Financing Your Future
Tips on Saving for College
My dramatic daughter, Bethany, was five years old and playing next door at a friend's house when I suddenly saw her run in the door, up the stairs to her room, and throw herself on her bed, crying. I hurried up to see what was wrong.
“Why are you crying, Bunny?” I smoothed her hair as the tears flowed without restraint.
She sat up in bed, looked me full in the face. “I don’t want to leave you, that’s why.” Then the waterworks started afresh.
I struggled to follow her line of reasoning. “What do you mean by ‘leave me,’ Sweetie? You’re not going anywhere.”
“Oh yes I am! I’m going to have to go to COLLEGE,” she sobbed.
It’s not easy to track with a Bunny, so by the time I got to the bottom of the story, I discovered that our neighbors had their oldest son going to college and his younger sister, who was Bethany’s playmate, was very upset by the thought. In our five year old’s mind, she was next.
Fast forward twelve years to 2008 and guess what? Bunny’s hopping off to college this year. The jury is still out on where she will go, but we’ve launched two boys before her who will graduate debt-free (from the University of Texas and from the United States Naval Academy) and our goal is to have Bethany debt free as well.
A big question on consumers' minds, especially in light of the current economy, is this: how do we put our kids through college?
First Things First
In any discussion of college costs, it’s important to keep priorities straight. Parents should try to avoid borrowing on their future in order to pay for their child’s future. This means it’s best to avoid college funding options that would include a home equity loan, a HELOC (home equity line of credit), or the refinancing of an existing home mortgage. These options would reduce the amount of equity in the home, increase the risk of possible foreclosure, and incur costs in interest charges that may cost more if the term on the new mortgage is greater than the remaining term on the existing mortgage for example, if there is ten years left on the mortgage and parents get a new 30-year loan. Furthermore, if parents choose to pull out enough money in equity for the first year or for four years of college all at once, then parents are paying interest on money that won’t be needed until the upcoming sophomore, junior, and senior years.
Savings Plans for Every Family
Saving for college is a highly individualized task. It will vary based on many different factors including income levels, the number of children, the amount of savings in existence, and the number of years left before a child starts college. Here’s a guide to the most popular investment tools:
- UGMA – Uniformed Gifts to Minors Act – Parents of young children can start saving now for education but do it the tax-smart way. By investing in a UGMA in a child’s name, income is taxed at the child’s marginal tax bracket rather than the parents'. The account must be registered in the child’s name. An adult (usually a parent or grandparent) serves as custodian and is responsible for investing and managing the assets. But the child is the "beneficial owner," meaning the assets really belong to the child. At age 18 (in most states), control of the assets must be turned over to the child (which could be a disadvantage for this plan when it comes to financial aid qualifications.)
All states offer UGMAs, and many have adopted the Uniform Transfers to Minors Act, or UTMA, as well. A UGMA allows children to own stocks, bonds, mutual funds, and other securities; while a UTMA allows the children to also own real estate. Under UTMA, parents can delay giving the assets to the child until age 21.
According to Jeff Schnepper of MSN Money, “If your 2-year-old son has interest income of $700, the tax on that is zero. If he had income of $1,400, the next $700 is taxed at his 10% rate. If you’re in the 30% bracket in 2002, the tax on the $1,400 total would be $420. Your son is only paying $70, so you’ve just saved $350 more for his college education.”
- EE US Savings Bonds – If income from these bonds is used to pay for education expenses, then that interest may be excluded from taxes. But this exclusion is phased out beyond certain income levels.
- Zero Coupon Bonds – The interest on these bonds is deferred until they mature, when it is paid in a lump sum. Parents do have to pay income tax on interest as it accrues each year the bond is held. It’s often wise to "ladder" these bonds, where the bonds come to maturity in each year of the child’s college career.
- 529 Plan – This 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 you, the plan participant (Section 529 of the Internal Revenue Service ). The 529 plans are usually categorized as either prepaid or savings, although some have elements of both. Every state offers a 529 plan and it’s up to each state to decide what it will look like. Educational institutions can offer a 529 prepaid plan but not a 529 savings plan (the private-college Independent 529 Plan is the only institution-sponsored 529 plan thus far). Parents can invest in any state’s plan, no matter where they live. And regardless of what plan they choose, their beneficiary can attend any college or university in the country. What’s more, grandparents or other benefactors can contribute money to a 529 plan. However, they may crimp a child’s ability to get financial aid in the future. It is important to review the state ratings for residents and non-residents, as some are rated better than others. These plans are growing in popularity, and it is projected that there will be a total of $175 billion to $250 billion invested in 10 million to 15 million accounts by the year 2010.
- Coverdell Education Savings Accounts – The Coverdell ESA will allow up to $2,000 of pretaxed income to be invested annually if the modified adjusted gross income is less than $95,000 as a single tax filer, or $190,000 to $220,000 as a married couple filing jointly in the tax year in which the money is contributed. The $2,000 maximum contribution limit is gradually reduced if the modified adjusted gross income exceeds these limits. There are limits on how much can be invested based on income and the funds must be spent before the child turns thirty. This education IRA will not interfere with the parents’ ability to invest in a tax-deferred annuity in their own retirement account. But it will count heavily against the student when financial aid packages are calculated.
Jay Stillman, a consultant for Saving For College says “Because Coverdell IRA funds can be rolled over into a 529 without penalty, parents can sidestep its principal drawbacks—the age limit and the fact that the IRA counts as the child’s asset, which can adversely affect his ability to receive need-based loans.” Therefore, a Coverdell account may be the best single investment option for parents whose income is below $50,000. The accounts are easier and less expensive to set up than 529 plans, and people in this lower tax bracket aren’t usually able to take advantage of the maximum lifetime contributions allowed under a 529, which range from 110K to 305K because they don’t pay that much tax in the first place.
- Prepaid Tuition Plans – They are prepaid similarly to a 529 plan but they are less risky. They allow parents to pay tomorrow’s expenses at today’s prices, either by the year or by the credit hour. The drawbacks are that even though parents can often transfer some of these plans to other state colleges or private tuitions—those schools do not guarantee the same services and prices. Thus, college students could come up short. Contributions to prepaid plans might also reduce a student’s eligibility for financial aid on a dollar-to-dollar basis, more than with a 529 plan. If the child does not attend college, the contributions are refundable, but there might be a cancellation fee and/or loss of interest earned. It’s important to compare 529 plans to find the plan that works best for different families. These plans are best if (1) parents don’t expect to qualify for financial aid, (2) parents are conservative or novice investors, and (3) parents understand the risks.
- Financial Aid Office – The university’s financial aid office is a clearinghouse of information. A good aid office will not only help students determine what loans they qualify for, but they will steer them to participating lenders who are offering the best terms and service. Parents can do their own assessment at paying for College Web page calculator.
Filling out the FAFSA (Free Application for Student Financial Aid form) is the first step in applying for aid that includes: 1) need-based guaranteed loans (Stafford Loans are variable, while Perkins Loans are fixed.) 2) Grants—the Pell Grants and the Federal Supplemental Education Opportunity Grant each provide a gift of up to a designated amount per student per student year. 3) Work-study. Students can receive up to $2,000 per year, 25% of it matched by the participating institution, from the federal work-study program.
There are also state loans and grants available and the financial aid office should be able to quickly assess the student’s eligibility.
- Scholarships – Millions of dollars of scholarship money go unclaimed every year. This is free-lunch money that parents or prospective students who are willing to do some detective work may find more quickly than they think. Fast Web.com has over 1.3 million scholarships to research. Don’t forget to have students apply to local civic organizations and community scholarships as well—the high school counselor should have a list of these scholarships.
Ellie Kay is a national radio commentator, a frequent media guest, a popular international speaker, and the best-selling author of ten books including her most recent release, A Tip A Day With Ellie Kay: Twelve Months Worth of Money Savings Ideas (Moody, 2008).
For money savings links or to subscribe to Ellie’s free newsletter, go to www.elliekay.com.
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