FOR OUR PARENTS – COLLEGE SAVING STRATEGIES

Do something today that your future self will thank you for. -Sean Patrick Flannery

As a tax professional, every year I get an influx of calls from clients requesting assistance in completing the FAFSA (Free Application for Federal Student Aid) forms as their children prepare for college. They are looking to secure grants, work study opportunities, and loans to fund their child’s college education. The aid is based on household income stated on the 1040 tax return. Some families with household incomes of $50,000 qualify for the federal Pell grant but most recipients are those families whose household incomes hover at about $20,000. However, most often the aid only satisfies a fraction of tuition, fees, etc.…required, depending on the institution.

The College Board reports the average annual cost of tuition and fees can range from just over $9,000 annually for in-state residents at public universities to more than $32,000 per year at private colleges. Multiply that by six years — the typical length of time it takes students to earn a bachelor’s degree, (U.S. Department of Education) — and you’re talking about a big number. And that doesn’t include housing, food and transportation.

Committing to a diligent college savings plan early can mean success later, based on small contributions over a long period of time. Several strategies are available to help you meet that goal. Consider the following options:

The 529 Plan
Savings accounts and CD’s
Coverdell Education Savings Accounts

529 college savings and prepaid plans

529 plans are the most popular education-specific savings plan for college. They come in two flavors: as an investment savings account or a prepaid tuition plan.

A 529 savings account allows you to invest in mutual funds or exchange-traded funds that carry the same risk/return profiles of other stock-and-bond-based investment accounts. Meanwhile, prepaid tuition plans allow you to effectively “lock in” tuition costs and avoid the impact of ever-increasing fees.

529 savings plans

529 savings accounts allow you to set aside after-tax contributions that grow tax deferred, like a Roth IRA but with much higher contribution limits. The proceeds can be used for qualified educational expenses, such as tuition, room and board, and books. Nonqualified expenditures will be taxed — and accrue a 10 percent penalty.

Before you invest, it’s a good idea to check your home state 529 plan first. Many states offer tax breaks or credits to residents, and some even kick in matching funding as an additional incentive. The savings can be used at any college for qualified education expenses, not just those located within the resident’s home state.

529 prepaid tuition plans

College tuition rises an average of 5% annually, according to the College Board. One way to “lock in” your tuition costs is by selecting a 529 prepaid tuition plan. By paying in advance all or part of the costs of attending a university — or, in some cases, a group of institutions participating in a plan — you can avoid future tuition hikes. For example, you might pay for eight semesters in today’s dollars; that will allow you eight semesters in the future, even if the costs at that time are higher. However, some educational systems have realized just what a bargain these have turned out to be and have terminated their prepaid plans. Therefore, these plans are few and far between and often only cover tuition and fees.

Pros:

High contribution rates, generally with no household income limits or age restrictions.
Beneficiary flexibility. The account can be designated, and changed in the future, for the benefit of any individual’s education expenses — even your own.

If the parent is the account holder, it is considered a parental asset, with little impact on financial aid awards.

Cons:

Since the 529 is dedicated strictly to educational expenses, if the money is used for other purposes, you will be taxed on the distribution.
Stock market exposure can impact returns in a down market

Tax Implications:

Contributions grow tax-deferred and distributions for qualified education expenses are tax free.

SAVINGS ACCOUNTS & CD’S

Nearly two-thirds of Americans use regular savings or checking accounts to set aside money for their children’s education, according to Sallie Mae. Although providing little in the way of interest, these accounts do offer flexibility, but that can also be a drawback. Tapping the accounts for non-college-related expenses with the hope of replenishing the funds later can result in a depleted college fund.

SAVINGS ACCOUNTS, CDS, AND U.S. SAVINGS BONDS

In these days of low interest rates, savings, certificates of deposit (CDs) and U.S. savings bonds have fallen out of favor. But for very conservative contributors, laddering such investments can still be an option, at least for a portion of the savings goal.

Series EE and I savings bonds feature an education tax exclusion allowing the interest paid to be excluded from gross income for bonds redeemed for qualified higher education expenses. There are some restrictions. Full details can be found at  TreasuryDirect.

Pros:

Investment flexibility

Cons:

Low returns; often less than the inflation rate

Tax Implications:

Interest earned on savings and CD’s is taxable

COVERDELL EDUCATION SAVINGS ACCOUNTS

Education Savings Accounts, or ESAs, are a bit like a 529 with training wheels. Yes, qualified withdrawals are tax free and, as with a Roth IRA, you can buy a wide variety of investments. But contributions are limited to $2,000 per year, and only until the beneficiary turns 18.

Although potentially meager in their growth potential, ESAs do offer more flexibility than 529 plans. Qualified expenses in Coverdell accounts can include educational expenses throughout the life of your child, from K-12 all the way through grad school.

Pros:

A wide variety of available investments and tax-deferred growth.

Cons:

The beneficiary changes are not as straightforward as with a 529 account and can vary by custodian — and all assets must be distributed to the beneficiary by age 30.

Tax Implications: