Which College Savings to Tap First

Don't rush to your 529 account just yet. For school expenses this year, cash out taxable assets before a new law may apply higher tax rates to that money in 2008.

Our son just turned 18 and starts college this fall. We will need to sell stock at some point to pay for tuition -- some is in a custodial account that we've had for a long time and some is in our own accounts. Should we sell the stock now and use it for college bills or spend money from his 529 account? We are stunned that college is actually right around the corner and appreciate any guidance.

Because of a new kiddie-tax law that was passed just a few weeks ago, now is a particularly good time to sell stock in your son's account. In the past, certain investment income from a child's custodial account was taxed at the parents' higher rate until the child turned 14. That age increased to 18 in 2006. This year, the first $850 of a child's investment income is tax-free and the next $850 is taxed at the child's rate (generally 5% for long-term capital gains). Then investment income in excess of $1,700 is taxed at the parents' higher rate (generally 15% for long-term capital gains) if the child is under age 18.

But Congress just changed the age again. Starting in 2008, that investment income will be taxed at the parents' higher rate until the dependent child reaches age 19, or 24 for full-time students.

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Parents whose children are from age 18 to 23 by the end of 2007 may want to sell at least some of their child's assets before 2008, while they're still taxed at the child's rates. Parents may also benefit from giving children in the 18 to 23 age range appreciated assets that they can sell this year, when the profits will be taxed at the child's lower rate.

That means for you it can be a good idea to tap your son's custodial account first for this year's college bills. And you may also want to transfer some of your own investments to your son so he can sell them before the end of the year and get the lower tax rate. For more information about the new law, see Congress Closes Kiddie-Tax Loophole.

Then you can pay many of the future college bills from the 529, where withdrawals continue to be tax-free if used for qualified education expenses.

Tax matters for 529s

But you need to be aware of a few other tax laws when deciding how much money to use from a 529 for college bills each year, because you could give up valuable tax breaks if you withdraw too much money from a 529 in one year.

If you pay all of the college bills for any year from a 529 or Coverdell education savings account, you could give up your chance to take the Hope or lifetime learning credit or the tuition and fees deduction on your income tax return. That's because withdrawals from those accounts are already tax-free for college costs, and you can't double dip on tax benefits.

You can qualify for the Hope and lifetime learning credit if you're married filing jointly and earn less than $114,000 in 2007, or $57,000 for single filers. The Hope credit can reduce your tax bill by up to $1,650 per child in each of the child's first two years of college. But you can claim the full credit only if you pay at least $2,200 of the college bills from an account other than a 529 or Coverdell.

After your child's first two years of college, you may qualify for the 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.

If you earn too much money to get those credits, you may be able to take the tuition and fees deduction, which lets you deduct up to $4,000 in college bills for the year. To qualify for the full deduction, your adjusted gross income must be less than $130,000 for joint filers, or $65,000 for single filers (joint filers earning up to $160,000, or $80,000 for single filers, can take a partial deduction). If you are in the 25% tax bracket, this deduction can lower your tax bill by up to $1,000. For more information, see IRS Publication 970 Tax Benefits for Higher Education.

Kimberly Lankford
Contributing Editor, Kiplinger's Personal Finance

As the "Ask Kim" columnist for Kiplinger's Personal Finance, Lankford receives hundreds of personal finance questions from readers every month. She is the author of Rescue Your Financial Life (McGraw-Hill, 2003), The Insurance Maze: How You Can Save Money on Insurance -- and Still Get the Coverage You Need (Kaplan, 2006), Kiplinger's Ask Kim for Money Smart Solutions (Kaplan, 2007) and The Kiplinger/BBB Personal Finance Guide for Military Families. She is frequently featured as a financial expert on television and radio, including NBC's Today Show, CNN, CNBC and National Public Radio.