Vol. 2, Issue 3August 2010


Paying for College

The cost of college is high, and getting higher. College costs are rising faster than the rate of inflation, and many public universities are seeing steeper increases than those at private schools. So how will you be able to pay the bills?

First, don't panic. Most students don't pay full freight. Grants, scholarships and the like can substantially reduce the amount many students, or their parents, actually have to put out. But paying for college still can be a significant drain on a family's finances. How can you ease the pain?

Start early. As with any saving and investing effort, the earlier you start, the better. That gives your money longer to benefit from compounding, or the growth of investments over time.

What if you already missed your chance to start early? Then start now. The important thing is to have a savings plan.

You have several options. You can just earmark an investment account for college costs. This is simple, but it does not give you any tax breaks – returns are taxed at your tax rate.

You can transfer money directly to your child under a custodial account arrangement. With these accounts, you control the money until the child reaches majority – usually either 18 or 21. At that point the child controls the money, which can be a problem: Junior can decide to use the money for a motorcycle trip through Mexico rather than for college. In addition, you don’t get much of a tax break with custodial accounts. Earnings are taxable, although at the child's rate rather than yours. This rate should be lower, since your child probably makes less than you do. (If she doesn't, let her pay for her own education!)

There are two options that give you both more control and better tax breaks: a Coverdell education savings account, and the popular 529 college plans.

A Coverdell account works like a Roth IRA: The money you put in is post-tax, but the earnings are tax-free and, as long as the withdrawals are used for education expenses, they are also tax-free. There are some rules, though. First, you must meet income restrictions in order to make a Coverdell contribution. In addition, the beneficiary cannot be older than 18 at the time of the contribution, which means that, in most cases, contributions cannot be made after the child starts college. And even if multiple people open a Coverdell for the same child, the total contribution for that child cannot exceed $2,000 per year. Finally, once the beneficiary is 30, he or she gets whatever is left in the account.

The 529 college savings plan has become extremely popular. Under a 529 plan, you contribute to a prepaid tuition plan or college savings plan, usually run by the state. In fact, every state offers at least one 529 plan, and the specifics vary, sometimes significantly. Your child is not required to go to college in that state – 529 plan money can be used at virtually any college or university in the country, and at many schools overseas.

The money in a 529 plan grows tax-deferred, and withdrawals for higher education costs are not taxed by the IRS, although some state taxes might apply.

Unlike with a Coverdell account, there are no age or income limitations, so anyone can open a 529 account. In addition, you can save a lot of money in a 529 account – more than $300,000 per beneficiary in many states. And you –not your child – have control over the money.

What happens if you save more than you need? No problem. You can transfer the account to another family member. You also can take out money for your own use, although that is subject to taxes and penalties. But you usually can avoid the penalties on withdrawals if the beneficiary gets a scholarship and therefore doesn't need the money in the account, or if the beneficiary dies or is disabled.

A 529 plan also might be more favorable when figuring family income for financial aid purposes. The assets in a 529 plan are considered parent assets when determining need-based financial aid. However, they are given substantially less weight than assets owned in the child's name or in a custodial account.

The right college savings vehicle – or combination of vehicles – depends on several things, including your overall financial situation, the number of children and their ages, etc. Your financial adviser can help you sort through all the options and determine the best approach for you. That way, when the time comes to send your child off to college, you will be ready -- at least financially.

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