Knowledge is Power

Lions, Tigers, and College Oh My

While I excitedly awaited the arrival of our first child in February, many thoughts played through my mind. Is the baby a boy or a girl? What will the baby look like? The first cry, the excitement of the baby’s first steps, that first intelligible word…all wonderful milestones eagerly anticipated by parents. Then, another thought crossed my mind, the inevitable downer – saving for college.

In the past ten years, tuition and room and board costs have increased an average of 31% at private colleges and by 42% at public institutions (National Association of Student Financial Aid Administrators). On average, a four-year private college costs approximately $30,000 per year, while the average four-year public college is coming in around $12,000 per year and climbing. This translates into an average of $20,000 in debt for the average four-year college graduate. Any way you look at it, this is not the best way to start your adventure into the “real world”.

College expenses are a frightening reality. Whether you plan to have your child sign the dotted line or aid them financially, it is wise to become familiar with the options available to lessen the burden of their higher education adventure. Some available savings tools are 529 college savings plans, 529 prepaid tuition plans, custodial accounts under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA), U.S. Savings Bonds, and personal investment accounts.

The 529 college savings plan is one of the most popular and effective ways to save for your child’s college education. Deriving their names from section 529 of the Internal Revenue Code, there are two types of section 529 plans, prepaid tuition plans and college savings plans. Prepaid tuition plans lock in future tuition rates at in-state public, and some private colleges, at current prices and are usually guaranteed by the state. College savings plans are more flexible, but the results are not guaranteed.

The value of a 529 college savings plan is determined by the investments held within the plan. Most plans include fixed income and equity mutual fund options that allow you to make one adjustment annually. Another investment option that is usually available, the age-based mutual fund, automatically adjusts based on the beneficiary’s age. As the beneficiary approaches college age, the portfolio begins to shift more assets into fixed income investments. These investments are not guaranteed and are subject to market volatility.

Recently, the Pension Protection Act of 2006 was signed into law. Among the many features of this Act is the tax exempt feature of 529 college savings plans. Prior to the passing of this Act, the tax exempt feature of qualified withdrawals were scheduled to expire on December 31, 2010. Now, the tax exempt benefit for qualified withdrawals has been made permanent. This means that withdrawals taken from a 529 college savings plan for “qualified expenses,” such as tuition, fees, room and board, books, supplies, and equipment, will remain federal income tax-exempt. Earnings not used for “qualified expenses” may be taxed at ordinary income and receive a 10% penalty tax. The assets in these plans will continue to grow tax-deferred, similar to retirement plans. Some states such as Pennsylvania offer state tax benefits. Contributions which can be made by anyone (parent, grandparent, uncle, friend, etc.), may be totally or partially deductible on the contributor's state income tax return. Also, earnings on qualified withdrawals may be tax-exempt from state income tax, as well as, federal income tax depending on the plan.

An important difference between the 529 plans versus other methods of saving for college is that the 529 plan is controlled by the person who established the account. The beneficiary cannot decide to take a withdrawal from this account to purchase that long coveted Corvette. Rather, the account is solely controlled by the account owner. However, the plan beneficiary can be changed without incurring penalties or tax implications. This is an important feature as situations change without notice. Perhaps the beneficiary decides not to attend college, or they may receive a scholarship or have their education provided for by some other means. In order to maintain the tax benefits, it may make sense to transfer the account to an eligible family member (son, daughter, brother, sister, father, mother, stepfather, stepmother, spouse, any first cousin, and appropriate in-laws).

A second option available to save for college expenses are custodial accounts under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). This investment plan allows you to set aside assets for the benefit of the child while benefiting from the child’s lower tax rate. These accounts can be opened by anyone for the benefit of a child. The child will gain control of the assets at the age of 18 or 21(depending on the state). These plans can be used for any expenses benefiting the child while the child is still considered a minor and are considered the asset of the child.

Anyone can invest into a UGMA or UTMA custodial plan regardless of their income level. Remember, individuals can contribute up to $12,000 per beneficiary avoiding federal gift tax. As these accounts are in the student’s name, they can have an ill effect on the student’s financial aid eligibility. Unlike a 529 Plan, UGMA/UTMA accounts cannot be transferred between beneficiaries.

A wide range of investments can be used in UGMA/UTMA accounts and are subject to market volatility. Most investments are not insured, meaning the principle investment can and may be lost. Contributions are not tax-deductible and withdrawals are not tax exempt. Investment income is also subject to federal income tax. For owners under 18 years old, the first $850 of earnings are tax-free, the second $850 are taxed at the child’s tax rate, and earning over $1,700 are taxed at the parent’s marginal tax rate.

A third option available when saving for college are U.S. savings bonds. Almost everyone has received a U.S. savings bond as a gift or may have given one as gift. These bonds can be purchased by anyone through a bank or other financial institution and have a guaranteed principal backed by the U.S. Treasure. Two types of U.S. savings bonds, Series EE and Series I, offer some tax breaks when used for qualified higher education expenses. Series EE bonds are typically purchased at half the face value ($50 bond costs $25) and accrue until they reach face value and can earn interest up to 30 years. Series I bonds are purchased at the full face value. These bonds accrue at two interest rates (a fixed and a variable) over 30 years.

Another option available involves opening an account at a bank, investment firm, or other financial institution and earmarking these funds for college education costs. This option is attractive for those investors who are not as familiar or comfortable with the options specifically developed for saving for college. This method allows the contributor a good deal of freedom. A vast array of investment options are available, which may include individual stocks, mutual funds, certificates of deposit, bonds, etc. The assets can also be used for any purpose and an unlimited amount of money can be invested. These assets are subject to state and federal income tax and are not tax deductible.

When determining the college savings method that makes sense for you, it is important to consider the different benefits associated with each plan. The method used to save for your child’s college education is just as important as the college your child chooses to attend. Keep in mind that college debt is not necessarily a bad thing. Rather, it gives your child ownership in their education. However, it is important to keep the debt manageable so that, after college, your child will be able to begin saving for other large purchases such as a car or home.

Please disregard the above if your child is the next Tiger Woods or LeBron James.

Sources: Fidelity Investments & Vanguard Investments