Making smart choices when paying for college

Paying for college is never easy. And for many parents, coming up with the cash so that their child can attend the college of their dreams is one of the most daunting financial challenges they face.

The most important thing to keep in mind: While no parent wants to send their child off into the world with debt, the reality is that a 22-year-old college graduate has more time to pay off her debts and save for retirement than her 55-year-old parents. You may want your child to begin "adult" life with a small nest egg, but don't make financial decisions that can put your retirement financial independence in jeopardy.

For that reason, as tempting as it is, parents should avoid taking withdrawals from a 401(k) or other retirement account to pay for college. Not only might you pay an early-withdrawal tax penalty, you may never have a chance to replace those funds.

Also, use extreme caution if considering a loan from your 401(k) to pay for your student's education. It may be harder to pay these back than you think. You can obtain loans for college; you can't obtain loans for retirement.

Probably the second most important thing to keep in mind: For all sorts of reasons, your student should contribute to the financial costs of college. I'll just focus here on the financial benefits.

Consider this: the sooner your student spends the money that's in his or her name, the more financial aid he or she could receive in subsequent years. If your child has appreciated stock or mutual fund shares, he or she should sell those assets. Children typically pay capital gains tax at a lower rate versus the 23.8 percent rate for higher earning parents. So appreciated assets transferred to and sold by the student goes further than the same amount of appreciated assets sold by a parent.

Next, take inventory of the various financial accounts where you've stashed money for your student's education costs. Here are a few of the most popular types of accounts and what you need to know in respect to spending these for college costs:

Coverdell Education Savings Accounts: These are similar to the Roth IRA because the money withdrawn from a Coverdell ESA to pay qualified education expenses is tax-free. The money in an ESA is considered the child's assets for purposes of qualifying for financial aid. If you qualify for financial aid you may want to spend money in these accounts first. Also keep in mind that you can't claim expenses paid from money withdrawn from the ESA towards an education tax credit (I'll write more about these next week).

Savings Bonds: With interest rates hovering at historically low levels, Savings Bonds have a very low rate of return, so it's a good move to spend this money and allow other investments to grow. Since the earnings on savings bonds purchased after 1989 are tax-free when used to pay for education expenses (certain income restrictions apply), you can't claim the same expenses for the education tax credits.

529 Plans: These savings plans have become super popular. According to the College Savings Plans Network, parents have stashed over $227 billion in 529s as of the end of last year. The average balance in a 529 plan account is about $19,500. Like the ESA, tuition and fee expenses paid for with tax-free earnings withdrawn from the 529 can't be claimed toward the education tax credits. It may make more sense to allow this money to grow as long as possible before spending it.

You may want to speak to a financial adviser about the best way to withdraw funds from these accounts given your particular situation.

Finally, if you find yourself out of savings, there are a few financing strategies to consider. First, try making a second request -- nearly half of all updated requests result in higher financial aid rewards.

You can also look into extended payment plans, which allow you to pay tuition in monthly installments instead of in a lump sum at the beginning of the semester. Many universities and colleges offer these plans. Typically, they outsource billing to third-party companies that service these extended payment plans for an annual fee of about $50.

Lastly, consider a home equity line of credit and put that money into a retirement account. Saving for retirement won't be held against you, and if you have a significant amount of home equity, you'll qualify for less financial aid.

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.