before taking out loans. Joint filers with more than $180,000 in modified adjusted gross income (MAGI)–adjusted gross income before deducting tuition and fees—fall into this group. So do singles and heads of household with MAGI of more than $90,000.

You can tap your child's 529 account to pay for "qualified" college costs: tuition, fees, books, supplies, and generally, room and board. Those 529 withdrawals-the money you originally invested, plus built-up gains–will be tax-free as long as they don't exceed what you pay in qualified costs in a calendar year. "Using your 529 account locks in the tax break on any gains," says Joe Hurley, a certified public accountant and founder of Savingforcollege.com.

You don't have to report gains in a 529 account on the FAFSA. And drawing down a 529 account will reduce the assets you do have to report. So by using 529 funds, you take advantage of a tax break while potentially improving your child's financial-aid eligibility in the coming school year.

Check our parents' guide to saving for college to learn more about your choices and why you should start putting away money early.

If your income isn't as high: Weigh tax breaks

If your MAGI is below the $90,000 or $180,000 threshold, you might qualify for a tax break called the American Opportunity Tax Credit (AOTC). Or you might be able to deduct up to $4,000 in tuition and fees on your tax return. But you can't claim both benefits for the same student in the same year.

The AOTC is a credit subtracted directly from your taxes. Claiming it can cut your taxes by up to $2,500 per student a year. In contrast, the tuition-and-fees deduction will cut your adjusted gross income by up to $4,000 a year; if you're in the 25 percent bracket, you could save $1,000. Tax software will automatically select the better option for you. "Most programs indicate that the AOTC will reduce your tax bill by more than the tuition-and-fees deduction," says Deborah Fox, who heads Fox College Funding, a planning firm in San Diego.

But tax software doesn't take into account the fact that claiming the tuition-and-fees deduction might enable your child to qualify for more need-based financial aid, Fox says. Deciding which break works best might require running the numbers with a financial adviser. Keep in mind that you can't claim tax breaks for the same expenses you cover with 529 withdrawals. If you do, some earnings from the 529 will be considered "nonqualified"–that is, taxable.

If you have multiple 529 plans: Manage withdrawals

When there's more than one 529 plan for the same student, withdraw from the account with the highest returns first. You'll realize larger tax-free gains.

Accounts owned by grandparents don't have to be listed as an asset on the FAFSA, which can help the grandchild qualify for more student aid, notes Mark Kantrowitz, publisher of Edvisors.com, a network of websites about planning and paying for college. The catch? Paying college bills from a grandparent-owned 529 can reduce financial aid eligibility by as much as half of the amount taken from the account.

Kantrowitz suggests changing the account ownership from the grandparent to the parent or student, a move allowed by most states. The shift will affect financial aid eligibility a little, he says, but much less than if the grandparent's 529 plan paid the college bills. Or, he says, wait to take distributions from the grandparent's account until after the FAFSA is filed for the senior year in college, when you no longer have to file future FAFSA applications.

Hurley has a different take. He favors using money from the grandparent's 529 account sooner than later to pay college bills. "It is generally best to use other people's money before you lose it," he says.

   

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