Being able to send your child to college is near the top of the wish list for most parents. A college education can open doors to many opportunities, and is increasingly necessary in today’s economy. But that diploma doesn’t come cheap. Unless you are very well off financially, it’s difficult to sit on the sidelines for years, and then suddenly find the money for college expenses when your child is ready to leave for college.
For the 2012/2013 school year, the average annual cost for a four-year public college is $22,261 (in-state students) and for a four-year private college, $43,289 (Source: The College Board). Total figures include tuition and fees, room and board, books and supplies, transportation, and personal expenses. It’s a likely bet that costs will continue to rise, but by how much? Annual increases in the range of 4 to 7% would be in keeping with historical trends. Keep in mind, the actual percentage increase in any year could be higher or lower, and the rate could vary from public to private college.
How will I pay for it?
Year after year, thousands of students graduate from college. So how do they do it? Many parents save less than 100% of their child’s education costs before college. Typically, they put aside enough money to make a down payment on the college bill (in the same way you might purchase a home). Then, at college time, parents supplement this down payment with:
- Current income;
- Federal PLUS loan;
- Private loans (e.g., home equity loan, margin loan);
- Investments (e.g., 529 plan, mutual funds, 401(k) plan, cash value life insurance);
- Federal and college student-based financial aid (e.g., student loans, grants, scholarships, work-study);
- Child’s savings, investments, and/or earnings from a part-time job, and/or
- Gifts from grandparents
How much should I save?
You’ll want to put aside as much money as you can in your child’s college fund. The more money you put aside now, the less you or your child should need to borrow later. Start by estimating your child’s costs for four years of college. Then, decide how much of the bill you want to fund—100%, 75%, 50%, and so on. Use a financial calculator to determine how much money you’ll need to put aside each year to meet your goal. In many cases, the amount of money you set aside really comes down to how much you can afford. Every situation is different. You’ll need to take a detailed look at your family’s finances to see what you can afford to add to your child’s college fund each month or year.
Start a Savings Program as Early as Possible
Perhaps the most difficult time to begin a college savings program is when your child is young. New parents face many financial strains that always seem to take over—the possible loss of one income, child-related spending, the competing need to save for a house or car, or the demands of your own student loans. Yet this is the time when you should start saving. When your child is young, you have time to select investments that have the potential to outpace college cost increases (though investments that offer higher potential returns may involve greater risk of loss). This table shows what a consistent monthly investment might grow to over a certain period of years.
|
Amount Invested
|
5 Years
|
10 Years
|
15 Years
|
|
$100 |
$6,977 |
$16,388 |
$29,082 |
|
$300 |
$20,931 |
$49,164 |
$87,246 |
|
$500 |
$34,885 |
$81,940 |
$145,409 |
Note: Table assumes an after-tax return of 6%. This is a hypothetical example, and it is not intended to reflect the actual performance of any investment.
You’ll also benefit from compounding—the process of earning additional funds on the interest and/or capital gains that your investment earns along the way. With regular investments spread over many years, you may be surprised at how much you can accumulate in your college fund. Don’t worry if you can’t save hundreds of dollars every month right from the beginning. Start with a small amount, and add to it whenever you can.
In the college savings game, all strategies aren’t created equal. The best savings vehicles offer special tax advantages if the funds are used to pay for college. Tax-advantaged strategies are important because over time, you can accumulate more money with a tax-advantaged investment compared to a taxable investment. Ideally, though, you’ll want to choose a savings vehicle that offers the best combination of tax advantages, financial aid benefits, and flexibility, while meeting your overall investment needs.
529 Plans
Since their creation in 1996, 529 plans have become to college savings what 401(k) plans are to retirement savings–an indispensable tool for helping you amass money for your child’s or grandchild’s college education. That’s because 529 plans offer a unique combination of benefits unmatched in the college savings world.
There are two types of 529 plans—college savings plans and prepaid tuition plans. Though each is governed under Section 529 of the Internal Revenue Code (hence the name “529” plans), college savings plans and prepaid tuition plans are very different college savings vehicles. Keep in mind, there are fees typically associated with opening and maintaining each type of account. Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about specific 529 plans is available in each issuer’s official statement. You should be read these carefully before investing. Another consideration for you, is to determine if your state offers a 529 plan that provides residents with favorable state tax benefits.
529 College Savings Plans
A 529 college savings plan is a tax-advantaged college savings vehicle that lets you save money for college in an individual investment-type account. Some plans let you enroll directly, while others require you to go through a financial professional.
The details of college savings plans vary by state, but the basics are the same. You’ll need to compete an application, where you’ll name a beneficiary, and select one or more of the plan’s investment portfolios to which your contributions will be allocated. You’ll typically be required to make an initial minimum contribution, which must be made in cash. 529 college savings plans offer a unique combination of features that no other college savings vehicle can match:
Federal tax advantages:Contributions to your account grow tax deferred and earnings (if any) are completely tax free if the money is used to pay the beneficiary’s qualified education expenses. The earnings portion of any withdrawal not used for college expenses is taxed at the recipient’s rate and subject to a 10% federal penalty.
State tax advantages: Many states offer income tax incentives for state residents, such as a tax deduction for contributions or a tax exemption for qualified withdrawals. Be aware, however, that some states limit their tax deduction to contributions made to the in-state 529 plan only.
High contribution limits: Most college savings plans have lifetime maximum contribution limits over $300,000.
Unlimited participation: Anyone can open a 529 college savings plan account, regardless of income level.
Professional money management: College savings plans are managed by designated financial companies that are responsible for managing the plan’s underlying investment portfolios.
Flexibility: Under federal rules, you can change the beneficiary of your account to a qualified family member at any time, without penalty. You can roll over the money in your 529 plan account to a different 529 plan once per year, without income tax or penalty implications.
Wide use of funds: Money in a 529 college savings plan can be used at any college in the United States or abroad that is accredited by the U.S. Department of Education and, depending on the individual plan, for graduate school.
Accelerated gifting: 529 plans offer an excellent estate planning advantage in the form of accelerated gifting. This can be a favorable way for grandparents to contribute to their grandchildren’s college education. Individuals can make a lump-sum gift to a 529 plan of up to $70,000 ($140,000 for married couples) and avoid federal gift tax, provided a special election is made to treat the gift as having been made in equal installments over a five-year period. This is provided that no other gifts are made to that beneficiary during the five years.
Variety: Currently, there are over 50 different college savings plans to choose from because many states offer more than one plan. You can join any state’s college savings plan. But college savings plans have a drawback: returns aren’t guaranteed. You “roll the dice” with the investment portfolios you’ve chosen. Your account may gain or lose value depending on how the underlying investments perform.
529 Prepaid Tuition Plans
Prepaid tuition plans are distant cousins to college savings plans–their federal tax treatment is the same, but their operation is very different. A 529 prepaid tuition plan is a tax-advantaged college savings vehicle that lets you pay tuition expenses at participating colleges at today’s prices for use in the future. Prepaid tuition plans can be run either by states or colleges.
As with 529 college savings plans, you’ll need to complete an application and name a beneficiary. But instead of choosing an investment portfolio, you purchase an amount of tuition credits or units (which you can then do again periodically), subject to plan rules and limits. Typically, the tuition credits or units are guaranteed to be worth a certain amount of tuition in the future, no matter how much college costs may increase between now and then. As such, prepaid tuition plans provide some measure of security over rising college prices.
Federal and state tax advantages: The federal and state tax advantages given to prepaid tuition plans are the same as for college savings plans.
Other similarities to college savings plans: Prepaid tuition plans are open to people of all income levels. They offer flexibility in terms of changing the beneficiary or rolling over to another 529 plan once per year, as well as accelerated gifting. Prepaid tuition plans have some limitations, though, compared to college savings plans.
One major disadvantage is you’re generally limited to your own state’s prepaid tuition plan, and then you’re limited to the state colleges that participate in that plan. If your child attends a different college, prepaid plans differ for the amount that is returned to you. Some prepaid plans have been forced to reduce benefits after enrollment. This is due to investment returns that have not kept pace with the plan’s offered benefits. Even with these limitations, some college investors appreciate the peace of mind that comes with not worrying about college inflation each year by locking in college tuition today.
Coverdell ESAs
A Coverdell education savings account (Coverdell ESA) is a tax-advantaged education savings vehicle that lets you save money for college, plus elementary and secondary school (K-12) at public, private, or religious schools. Here’s how the Coverdell ESA works:
Application process: You complete an application at a participating financial institution and name a beneficiary. There may be fees associated with opening and maintaining the account. The beneficiary must be under age 18 when the account is established (unless he or she is a child with special needs).
Contribution rules: You (or someone else) make contributions to the account, subject to the maximum annual limit of $2,000. This means that the total amount contributed for a particular beneficiary in a given year can’t exceed $2,000, even if the money comes from different people. Contributions can be made up until April 15 of the year following the tax year for which the contribution is being made.
Investing contributions: You invest contributions as you wish (e.g., stocks, bonds, mutual funds, certificates of deposit)—you have sole control over your investments.
Tax treatment: Contributions to your account grow tax deferred, which means you don’t pay income taxes on the account’s earnings (if any) each year. Money withdrawn to pay college or K-12 expenses (a qualified withdrawal) is completely tax free at the federal level and at the state level, too. If the money isn’t used for college or K-12 expenses (a non-qualified withdrawal), the earnings portion of the withdrawal will be taxed at the beneficiary’s tax rate and subject to a 10% federal penalty.
Rollovers and termination of account: Funds in a Coverdell ESA can be rolled over, without penalty, into another Coverdell ESA for a qualifying family member. Any funds remaining in a Coverdell ESA must be distributed to the beneficiary when he or she reaches age 30 (unless the beneficiary is a person with special needs).
Unfortunately, not everyone can open a Coverdell ESA–your ability to contribute depends on your income. To make a full contribution, single filers must have a modified adjusted gross income (MAGI) of less than $95,000, and joint filers must have a MAGI of less than $190,000.
Custodial Accounts
Before 529 plans and Coverdell ESAs, there were custodial accounts. A custodial account allows your child to hold assets—under the watchful eye of a designated custodian—that he or she ordinarily wouldn’t be allowed to hold in his or her own name. The assets can be used to pay for college or anything else that benefits your child (e.g., summer camp, a computer). Here’s how it works:
Application process: You complete an application at a participating financial institution and name a beneficiary. There may be fees associated with opening and maintaining the account.
Custodian: You designate a custodian to manage and invest the account’s assets. The custodian can be you, a friend, a relative, or a financial institution. The assets in the account are controlled by the custodian.
Assets: You (or someone else) contribute assets to the account. The type of assets you can contribute depends on whether your state has enacted the more common Uniform Transfers to Minors Act (UTMA) or the Uniform Gifts to Minors Act (UGMA). Examples of assets typically contributed are stocks, bonds, mutual funds, and real property.
Tax treatment: Earnings, interest, and capital gains generated from assets in the account are taxed every year to the child, which means you might reap some tax savings. But this opportunity is very limited because of special rules, called the “kiddie tax” rules, that apply when a child has unearned income. Under these rules, children are generally taxed at their parents’ tax rate on any unearned income over a certain amount. The kiddie tax rules apply to: (1) those under age 18, (2) those age 18 whose earned income doesn’t exceed one-half of their support, and (3) those ages 19 to 23 who are full-time students and whose earned income doesn’t exceed one-half of their support.
|
If Unearned Income
is in this Range… |
And Child is Subject to the Kiddie
Tax, Then Income is… |
|
$0 – $1,000 |
Tax free
|
|
$1,001 – $2,000 |
Taxed at child’s rate |
|
More than $2,000 |
Taxed at parent’s rate |
In addition to the kiddie tax rules limiting tax savings, there are other drawbacks too: All gifts to a custodial account are irrevocable, and money can only be withdrawn for the child’s benefit. When the child reaches the age of majority (either 18 or 21, depending on state law), the account terminates and the child gains full control of all the assets in the account.
U.S. Savings Bonds
Series EE and Series I bonds are types of savings bonds issued by the federal government that offer a special tax benefit for college savers. The bonds can be easily purchased from most neighborhood banks and savings institutions, or directly from the federal government. They are available in face values ranging from $50 to $10,000. You may purchase the bond in electronic form at face value or in paper form at half its face value. If the bond is used to pay qualified education expenses and you meet income limits (as well as a few other minor requirements), the bond’s earnings are exempt from federal income tax. The bond’s earnings are always exempt from state and local tax.
In 2013, to be able to exclude all the bond interest from federal income tax, married couples must have a modified adjusted gross income of $112,050, or less, at the time the bonds are redeemed (cashed in), and individuals must have an income of $74,700, or less. A partial exemption of interest is allowed for people with incomes slightly above these levels.
The bonds are backed by the full faith and credit of the federal government, so they are a relatively safe investment. They offer a modest yield. Series I bonds offer an added measure of protection against inflation by paying you both a fixed interest rate for the life of the bond (like a Series EE bond), and a variable interest rate that is adjusted twice a year for inflation. However, there is a limit on the amount of bonds you can buy in one year, as well as a minimum waiting period before you can redeem the bonds, with a penalty for early redemption.
Qualified Education Expenses
To be tax free at the federal level, investment funds have to be used for “qualified” education expenses. Surprisingly, this can mean different things, depending on the savings vehicle.
U.S. Savings Bonds: Qualified education expenses include tuition and fees for post-secondary education, as well as contributions to 529 plans and Coverdell ESAs. Room, board, and books are not qualified education expenses.
529 plans: Qualified education expenses for 529 college savings plans include tuition, fees, books, equipment, and room and board for college and graduate school; qualified education expenses for 529 prepaid tuition plans generally include only tuition and fees for college (not graduate school).
Room and board: Room and board is a qualified expense only if the student is enrolled at least-half time. If the student lives on campus, room and board is limited to the actual amount charged by the school; if the student lives off campus or at home, room and board is limited to the college’s specific published room and board allowance figure.
Computers: Computers are a qualified expense only if the college specifically requires one in order to enroll or attend.
Special needs services: Special needs services are a qualified expense only if they are incurred by a beneficiary with special needs in order to enroll or attend.
Coverdell ESAs: Qualified education expenses include elementary, secondary, and post-secondary education expenses, including tuition, fees, tutoring, books, supplies, room and board, uniforms, transportation, and related equipment. Computers are a qualified expense for students in elementary and secondary school, even if the school doesn’t require one, but are not qualified at the post-secondary level, unless the college requires one.
Financial Aid
Financial aid is money distributed primarily by the federal government and colleges in the form of student loans, grants, scholarships, and work-study jobs. Loans and work-study must be repaid (through monetary or work obligations), while grants and scholarships do not. A student can receive both federal and college aid.
Financial aid can be further broken down into two categories: needs-based, which is dependent on your child’s financial need, and merit-based, which is awarded on the basis of academic, athletic, musical, or artistic merit. Most financial aid is needs-based, though merit aid has been making a comeback in recent years as colleges, particularly private colleges, use favorable merit aid packages to attract bright students to their campuses, regardless of their financial need. However, be aware the availability of college-sponsored merit aid tends to fluctuate from year to year, as colleges decide how much of their endowments to spend, as well as the specific academic and extracurricular programs they want to target.
The Financial Aid Impact
The college savings decisions you make can impact the needs-based financial aid process. Come financial aid time, your family’s income and assets are run through a formula at the federal level (and at the college level for institutional aid). This process is to determine how much money your family should be expected to contribute to college costs before you are eligible for financial aid. This process is called needs analysis. The resulting figure is known as your expected family contribution, or EFC.
The difference between your EFC and the cost of attendance at any given college equals your child’s financial need. Your EFC remains a constant, but the amount of your child’s financial need varies, depending on the cost of attendance at the underlying college. The higher your EFC, the less needs-based aid your child will be eligible for. Under the federal methodology, student assets are weighed differently than parent assets. Students must contribute 20% of their assets each year, while parents must contribute 5.6% of their assets.
For example, $10,000 in your child’s bank account equals an expected contribution of $2,000 from your child ($10,000 x.20), but the same $10,000 in your bank account equals an expected $560 contribution from you ($10,000 x.056). Under the federal rules, 529 plans and Coverdell ESAs are considered parental assets only if the parent is the account owner. This is true for mutual funds, stocks, bonds, U.S. savings bonds, certificates of deposit, real estate, and any other investment that may be owned by the parent.
Exceptions under the federal methodology are retirement plans (e.g., 401(k) plans, Roth IRAs, 403(b) plans) cash value life insurance, and home equity. These assets are never counted, even if they are owned by the parent. By contrast, a custodial account is classified as a student asset. This means that it is assessed at a higher rate than a parental asset (20% vs. 5.6%).
How Much Should I Rely on Financial Aid?
Some parents assume that financial aid will do most of the heavy lifting when it is time to pay the college bills. But the reality is you shouldn’t rely too much on financial aid. Although it can certainly help cover your child’s college costs, student loans make up the largest percentage of the typical aid package, not grants and scholarships.
As a general rule, plan for student loans covering up to 50% of college expenses, grants and scholarships up to 15%, and work-study jobs covering a variable amount. But remember, parents and students who rely mainly on loans to finance college can finish with a considerable debt burden. The best thing is start saving as early as possible.
At Henssler Financial we believe you should Live Ready, which includes understanding your options for funding your child’s college education. If you have questions regarding your education savings strategy, the experts at Henssler Financial will be glad to help. You may call us at 770-429-9166 or email at experts@henssler.com.
Disclosures
The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
