As the cost of a college education continues to rise, outpacing the rate of inflation, it is becoming beyond the reach of most people unless they have planned early on. For people starting a college savings plan today, questions arise as to the best way to save. For such an important and long term goal, it pays to do some research when selecting a plan.
There are many factors to consider when selecting a college savings plan. As with any savings goal, individual factors such as time horizon, risk tolerance, investment preferences and tax situation need to be considered and weighed in order to select the most suitable savings plan. In addition, special consideration needs to be given to who will actually own the college funds as the decision is likely to impact the availability of financial aid in the future.
Traditional Savings Methods
College savers can opt for the more traditional methods of accumulating college funds such as savings accounts (CDs, money market funds), tax-free municipal bonds, U.S. Treasury securities, or mutual funds. If the time horizon is long, savers may be able to afford the higher risk of investing in vehicles that offer potentially higher returns. As the time horizon shortens, they could gradually move their funds into more conservative savings of investments.
Tax Advantaged Methods
As an incentive for families to start early with their own college savings plans, the federal tax laws provide for tax advantaged methods to pay for college expenses. The methods involve different tax rules so they can be somewhat complicated. The best approach is to seek the guidance of a qualified tax or financial professional to help determine which method is most suitable.
IRC Sec. 529 Qualified Tuition Plans
These plans are designed to help a family cover the cost of college by taking advantage of tax incentives provided through the federal tax code. The plans may vary between the individual states and educational institutions that offer them. Contributions are not tax deductible, however, the accumulation is not subject to current taxes. Also, if certain requirements are met, the distributions that pay for qualified higher education expenses are not taxable.
There are two main types of 529 Plans: a pre-paid tuition plan, and a college savings plan. Pre-paid tuition plans involve purchasing units or credits at participating educational institutions that can apply to tuition and, in some cases, living expenses. Participation in a prepaid tuition program does not guarantee a child will be accepted into a university or school. Most are sponsored by state governments and have residency requirements.
College savings plans establish an account for a student that can be used to pay eligible college expenses. Many 529 College Savings Plans offer a choice of investments including mutual funds, money market funds and fixed investment.
Investors should consider the investment objectives, risks, charges, and expenses associated with 529 College Savings Plans before investing. This information is found in the issuer’s official statement and should be read carefully before investing. The investor should also consider whether the investor’s or beneficiary’s home state offers any state tax or other benefits available only from that state’s 529 Plan. Any state-based benefit should be one of many appropriately weighted factors in making an investment decision. The investor should consult their financial or tax advisor before investing in any state’s 529 Plan.
Investments in the 529 College Savings Plan are subject to market risk and there is no guarantee that funds will be sufficient to cover all college costs. It is important to carefully consider how to invest in a 529 Plan, since it can impact a student’s eligibility to participate in need-based financial aid programs.
Coverdell Education Savings Plan
Coverdell ESAs are designed for low- to moderate-income families, so there are income restrictions that govern whether or not you can contribute to one. Specifically, the ability to contribute to a Coverdell phases out above a modified adjusted gross income (MAGI) of $95,000 for single filers and $190,000 for married couples filing jointly, and taxpayers with MAGI above $110,000 and $220,000, respectively, cannot contribute to a Coverdell ESA at all.
The maximum that can be contributed to a Coverdell ESA is $2,000 per student, per year.
- Contributions can be made, without penalty, to both a Coverdell ESA and a QTP in the same year for the same beneficiary.
- Contributions to a Coverdell ESA are not deductible, but amounts deposited in the account grow tax-free until distributed.
- Contributions to a Coverdell ESA may be made until the due date of the contributor’s return, without extensions.
- Contributions must be made in cash.
- Contributions must be made before the beneficiary reaches age 18.
- Contributions can be made to one or several Coverdell ESAs for the same designated beneficiary, provided the total contributions to all accounts do not exceed the contribution limits for the year.
Qualified withdrawals are tax-dree for education expenses include tuition and fees, as well as books, supplies, and equipment required for enrollment or attendance. The money can also be used for special needs services, room and board for students enrolled at least half-time, or the purchase of computer equipment.
U.S. Savings Bonds
The interest earned from series EE and Series I savings bonds may be excluded from income if it is used to pay for qualified education expenses in the year that the bonds are redeemed. The same exclusion applies to the interest earned from these bonds that are contributed to a 529 qualified tuition program.
When saving for college, special consideration should be given to future eligibility for financial aid. Most needs based financial aid programs base eligibility on the amount of assets that are owned by the child. Generally, assets that are owned by the parents are not considered for financial aid eligibility. If assets are held in the child’s name, or in a trust for the child, they could negatively impact eligibility.
Working together, we can examine college investment options to build a customized portfolio that takes into consideration your financial goals, risk tolerance and timeline. Contact us today to find out more.