By Douglas Charney
Have you started saving for your child’s college education?
If not, you might want to start thinking about it because, according to the College Board, it costs an average of $46,000 for four years’ tuition to a public school. And private or out-of-state institutions could cost closer to $134,000. That’s right. And it doesn't seem to be getting much better because in the last ten years, college costs have increased at a rate of 4% above the rate of inflation, according to the College Board.
Although costs are on the rise, your child’s education may be the best investment you make in your lifetime. You must be ready, however, because most families don’t save enough money, and then struggle in the end to cover the cost. The following options provide an overview of the most popular savings plans available to your child:
UGMA or UTMA
In the past, the main investment vehicle for funding a college education was the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfer to Minors Act (UTMA). These accounts are essentially the same – they both permit gifts of money, property, or securities to minors without setting up a trust fund. They are set up in your child’s name, but you (the parent or guardian) control the investments until the child reaches a state determined age, usually between 18 and 21 years old. When the child does take over control, the money can be used for anything he or she determines, not just college tuition.
UGMAs and UTMAs are more flexible than a trust fund and allow for smaller deposits. But the account is subject to a gift tax if more than $14,000 per year is deposited, and the beneficiary must be a minor. If the child is under the age of 14, the first $1050 income from the investment in any calendar year is tax free. For children 15 and older, it is tax free, but the second $1050 is taxed at the child’s rate (usually 10 per cent) and income above $2,100 is taxed at the donating adult’s rate.
Prepaid Tuition Plan
The Pre-Paid Tuition Plan has become a popular method to save for college because it is virtually risk-free. These plans are managed by individual states for children of in-state residents. Parents or guardians pre-pay towards college tuition for designated in-state colleges. Some states even offer tax breaks for the money invested. These plans allow you to lock in tuition and fees today, and then use them in the future. When the money is used at designated educational institutions, no taxes apply, but some age restrictions exist and may vary from state to state.
Typically, these plans are limited to tuition costs and available at state institutions for in-state students only and while many state plans have made it easier to transfer the savings to private or out-of-state institutions, your children may still face some limitations in their choices.
Contribution limits vary by state and are usually based on the state college costs. The downside of these plans is they reduce your children’s eligibility for financial aid because the plan is counted in their assets rather than yours.
Coverdell Education Savings Accounts
Coverdell Education Savings Accounts, formerly known as Education IRAs, have become a better option because of recent tax laws. Although they provide no tax breaks for contributors, these accounts grow federally tax-free, as long as the money withdrawn is used to cover educational expenses. Beyond higher education, educational costs now include elementary and secondary schools, as well as accredited colleges and universities.
Some stipulations attached to this option include a contribution limit of $2,000 per year and the money must be used before the student turns thirty. Leftover funds, however, can be rolled over to cover another family member’s educational expenses.
The return on a Coverdell account may be affected by maintenance fees. And it may not coordinate with other tax breaks for education, such as Hope Scholarships and Lifetime Learning Credits. Donor income limitations may apply. A married donor with a household income of more than $220,000 a year or a single donor with an annual income exceeding $110,000 cannot contribute to a Coverdell account.
529 College Savings Plan
The 529 College Savings Plan may be the best available education savings tool due to its flexibility and donor control. The donor may designate anyone, of any age, as the beneficiary, and also may change the beneficiary to another family member at any time. Most 529 accounts offer an array of mutual funds.
The money saved in a 529 plan can be used to cover almost any educational expense, including tuition, room, board, books, and supplies. 529s can also be used as an Estate Planning Tool for contributions up to $70,000 ($140,000 per married couple) in any amount over a five-year period for each beneficiary, without exceeding the Federal Gift Tax Exclusion, and provided no further gifts are given over the five-year period. The advantage of this plan is the money in the 529 is not in the donor’s Estate. Instead the donor who gifted the money (in most cases a parent or grandparent) still has control over it.
Contribution limits vary by plan, but the maximum is typically $250,000 and above. Qualified withdrawals are exempt from federal income taxes. Also with this type of savings accounts, the donor can withdraw money for non-educational expenses, although these withdrawals are subject to income taxes, at the donor’s rate, plus an additional 10 per cent federal tax.
Saving for the Future
Saving for college is complicated because of all the choices in investment vehicles and strategies, but it isn’t impossible when you know what options exist. The bottom line is that you need to determine how much money you’ll need to fund your child’s future educational needs and base your plans on that figure. Then contribute enough money to reach that goal, based on a reasonable growth rate.
As you start to develop plans for your child’s education, use this overview of the different savings plans as a guide. When you know your different options, you can make the right planning decisions and a worthwhile investment in your child’s future.