The cost of college. Four simple words that strike fear in the hearts of parents everywhere. However frightening the skyrocketing costs of sending a child to a top-tier private college, there’s good news. The growth of college costs is finally cooling down, and even better, a little planning goes a long way towards contributing to this expense. In this section we’ll discuss:
- Why you should start saving for college expenses as early as possible
- Special savings plans for education
- How to choose the best investment plans with an eye towards financial aid applications
- Tax breaks for parents with kids in college
Regardless of the method you choose, saving for your child’s college education is like any other investment. The time to start is now. The sooner you start, the better the chances your money will increase substantially and enable you to pay for your child’s education with ease. Use a Saving for a College Education Tool to help you plan how much money to put aside for the colleges you are interested in.
Understanding Savings Plans
Parents can choose between several different saving and investment plans designed to help save for their children’s future education. Choosing the right plan depends largely on your income and your ability to save. Below you’ll find a summary of the available plans.
UGMA – Uniform Gifts to Minors Act is a custodial account placed in your child’s name and Social Security number, with a parent named as custodian. While this plan offers financial benefits, there are some drawbacks in terms of ownership and qualifying for financial aid.
The Education IRA has been given a new moniker: the Coverdell Education Savings Accounts. The Coverdell ESA allows for a maximum annual contribution of $2,000 per student. The earnings in the account grow tax-free as long as distributions are used for eligible expenses, which are not limited to college costs. See Tax Topics for more details.
Roth IRA Accounts – This is a good investment strategy that works for parents who will be at least 59 ½ years old when their kids are in college. You can invest up to $5,500 a year, at least 3 times the amount of an education IRA allowing for accumulation potential.
Section 529 College Savings Plans – There are numerous advantages to the 529 Qualified Tuition Savings Plan, including the fact that the federal tax advantages can save you thousands. They are currently offered by various states, through the help of a professional money manager or a State Treasurer’s Office. The plans can be extremely different, and so it pays to ask questions.
Investing for College
Once you’ve surpassed contribution limits to these special savings programs, there are other investing strategies that help pay for college.
While these separate investments may not have special tax-advantaged status, there are ways to minimize the effect of capital gains taxes. For example, if you have made long-term investments in the stock market, you can give your child enough stock to pay for their tuition bill. When your child sells the stock, they pay the long-term capital gains taxes at their lower tax rate.
What kind of investments should you make? There are a number of things to keep in mind when designing a portfolio to pay for a future college education:
- Choose a diversified mix of stocks.
- Stocks with dividend reinvestment plans are ideal.
- No-load mutual funds are good choices.
- The younger your child, the more aggressive you can afford to be.
Ted Miller, editor of Kiplinger’s Personal Finance magazine, recommends the following course of action: 4 years before freshman year, sell enough stock (and bank the money) to pay for the first year, repeat this practice for the next four years so that by the time your child is ready to start, you have the money cashed out and waiting.
Education Tax Credits
Once your child is grown and attending college, there are currently 2 options that offer a measure of relief:
With the Hope Scholarship, families can receive a tax credit of up to $2,500 a year for the first 2 years of college. This credit applies against college costs like tuition and fees–books and room and board do not qualify. There are income restrictions on using this tax credit: single filers can earn up to $80,000 before the phase-outs begin (they end at $90,000) and joint filers can earn up to $160,000, with phase-outs at $180,000.
The Lifetime Learning Credit offers a $2,000 tax credit taken for the third school year and beyond. It is per family not per student. The credit can be used by both college students and adults to offset the cost of professional seminars and adult-education courses. The income limits are as follows: $55,000 before the phase-outs begin (they end at $65,000) and joint filers can earn up to $110,000, with phase-outs at $130,000.
You can only claim one of these credits on any given tax year, but during years in which you make withdrawals from an Education IRA, neither of these credits may be claimed. For current information visit the U.S. Department of Education website on HOPE Scholarship and Lifetime Learning Credits at http://www.ed.gov/inits/hope/.
Their College vs. Your Retirement
Trying to save for your children’s college education and your own retirement at the same time seems like a recipe to shortchange both. What to do? Pay yourself first. Financially, it usually makes more sense to fully fund your 401(k) or other tax-deferred retirement plans and grow that money tax-free. Why? These plans reduce your taxes, grow tax–deferred, and if your employer offers matching funds, you get a substantial return right away.
When you have college bills to pay, you may be able to borrow against your retirement plan to pay for some of your kid’s education. Many 401(k)s and profit-sharing plans let you borrow up to half of the funds in your account, to a maximum of $50,000. But the requirements for these plans vary widely; make sure to investigate the particulars surrounding your retirement plan.
Should You Borrow from your 401k? Use this calculator to learn that it could cost you 1/3 more to replace the funds you took out of your 401k because their were pre-tax dollars and the funds you will be returning back to the 401K (after borrowing them) are post-tax and based on your effective tax rate. Visit http://www.401khelpcenter.com/ for an unbiased information on 401k’s.