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Are you saving money for your child to go to college? College expenses are on the rise, so check out the many savings options available to you.
Recent studies indicate that, on average, the tuition and living expenses for a private college can cost more than $30,000 per year. The estimate drops to about $13,000 for a public college. That means a four-year college education can cost a total of $50,000 to $120,000. If you intend to pay for your child's college education, it's in your best interest to start saving now.
If you think about college as a long-term investment rather than as a short-term expense, it really helps you to save the money needed to afford your child's first-choice school. Saving early means you'll invest less money to meet the same goal than if you wait until a couple of years before your child starts college. Saving early also means that you can afford to be more aggressive in your investing strategy because long-term investing typically withstands higher risk and potentially higher returns.
The first step to creating a savings plan for college is to determine how much you'll need. Questions to consider include:
Will your child go to a private or a public college?
How much time do you have to save?
How much can you afford to save each month?
What types of financial aid will be available?
The type of investments you choose will depend on how you answered the questions above. For example, you'll need to save more money if your child plans on attending a private college instead of a public one. You'll benefit from an aggressive investment strategy if your child is very young, until age 5 or 6. Investing in the stock market is a good option for you because historically, over a long period of time, it has a 10% to 12% rate of return. If you averaged 10% interest on $1,200 invested each year, it would grow to $60,191 in 18 years. If you start investing as your child gets older, you'll want to be less aggressive the closer your child gets to the first day of school. It's a good idea to talk with a financial professional who can recommend an appropriate mix of investments, such as stocks, bonds, and mutual funds.
There are financial investments that allow you to fund your child's education and receive tax breaks at the same time. You may consider one or more of the following:
Individual Retirement Accounts (IRAs) – Withdrawals for college expenses aren't subject to a 10% penalty for withdrawal before retirement age. However, withdrawals are subject to income tax.
Roth IRAs – Funds may be withdrawn penalty-free to fund education expenses. Contributions that are withdrawn are free from income tax, but disbursement of the earned interest on the account is subject to income tax.
Coverdell Education Savings Accounts (formerly called Education IRAs) – Contributions can be up to $2,000 per year for children under age 18. Coverdell account funds aren't taxed until they're distributed. See the Internal Revenue Service (IRS) article about Coverdell Education Savings Accounts.
Savings bonds – You can cash in savings bonds and declare the interest that was earned tax exempt if the amount doesn't exceed qualified education expenses, such as tuition, housing, and books. For details, see the TreasuryDirect.gov webpage about Education Planning.
These tax incentives all have certain requirements and restrictions, such as income level, so it's important to discuss them with a financial professional who can help you determine what's right for your situation.
Another way to save that offers tax incentives is a state-offered college savings plan. These qualified tuition programs, also known as 529 plans because they are described under Section 529 of U.S. Code, are offered in all 50 states. There are two types: savings investment plans and prepaid tuition plans. Money from either of these plans is usually exempt from state taxes. Federal taxes at your child's tax rate are deferred until the money is withdrawn.
State Education Savings Plans – If you invest in a savings investment plan, the money is invested in the stock market either through a brokerage or directly by the state. You can invest in any state's plan without regard to residency. Note that you can invest in a plan offered by a state outside of your state of residency; some plans are better managed and have lower fees than others. Don't be limited by your state's plan if it is rated poorly. You can use the money for any public or private college in any state.
The advantages to these plans include:
Earnings are free from federal income tax and qualified withdrawals are free from federal income tax.
For a state's own plan, contributions are deductible on your state income tax. (The deductions vary according to state.) Some states, like Pennsylvania, allow tax deductions for contributions to any other state's college savings plan.
Contributions up to $12,000 per year, per child ($24,000 per couple filing a joint tax return), are exempt from federal gift tax. You can contribute $60,000 (or $120,000 for joint filers) all at once and take a five-year lump sum gift tax exemption. This is helpful for parents who got a late start saving for their child's college costs.
You have control of the assets in the account, regardless of the beneficiary's age.
These assets are partially protected in bankruptcy, depending on your state laws and when the contributions to the 529 plan were made.
There are drawbacks to these plans, including:
Your rate of return isn't guaranteed because your money is being invested in stock market portfolios.
You can't control how your money is invested because the funds are managed by the state (or its broker manager).
You might not qualify for state tax exemptions if your child attends a school in a different state, depending on the tax laws in your state.
Prepaid Tuition Plans – With this investment option, you pay for future college expenses at current rates. Payments can be made monthly or annually. These plans are offered in less than half of the states, and each state has its own requirements. Most states guarantee tuition for schools within that state.
The advantages to prepaid tuition plans include:
The advantages listed above apply to all 529 plans (both savings investment plans and prepaid tuition plans).
Prepaying tuition almost certainly means a substantial savings; it is extremely likely that college tuition will be more expensive in the future.
Interest earnings on prepaid tuition plans are usually greater than earnings on regular bank savings accounts or certificates of deposit.
Prepaid tuition plans are very low risk.
Drawbacks to this plan include:
Most of these plans are for state residents only. Therefore they are not an option if your child decides to go to an out-of-state or a private college. There is, however, an Independent 529 Plan, for prepaid tuition at any of the hundreds of private schools that participate in the plan, including Stanford, Princeton, M.I.T., George Washington University, and the University of Chicago.
Prepaid tuition plans can only be used to pay for tuition, fees, and room and board — not any other expenses associated with attending college.
Prepaid tuition plans have a lower rate of return on your investment earnings.
You may only receive a partial refund if your child decides not to go to college.
For more information about state-sponsored college savings plans (529 plans), read the USA Today article 529 Plans Becoming Top Savings Option and the U.S. Securities and Exchange Commission article An Introduction to 529 Plans.
Once your children are in college, you can take advantage of the 1997 Taxpayer Relief Act, which introduced two new tax credits to help with the cost of paying for college:
Hope Scholarship credit – This tax break (note that it is a tax deduction and not a scholarship) is for middle- to low-income families who have a maximum yearly adjusted gross income of $55,000 ($110,000 for married couples filing a joint return). You can deduct up to $1,650 for the first two years your child is in college.
Lifetime Learning credit – Like the tax credit above, the maximum gross income is $55,000 ($110,000 for married couples filing a joint return). The Lifetime Learning credit lets you deduct 20% of the first $5,000 (i.e., maximum $2,000 per year) of qualified education expenses. For more information about the Hope Scholarship and Lifetime Learning tax credits, read this Parent and Student Guide by the National Association of Student Financial Aid Administrators.
Student loan interest deduction – You can deduct from your income up to $2,500 of interest paid on an education loan taken for your child, your spouse, or yourself, if your maximum gross income is $65,000 ($135,000 for married couples filing a joint return).
For more information about the tax savings on the options described in this article, see the IRS Publication 970: Tax Benefits for Education.
Thinking about paying for your child's college education doesn't have to be horrible if you're prepared. Selecting appropriate investment strategies is the first step to being in control of the situation. For more suggestions, read the Federal Citizen Information Center article Financial Planning for College.
For a detailed discussion on financial aid, IRA's, savings accounts, or budgeting, read the related articles in our Knowledge Center Library.
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