Which college plan should you tap first?

By: Savingforcollege.com

Q:

Dear Joe, I have two daughters, one in 11th grade and one in eighth grade. I have a Uniform Gift to Minors Act account and a 529 for each of them. The UGMA accounts each have about $16,000 in them and I no longer contribute to them. Each 529 has about $13,000 and I am still contributing to them in age-based portfolios. I'm in the 25 percent tax bracket. The girls have no other income. Which one should I tap first to pay for their college expenses? -- David

A:

Dear David,

I suspect you'll be best off by using the UGMA money before tapping your 529 plans. The biggest reason has to do with financial aid: Investment assets in your daughters' names, or in their UGMAs, are counted heavily in determining their expected family contribution, or EFC. Higher EFC means less need-based financial aid.

By spending down those assets before filing the Free Application for Federal Student Aid, or FAFSA, financial aid application, your daughters will have a better chance of receiving government-subsidized loans and work-study.

Another reason to choose the UGMA money first has to do with income taxes. Each of your daughters can report up to $1,800 in investment income this year (2008) using the lowest income-tax brackets. (Unearned income above $1,800 will be subject to the "kiddie tax" and taxed at your 25-percent bracket.)

Even better, the portion of their investment income below $1,800 that consists of long-term capital gains and qualifying dividends will not be taxed at all for federal purposes. The zero-percent bracket for capital gains and dividends is available for the years 2008 through 2010 to all taxpayers who are in the 10-percent or 15-percent ordinary-income brackets.

A reasonable strategy would be to take maximum advantage of your child's low or zero tax brackets each year by triggering gains, as long as the gains are not so high as to incur the kiddie tax. The cash can then be spent on anything that benefits your child, including education.

Or, it can be contributed to a "custodial" account with a 529 plan. Spent assets will not be reported on the FAFSA (obviously) and 529 assets owned by your child will add much less to the EFC than will non-529 investment assets owned by your child or in the UGMA.

Take note, however, of the impact of a child's income on EFC. If your older daughter applies for financial aid next year, this year will be her "base" year for reporting income on the FAFSA. You do not face this problem -- yet -- for your younger daughter.

A 529 plan has an advantage in that the tax-free distributions used to pay for college will not be reported as income on the following year's FAFSA.

Your 529 accounts can be left to grow until your daughters' UGMA money has been fully spent. Money from the 529s can then be withdrawn tax-free for college expenses.

The biggest caveat concerns a situation where you may have more money in 529 plans than needed for your daughters' college expenses. You want to avoid being in the position where your withdrawals from the 529 plans are subject to tax and penalty because you cannot show sufficient qualified education expenses.

In that case, it could make more sense to tap your 529 accounts before using non-529 assets to pay for college.