How to save for College
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A big reason kids cost so much money is because sending them to college isn't cheap -- roughly $137,000 today for four years at an Ivy League school. Paying for a child's college education is "the second-largest expense you have besides buying a house," said Ken Decker, a certified financial planner (CFP) in Houston. The numbers are grim and not getting better. "For the first time in 15 years, tuition hikes at public colleges and universities surpassed those of private institutions -- average tuition and fees for four-year public colleges increased at a rate almost three times that of inflation," said collegeboard.com Inc. And college costs include more than just tuition. You also need to include room, board, books, supplies, computer, parking (and parking tickets), transportation and personal expenses (like midnight pizza). How can you afford the bill? Saving in advance is a good strategy, and the earlier you start, the better. Even if you start late, it's worth it, because you will be able to defray at least part of this cost. Still, it can be tough to fit in college savings among all the other bills. And the choices of savings plans makes taking the SAT seem easy compared to choosing a plan. Here's a college savings prep course. Many parents wonder whether saving for their children's college education will hurt their chances of receiving financial aid when it comes time for college (assuming that they won't be able to save the entire amount necessary). The answer is, "Maybe."
When schools assess financial aid needs, assets in the child's name are given the most weight. Parents' assets are given less weight, and parents' savings in tax-deferred retirement accounts are not counted at all. As the following summaries explain, some savings plans count as the child's assets, while one (the 529 plan) counts as the parents' assets. Plan basics: This is the most widely advertised tax-advantaged college savings plan today. It gets its name from the section of the IRS code defining it. You contribute after-tax money, which grows tax-deferred and can be withdrawn tax-free to pay for qualified education expenses. (Some states allow 529 plan contributions to be deducted from state income taxes.) If you don't use the money for qualified education expenses, you'll have to pay income tax plus a 10 percent penalty on the earnings when you withdraw them. Generally, you have a choice of funds or pre-set portfolios reflecting different investment styles (conservative, moderate or aggressive) in which to invest the money. Originally, 529 plans benefited only in-state residents, but now, residents of any state can participate in any state's plan. All 50 states currently offer 529 plans. Advantages: High contribution limits. The IRS has no defined maximum contribution limit, and limits set by individual states range from $100,000 to $260,000. There are no income limits to qualify. Parents, relatives or friends can make contributions. You can switch beneficiaries easily, so if your son doesn't need the money, for example, you can redirect it to your daughter. Disadvantages: The large number of choices can be overwhelming. (More than 50 plans are available, as some states offer more than one.) Investment selections may be limited -- more limited than for a 401(k) plan, for example. The tax-free withdrawal provisions will phase out in 2010, unless Congress extends them. Financial aid implication: The assets are not the property of the child; they are controlled by the parent or benefactor. 529 shopping tips: Brian Orol, a certified financial planner with Strategic Financial Planning Group of Raleigh, N.C., offers a five-point checklist to use in comparing plans:
Plan basics: This is a type of 529 plan, sponsored by state governments, but is less known than the 529 savings plan discussed earlier. In this plan you pay college tuition at today's rate (either by installment payments or a lump sum) and your child's tuition will be fully paid by the time he or she reaches college. The state hires an investment manager who ensures that the money you contribute covers tuition costs by the time Junior enrolls in college. Some programs allow the savings to be used for other qualified education expenses, as well as private colleges and out-of-state colleges. Typically, the prepaid benefits don't fully cover tuition at private or out-of-state schools. For instance, with the state of Illinois' plan, if you have a two-year-old child, you could pay a lump sum of $18,949 for eight semesters (four years of college) today, and that will cover your child's in-state tuition when he or she is ready for college in 16 years. You could also choose an installment plan, which would be more expensive. Advantages: You don't need to manage investments and your costs are known. Investment gains are tax-free upon withdrawal, through the end of 2010, provided they are used for qualified tuition costs. (If not, you will owe income tax and a 10 percent penalty on the gains.) Parents, relatives or friends can make contributions. There are no income limits to qualify to contribute. This plan could be attractive to families with limited resources, because of the known costs and guarantees. Some states allow contributions to be deducted from state income taxes. Disadvantages: The benefits generally cover only in-state tuition costs at public universities and colleges in the state sponsoring the plan. If you live in California but sign up for Illinois' plan, for example, your child will likely have to pay out-of-state tuition. But the Illinois prepaid tuition plan only covers in-state rates. You or your child will have to make up the difference. Your child might not want to go to college in the state you select. This plan also may not be a good choice if you want to manage the investments yourself. The tax-free withdrawal provisions will phase out in 2010, unless extended by Congress. Financial aid implications: The plan assets are the child's property and are counted as such in determining need. Plan basics: Coverdell education savings account is the new name for the old misnamed education IRA. The maximum that a single account may receive in 2002 is $2,000; this can be contributed by more than one person. One person can contribute to more than one account. Contributors must meet the income limits described below. Contributions are made on an after-tax basis. The money grows tax-deferred and withdrawals are tax-free when used for qualified expenses. (If the money is used for another purpose, you must pay income tax and a 10 percent penalty on the earnings.) Money in a Coverdell must be withdrawn by the time the beneficiary reaches age 30. A 6 percent excise tax is assessed to the beneficiary if account contributions exceed IRS limits. Advantages: Wide investment choice. You can invest the savings any way that is offered by the financial institution housing the account, provided the IRS allows it. Savings can be used to pay for private elementary and secondary school, as well as college. You can easily change the beneficiary to another child. Parents, friends or relatives can make contributions. Disadvantages: This account will revert to the lower Education IRA contribution limits ($500) in 2010 unless Congress re-authorizes the higher limits. Of the different types of education savings plans, this one has the smallest maximum annual contribution limit. Contributors must meet IRS income eligibility limits. In 2002, only individuals with modified adjusted gross income (MAGI) below $110,000 and couples with MAGI below $160,000 may contribute to this account. Can adversely impact the child's ability to qualify for the Hope Credit. Financial aid implication: The account is considered the child's asset. Plan basics: UGMA is short for Uniform Gift to Minors Act, a fancy way of saying you are giving a child a gift. An UTMA is a Uniform Transfer to Minors Act and is similar to an UGMA. This is not a college savings plan per se, but rather a custodial account set up to hold gifts for children. The benefactor receives gift tax benefits and withdrawals are considered taxable income to the beneficiary. Advantage: Unlimited choice of investments, no limit on contributions that may be received. Benefactors may contribute no more than $11,000 in 2002 tax-free to the account, according to IRS gifting rules. Disadvantage: When the child/beneficiary reaches the age of majority (18 or 21 depending on the state) the money becomes his and he may spend it as he wants. Financial aid implication: The assets are the child's property. When developing a college savings strategy, you need to be realistic about how much you plan to contribute toward your child's education -- the entire cost, some of it, or nothing? "What I am seeing is more parents promising an education and not quantifying how they are going to do it," Decker observed. "Folks (now) in their 60s said, 'We will be impoverished for your benefit because we believe in education.' So, they bought small houses, small cars and didn't entertain much." However, the current batch of baby boomer parents about to send their loved ones off for higher learning haven't necessarily scrimped and saved like that, said Decker.
They may face some tough choices when trying to make good on their promise. They could cut back on spending. Or, they could redirect savings from other goals, such as retirement. (The latter choice is a bad idea, said financial planners interviewed for this article.) Some parents may not have either choice available, and may simply have to tell their children they'll have to pay for college on their own. Students can consider many ways to fund college: loans, work-study programs, scholarship, financial aid, and gifts from relatives. "You can always borrow for education -- you can't borrow for retirement," said Jay Stillman, managing consultant with savingforcollege.com. A practical reason to save for college is because some other sources of funds might eventually dry up. At a time when the federal government has returned to deficit spending, it's reasonable to question whether some of these outside sources of funds will be there. Indeed, laws coming out of Washington are making tax-advantaged savings plans more attractive.
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