What to do when the tuition bill is due

As summer winds down, parents are getting ready to send their students to college -- and to get notices that tuition payments are due.

By now you’ve likely made a list of the various financial accounts that you could use for your student’s education costs. Some of the most common are 529 plans, savings bonds and IRAs.

Here are some things to think about before you send a check for this semester’s tuition.

If you’ve been a good planner and saved money in a 529 education savings plan, now’s the time to consider taking a withdrawal. Distributions from 529 Plan accounts to pay for qualified higher education expenses (QHEE) are tax-free when used to directly pay to the college or to reimburse the account owner (which is typically the parent) for college costs incurred during the year.

QHEEs include tuition, room and board (the specific amounts colleges list) and fees, books, supplies and equipment the school requires. If you withdraw more than the specified amount from a 529 plan account, the excess is a nonqualified distribution, which you’ll have to report as taxable income and pay a 10 percent federal penalty tax on the earnings portion of the nonqualified distribution. (The principal portion of a nonqualified withdrawal isn’t subject to tax or penalty.)

Because it can take a few weeks to process a withdrawal, contact your 529 plan provider now to inquire about the necessary steps, which could be done online or by using a request form. You’ll need the name and address of the college’s bursar’s office where the payment should be sent.

Also, if you own any U.S. savings bonds, consider cashing them in. The earnings on savings bonds purchased after 1989 are tax-free when used to pay for education expenses, but income restrictions apply. Another thing to keep in mind is that you can’t claim the same expenses you paid using savings bond proceeds toward education tax credits.

I suggest that parents spend down savings in taxable accounts or even borrowing from a home equity line of credit before taking withdrawals from IRAs or borrowing from 401(k)s to pay for college costs. One reason is that withdrawals from IRAs are taxable as income. But it’s true that IRA withdrawals used for higher education expenses are exempt from the 10 percent early-withdrawal penalty.

To be eligible for this exclusion, the distribution must be used for education, and the expenses must be for yourself, a spouse, child or grandchild. With funds withdrawn from an IRA, you can pay for books, tuition and other qualified education expenses without a penalty, but the student must be enrolled more than half-time at an eligible institution, as defined by the U.S. Department of Education.

Parents should avoid taking loans from a 401(k) or other retirement account withdrawals to pay for college. While a loan from your 401(k) might seem like a good idea, replacing those funds may not be as easy as you think. In addition, if you change jobs your 401(k) typically must be repaid at that time. Unpaid loans are treated as withdrawals and are taxable income in the year the loan is declared in default.

Remember: You can obtain loans for college, but you can’t get a loan for retirement.

If you don’t have any of these options, ask the college about a payment plan. Many institutions offer programs that allow monthly installments to pay for tuition instead of a lump sum at the beginning of a semester. Typically, schools outsource third-party companies to service these extended-payment plans for an annual fee of about $50.

  • 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.