While college costs continue to rise faster than the level of inflation, parents and grandparents now have more tools than ever before to better afford this cost years before a child graduates from high school.To most parents, saving for their children's higher education costs can seem like a daunting task, which makes planning all the more critical.
In 2004, the College Board released a report that stated that most students and their families can expect to pay, on average, somewhere between $231 and $1,114 more for the 2004-05 college school year than they did in 2003-04 for tuition and fees. A 2004 CNN Money report stated that the cost of an average college education is rising at a level two to three times the rate of inflation. In addition, the average cost of a four-year private college is more than $80,000, and more than $40,000 at four-year public institutions.
The good news is that there is more financial aid available than ever before - over $105 billion for the 2003-04 school year, according to the College Board. Tax-deferred savings plans have made it much more advantageous for parents to plan ahead and develop an affordable strategy for sending their kids to college.
Section 529
A 529 is an education savings plan operated by a state or educational institution designed to help families set aside funds for future college costs. As long as the plan satisfies a few basic requirements, the federal tax law provides special tax benefits to the plan contributor.
These 529 plans are usually categorized as either prepaid or savings, although some have elements of both. Each state can choose how its 529 plan(s) are managed. Educational institutions can offer a prepaid plan, but not a savings plan (the private-college Independent 529 Plan is the only institution-sponsored 529 plan thus far).
There's a misconception that state-sponsored 529 plans are only geared to families that send their children to a state school. Recent tax law changes now permit higher education institutions to offer their own 529 prepaid programs. These will allow you to target your tuition prepayment to the sponsoring institution (or group of institutions). The Independent 529 Plan is the only such program currently in operation.
Among the advantages of 529 plans:
* Significant income tax breaks. Your investment grows tax-deferred, and distributions to pay for the beneficiary's college costs come out federally tax-free. This treatment applies for distributions in the years 2002 through 2010. Unless Congress decides to extend this, qualifying distributions made after 2010 will be taxable to the beneficiary (earnings portion only). Assuming the student is in a low tax bracket, significant savings can still be realized.
* The donor stays in control of the account. With few exceptions, the named beneficiary has no rights to the funds. You are the one who calls the shots; you decide when withdrawals are taken and for what purpose. Most plans even allow you to reclaim the funds for yourself any time you desire, no questions asked.
* Provides a hands-off way to save for college. Once you decide which 529 plan to use, you complete a simple enrollment form and make your contribution (or sign up for automatic deposits). Then you can relax and forget about it if you like. The ongoing investment of your account is handled by the plan, not by you.
Plan assets are professionally managed either by the state treasurer's office or by an outside investment company hired as the program manager. You won't even receive a Form 1099 to report taxable or nontaxable earnings until the year you make withdrawals.
If you want to move your investment around, you may change to a different option in a 529 savings program every year (program permitting), or you may roll over your account to a different state's program, provided no such rollover for your beneficiary has occurred in the prior 12 months.
* Everyone is eligible. The amounts you can put in are substantial (over $230,000 per beneficiary in many state plans). Generally, there are no income limitations or age restrictions.
Coverdell Savings Account
In 2002, the Coverdell Education Savings Account became a very attractive college savings vehicle for many people, including families that wish to save for elementary and secondary school expenses. In fact, even if you like the 529 plan, you may still decide to contribute the first $2,000 of savings for each child into a Coverdell account.
If you know how a Roth IRA works, then you have a pretty good idea of how a Coverdell Education Savings Account works. They both allow you to make an annual non-deductible contribution to a specially designated investment trust account. Your account will grow free of federal income taxes, and, if all goes well, withdrawals from the account will be completely tax-free as well. You will need to meet certain requirements in the years that you wish to make the contributions, and in the years that you take withdrawals.
The first thing to do is determine if you are eligible to contribute to a Coverdell account. The beneficiary of the account must be under the age of 18 at the time of the contribution. There is no requirement that the beneficiary be your child or have any other particular relationship to you.
Also, your income must be below a certain level in the year you contribute. Contributors must have less than $190,000 in modified adjusted gross income ($95,000 for single filers) in order to qualify for a full $2,000 contribution. The $2,000 maximum is gradually phased out if your modified adjusted gross income falls between $190,000 and $220,000 ($95,000 and $110,000 for single filers).
It is also important to note that a Coverdell account is an investment vehicle targeted to education expenses, not to retirement. With a Coverdell Education Savings Account, the trustee or custodian must administer the account for the benefit of the child. Any withdrawals from the Coverdell Education Savings Account are paid to the beneficiary, and are not refunded to the parent or other person who establishes the account.
Various considerations of the Coverdell savings account include:
* In 2002, the contribution limit increased from $500 per child to the much more reasonable level of $2,000. However, you need to be careful that accounts established by different family members for the same child do not cause total contributions to exceed $2,000, or else a penalty will be owed.
* The relatively low contribution caps mean that even a small annual maintenance fee could significantly affect your overall investment return.
* Your contribution goes into an account that will eventually go to your child if not used for college, which signifies the potential loss of control.
* The Coverdell account is on equal footing with the 529 plan when applying for federal financial aid. The account is considered an asset of the account custodian, typically the parent. Withdrawals are not reported as student or parent income as long as it is tax-free for federal income taxes.
* The account must be fully withdrawn by the time the beneficiary reaches age 30, or else it will be subject to tax and penalties.
There are many other options to consider when saving for a child's college education.
For example, investors who use IRAs to pay a child's qualified higher education expenses, such as tuition, fees, room and board at undergraduate or graduate school may find some significant tax breaks. A traditional IRA is appropriate for those investors seeking tax-deferred accumulation of interest, shelter from financial aid consideration and asset control.
Other college savings investment options include:
UGMA/UTMA
An annual gift to a child under the Uniform Gifts to Minors Act or Uniform Transfers to Minors Act is easy to create and can also work well as a college-planning tool. A custodial relationship is created under these acts when an individual, presumably a parent or grandparent, gives property to a child.
Although the child owns the gifted property, the custodian assumes full management rights and is required to invest the property for the benefit of the child in a prudent manner.
There are additional investment vehicles that you can use to save for a child's college education. Experts can provide more details on college savings options. Remember, college costs will only continue to rise, and historically they have risen at or above the level of inflation. So the time to prepare is as early as possible.
Kevin J. Delaere, CFP, CPA, is a partner with GK & Co. Financial Services in Troy, Mich.
