Preparing for the Eventuality That Is: College

IT'S NICE TO SHARE:

You think tuition is stratospheric now? Imagine how expensive it will be by the time your kids come of age. Do yourself – and your offspring – a favor by putting some thought and savings into their higher education costs…starting now.

Here are some options to consider:

529 Plan

There are two types of 529s: college savings plans and prepaid tuition plans. Both share the same federal tax advantages, and yet they are not the same. With a college savings plan, you can use the funds at any college that’s accredited by the U.S. Department of Education. A prepaid tuition plan can only be used for undergraduate tuition at public colleges in your state. But that’s not all. Let’s take a closer look at the pros and cons of each.

Pros:

  • Both types of 529s offer Federal and state tax-deferred growth
  • If the money is withdrawn to pay for college, earnings are not subject to federal income tax
  • States can add their own tax advantages to 529 plans; a few of them even provide matching scholarships or matching contributions
  • 529s are open to anyone, regardless of income level and you don't need to be a parent to set one up
  • With a college savings 529, there is no age or time limit on when the withdrawal must be made

Cons:

  • With a college savings plan, you can choose from a variety of investment portfolios, but you can't direct the underlying investments
  • With a prepaid tuition plan, you don't pick anything…that’s only in the hands of the plan’s money manager
  • College savings plans don't guarantee your investment return, plus you can lose some or all of the money you’ve contributed
  • Prepaid tuition plans guarantee your investment return, at the very least; it’s just that the benefits paid out might change due to projected actuarial deficits
  • Using money in your 529 plan for something other than college will cost you: a 10 percent federal penalty, plus state penalties
  • You'll also pay income taxes on the earnings if the plan’s funds are not used for college…you might even forfeit your earnings entirely
  • Prepaid plans have a ‘use by’ date: your kid must be college-bound by the time he or she reaches age 30
  • Both types of 529 plans may charge annual maintenance fees, administrative fees and investment fees

Coverdell Education Savings Account

Tax-wise, the Coverdell ESA is treated like a 529…with a few key exceptions.

Pros:

  • A Coverdell ESA allows for greater investment flexibility
  • Education-related withdrawals are exempt from state income tax, depending on the tax laws in your particular state
  • Education-related withdrawals are not limited to college and can be used for uniforms, books, school-supplies and more, even at the elementary school level

Cons:

  • While 529s do not usually limit contributions, Coverdell ESAs do ($500 per child is the maximum annual contribution limit)
  • Coverdell ESAs must be used by the time the beneficiary turns 30, or turned over to another family member to avoid taxes and penalties
  • The income level of a donor determines whether or not he or she can make contributions
  • There may be fees associated with opening and maintaining this kind of account

U.S. Savings Bonds

Easy to purchase, backed by the full faith and credit of the federal government, it’s no wonder they’re so attractive. Like 529s, there are two types: Patriot bonds and Series I bonds, which are popular college savings vehicles.

Pros:

  • Any interest earned is exempt from state and local tax
  • Federal income tax can also be exempt, provided your modified adjusted gross income (MAGI) falls under a certain level
  • Fee-free, unless you purchase the bond through a broker

Cons:

  • Bond proceeds must be used to pay for qualified education expenses to avoid penalties
  • Return potential is lower than 529s because stocks generally perform better over time, though past performance does not guarantee future results

Mutual Funds

Investing in mutual funds was once the popular way of saving for college. That was before 529s and their tax-sheltered growth and tax-free withdrawals came on the scene. Still, there are pros…and cons.

Pros:

  • If assets are withdrawn for non-educational expenses, mutual funds do not impose restrictions or penalties
  • Mutual funds allow for greater flexibility and control over investment decisions

Cons:

  • The tax factor can cut into mutual fund returns: you'll pay income tax every year on income earned by your fund, even if it’s reinvested
  • When you sell shares, you open yourself up to Capital Gains tax

Custodial Accounts and Trusts

With custodial accounts and trusts, assets are held in your child's name. You or another custodian manages the account until your child reaches 18 or 21. After that he or she has complete control over the funds.

Pros:

  • While funds can be used for education, withdrawals are not subject to penalties if used for non-educational expenses
  • There are no funding restrictions
  • Total flexibility and control over investment choices
  • In the case of custodial accounts, they are generally fee-free

Cons:

  • Subject to so-called “kiddie tax” rules, meaning your kids will be taxed at your rate
  • Trusts are costly and complicated to set up

There is some hope (as in credits) down the line

When you pay for certain higher education costs, you can claim two types of tax credits: the Hope credit (now called the American Opportunity credit) and the Lifetime Learning credit.

Each depends on the amount of qualified tuition and related expenses you pay, as well as your MAGI (remember: modified adjusted gross income).

There are a lot of expenses to plan for when it comes to college. Inevitability you’ll get that call of: “um, can you guys send money for textbooks?” Good thing you prepared them for the real world.