Certainly the lost earnings potential for those with only a high school diploma is enormous. A person with a college education earns $23,000 more each year, on average, than does a person with only a high school education.
But the costs of college can be daunting, even for affluent families. And the cost of a college education continues to increase faster than the rate of inflation.
If your child is enrolling now, four years of tuition and fees at a private college will cost you approximately $100,000.
For a child born now, estimates are that the same tuition and fees will likely rise to $300,000. That doesn’t include room and board, books, travel costs, a computer (or other future technology), and necessary supplies.
As a result, the cost of a college education requires a bit of long-term planning. Fortunately, there are a variety of tax-advantaged savings plans and other financial strategies to help.
Expected Family Contributions for Financial Aid
Financial aid formulas vary from school to school and will change over time. Nevertheless, as a general guideline, you will be expected to contribute the following to fund your educational expenses:
Student―20 percent of assets and 50 percent of income
Parents―between 2.6 and 5.6 percent of assets, and between 22 percent and 47 percent of income
529 Plans [Qualified Tuition Plans]
One of the most common approaches to saving for college is the 529 plan. As of the end of 2007, the amount of money invested in these plans nationwide approached $12 billion.
Authorized by Section 529 of the Internal Revenue Code, 529 plans provide a tax-advantaged means to save for a child’s college education. Anyone, regardless of income level or relationship to the child―e.g., parent, grandparent, aunt or uncle, family friend―can set up an account.
You don’t get a federal tax deduction for your contributions to the plan, but earnings grow tax-free. As long as the money is used for qualified post-secondary education, the distributions are also free of federal income tax. However, unqualified withdrawals are subject to federal tax and a ten percent penalty on earnings. The state tax implications vary by state and plan, and gift taxes may also apply. Generally, there are also administrative costs and fees associated with these plans.
Beginning July 1, 2009, student-owned 529 plans are treated as parental assets when it comes to financial aid. This can be beneficial as parents are generally expected to contribute a significantly smaller percentage of their assets towards college costs than are students, as described above. A grandparent-owned 529 plan, on the other hand, is not considered in calculating the expected family contribution for financial aid. And although the 529 plan can only have one owner, others may contribute funds to the plan as well.
There are two types of 529 plans, as follows:
Prepaid tuition plans
These plans allow you to buy units representing future tuition at a participating college or university, thereby locking in tuition―and sometimes room and board―at current prices. Many of these programs are sponsored by state governments, and often the state guarantees the plan investments. Because of the state involvement, residency requirements often apply. Enrollment periods may be limited, and there may be age or grade limits for the child.
College savings plans
These plans provide the account’s owner with a variety of investment options within the mutual funds universe―such as index funds, age-based portfolios, and strategic portfolios―to save for college. The plan invests the funds, which you can subsequently withdraw to pay expenses at any college or university. The funds in the plan are not federally insured and generally not guaranteed by the state. Unlike prepaid tuition plans, prices are not locked in.
Benefits of 529 Plans
Tax-free growth is an obvious benefit. Perhaps less obvious is the resulting ability to shelter income from the kiddie tax. The kiddie tax refers to federal income tax rules that require a child’s unearned (investment) income―including interest, dividends, and capital gains―to be taxable at the parent’s higher marginal federal tax rate, if age requirements and certain other criteria are met. Before 2008, the kiddie tax applied only to children under the age of 18. Beginning in 2008, however, the tax has been expanded to include children age 18 (if earned income does not comprise more than 50 percent of the child’s support) and children age 19 through 23 (if the child meets the support test and is also a full-time student).
There are also a number of important estate and gift tax benefits. A 529 plan allows you to bunch your annual tax-free gifts. Under ordinary circumstances, you can give up to $12,000 to a child each year before utilizing your lifetime gifting exemption. If, however, you give to the child’s 529 plan, you can provide an up-front gift equal to five years’ worth of annual gifts―or $60,000―before using your lifetime gifting exemption.
The gift also generally reduces the estate of the person making the gift―a grandparent, for example. The gift may be reversed at any time and the beneficiary can also be changed (within the family, including cousins), providing important flexibility. In some states, the assets of the 529 plan are not available to creditors. In addition, the use of a 529 plan avoids the direct transfer of assets to the child.
Other Tax-Advantaged Strategies for College Funding
In addition to a 529 plan, there are a number of other tax-advantaged options that can help you fund a college education, including the following:
Coverdell Education Savings Accounts (ESAs)
Much like a Roth IRA for education, you can contribute up to $2,000 per year, per minor child, in order to cover elementary and secondary school expenses.
To qualify, your modified adjusted gross income for 2008 cannot exceed $95,000 if you are single, or $190,000 if you are married and file a joint return.
Although you do not get a federal tax deduction for your contributions, the earnings grow free of federal income tax. The withdrawals are also free of federal tax, as long as you continue to satisfy ESA requirements.
All funds in the ESA must eventually be distributed to the child, whether or not used for college. Any funds remaining in the account after the child reaches age 30 are subject to tax and penalties. (The ESA contribution limit is reduced to $500 after 2010, and some of the ESA benefits are set to expire at the same time, unless Congress acts to extend them.)
Hope Scholarship Credit
If your child is participating in a degree program at least half-time, and has not completed his or her second year as of the beginning of the tax year, you may qualify for a federal tax credit.
The amount of the Hope Scholarship Credit is equal to 100 percent of the first $1,200 you pay for college tuition and fees, and 50 percent of the next $1,200―with a maximum annual credit per child of $1,800. The amount of the credit begins to phase out if you are single and your income in 2008 exceeds $48,000 or you are married filing jointly and your income exceeds $96,000.
To qualify for the credit, your child cannot be declared as a dependent on someone else’s federal tax return.
Lifetime Learning Credit
The Lifetime Learning Credit applies to tuition and mandatory fees that you incur on behalf of yourself, your spouse, and your dependent children. There are no requirements mandating a degree program or half-time-or-greater participation, and there are no limits on the number of years you can take this credit.
For 2008, the credit is equal to the 20 percent of up to $10,000 in qualifying costs. It is subject to the same income phase-outs as the Hope Scholarship Credit.
You cannot claim both Hope Scholarship and Lifetime Learning credits for the same student in the same tax year.
U. S. Savings Bonds
You can redeem EE and I bonds tax-free if you use the funds to pay for tuition and fees that you incur on behalf of yourself, your spouse, and your dependent children. You must have purchased the bonds after 1989 and have been at least 24 years of age at the time.
The income exclusion phases out if you are single and your income in 2008 falls between $67,100 and $82,100 or you are married filing jointly and your income falls between $100,650 and $130,650.
Traditional and Roth IRAs
You can withdraw funds from your traditional or Roth IRA before age 59 ½ without an early withdrawal penalty as long as you use the funds for qualified post-secondary education for you or your spouse, or your child or grandchild.
Sources of Additional Information
For more information on the options available to help you with college expenses, refer to the following:
IRS Publication 970 (2007), Tax Benefits for Education
Savingforcollege.com, the internet guide to saving for college