What happens if I get a lot of financial aid from my college and then a big scholarship from a local community group? Will the college reduce my aid?

College scholarships are offered by thousands of organizations, including community groups, private companies, and non-profit foundations. Colleges refer to these types of scholarships as "private" or "outside" scholarships. Most colleges require students to notify the financial aid office if they receive an outside scholarship.

Every college has its own policy on the impact of outside scholarships on your financial aid award. Most colleges will reevaluate your financial aid and — depending upon their policy — may reduce your award.

Many colleges will reduce self-help aid (loans and work-study) before reducing gift aid (the college's grants and scholarships). Other schools reduce gift and self-help aid equally. Some colleges will not reduce your aid at all. To find out a college's outside scholarship policy, check the financial aid section of the college's website or contact the financial aid office directly.

Let's look at an example. Say three colleges each award you a financial aid package of $20,000. All aid packages contain 25% self-help aid and 75% gift aid. You then receive a $5,000 outside scholarship. Look what happens to the aid package when colleges respond differently.

College B offers a better aid package than College A, since it reduced your self-help more than your gift aid. College C offers the best package, since it didn't reduce your aid at all.

Factors that can influence how a college adjusts your award include whether aid is merit or need-based, any unmet need, your EFC, and the college's cost of attendance.

If you receive outside scholarships, discuss the situation with the financial aid office. The college may be able to make adjustments that minimize the impact on your financial aid.

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I am thinking of opening a 529 account to save for my child's college education. Is it true that the investment gains will be tax free?

529 savings plans are popular options for families saving for college. One incentive is a tax break. Investment gains are not subject to federal tax if the money is used to pay for qualified college expenses. (Similar tax breaks are offered by some states.)

In order to get the full benefit of the tax break, however, it pays to understand the 529 rules. At their heart is the definition of "qualified" college expenses. For 529 accounts, the definition is relatively broad. It includes tuition, living expenses, books, supplies, etc. But you must be careful to withdraw and spend your 529 money according to the following rules.

• The 529 money must be used to pay qualified college expenses. You will owe income tax and a 10% penalty on your gains if you do not use 529 money to pay for unqualified expenses. (The penalty may be waived if the student gets a scholarship that causes the 529 withdrawal to exceed eligible expenses, the student is disabled, or you roll the account over to another student in the family.)
• The amount you withdraw should not exceed the amount of your qualified expenses. If you withdraw more money than the total of your qualified expenses, the gain included in the excess amount is subject to tax.
• Withdrawal should take place during the year expenses are incurred. If you use 529 money to pay qualified expenses for a certain year, but withdraw it before or after that year, you will owe income tax and 10% penalty on your investment gains.

Certain circumstances can reduce your qualified expenses and could result in tax owed.

• Student receives tax-free scholarships or grants. The amount of the tax-free scholarship or grant must be deducted from the total qualified expenses.
• Parents take an education tax credit or the tuition deduction. The qualified expenses you used for the credit or deduction must be deducted from the total qualified expenses.

How could a reduction in qualified expenses affect tax liability on your investment gains? Let's say you withdrew enough money from your 529 account to cover your child's qualified expenses for one year. Then your child received a tax-free scholarship or you took an education tax credit or tuition deduction on your tax return. Your 529 withdrawal now exceeds your qualified expenses and you will owe tax on the gains in the excess amount.

You are off to a good start on a savings strategy for your child's college education. With careful planning you can build a healthy nest egg while minimizing potential taxation.

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