Best Ways to Cash in College Accounts

This fall Terri and Jeff Graham will tap their savings to pay for son Mitchell's freshman year at Carroll College, in Waukesha, Wis. The Grahams keep their college stash in a number of places -- a 529 account, a custodial account and their own savings -- and the order in which they take money out of those accounts can make a big difference in their tax benefits.

Because Mitchell is 18, he can withdraw money from his custodial account this year and pay taxes at his own rate -- 5% on long-term capital gains and qualified dividends -- instead of the 15% rate that his parents would pay. His parents could also save money by giving Mitchell a gift of appreciated stock, which he could sell before the end of the year.

But starting in 2008, Mitchell will lose that advantage (see Last Chance Tax Move). So his parents should consider emptying his custodial account while he still qualifies for the lower tax rate.

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The Grahams expect Mitchell's college expenses to total about $20,000 per year, which they'll also cover with tax-free withdrawals from the 529 account, plus their own investments and current earnings. But they need to be careful about how they make withdrawals from a tax-favored account, such as a 529 or a Coverdell education-savings account. If they make a mistake, they'll inadvertently lose other tax breaks, such as the Hope or Lifetime Learning credit, or the deduction for tuition and fees.

No double-dipping. You can qualify for the Hope or Lifetime Learning credit if you're married filing jointly and earn less than $114,000 in 2007, or if you're a single filer and earn less than $57,000. The Hope credit can reduce your tax bill by up to $1,650 per child in each of the first two years of college. But because you can't double-dip on tax benefits, you can claim the full credit only if you pay at least $2,200 of your college bills from a source other than a 529 or a Coverdell -- such as a custodial account or your own funds.

After your child's first two years of college, you may qualify for an annual Lifetime Learning credit of up to $2,000 per tax return. But you must pay at least $10,000 in college bills from a source other than a 529 or a Coverdell in order to receive the maximum credit.

Families who earn too much to qualify for the credits may be eligible to deduct tuition and fees. Joint filers earning less than $130,000 (or $65,000 for singles) can write off up to $4,000 in expenses. The maximum deduction is $2,000 if you earn less than $160,000 ($80,000 for single filers). Once again, that money must come from a source other than a 529 plan or a Coverdell account.