Advanced Personal Finance

If you’re a parent or parent-to-be and you’re reading a personal finance blog, probably one of the things that’s crossed your mind is the question of how to pay for college. Besides buying a home and saving for retirement, paying for college (if you pay for your kids) is very likely going to be the most expensive thing you’ll do in your life. For our purposes here, I’ll assume you are interested in paying for at least part of your child’s college (see this post for my own debate about why you might or might not). A quick word of warning: I strongly advise you fully fund your own retirement savings before considering saving for your kids’ college. They can borrow for school, if necessary. You can’t borrow for your retirement.

There are four main ways for you to save for your kids’ college education. First, there is the Coverdell Education Savings Account (formerly known as Education IRA, who knows why). There are two different types of so-called ‘529′ plans - savings plans and prepaid plans. Finally, some people use custodial accounts under the Uniform Gifts To Minors (UGMA) and Uniform Transfers To Minors (UTMA) Acts. Each of these methods has its advantages and disadvantages.

Coverdell ESA

The Coverdell Education Savings Account (’Coverdell’) is similar to an Roth IRA in that it allows you to save for college (actually any schooling including K-12) tax free (your contribution, of course, is after tax). If you don’t use the money for ‘qualified expenses,’ there is a 10% penalty for withdrawals. That may not see so bad, but remember that that money is then taxed as ordinary income, so you really don’t want to use the money for anything besides education if you can help it.

The main disadvantage to a Coverdell is that you can only contribute $2,000 per child per year. Since tuition has been rising far faster than inflation lately, it’s possible you may not be able to fully fund the cost even if you contribute the full amount every year. Another problem with them is that availability phases out with higher incomes ($95,000 for single filers; $190,000 for couples). Finally, you must take distribution by the time the beneficiary turns 30, even if it’s not for educational purposes.

Coverdells are transferable to other members of your family as long as that person is under the age of 30. So if your child doesn’t need the money for college, you can transfer it to another child or other relative (even a grandchild). As mentioned before, they can also be used for K-12 education, a feature unique to Coverdells. Another key advantage of Coverdells is that you control where the money is invested. You can put it in any mutual fund, just like an IRA.

529 Savings Plan

A 529 savings plan is like a Coverdell but without several of the restrictions. There are no income restrictions on 529 plans in most states and as of 2006, the tax-free treatment of distributions for higher education became permanent. Additionally, there is no age-based required distribution and you can transfer the beneficiary to another family member just like a Coverdell. You can also contribute significantly more money to a 529 than a Coverdell ($250,000).

One other large advantage is that if you live in a state like I do, you can deduct some or all of the contribution from your state income taxes. Here in Maryland, you can deduct up to $2,500 per year per beneficiary with carry forwards for ten years.

The 529 savings plan does have some disadvantages. The plans are run by outside administrators, generally profit-seeking ones. Therefore, you’ll have to pay fees (sometimes quite high) each year just like a mutual fund. Also, the choices for investing can be limited. A 529 savings plan is treated as a parental asset (see this post on financial aid for what that means).

529 Prepaid Plan

Another 529 plan is the prepaid plan. Literally, you’re paying today for the tuition years from now. You can buy anywhere from a semester to five years of tuition up front. You’re then guaranteed the average price of your state’s tuition when the child goes to college. If your child goes to an out-of-state school, the plan provides the average of your state’s tuition for use at that other college. Note that you’re only buying the tuition piece of your kid’s college costs. Room and board can be an significant additional cost. Your cost is determined by the age of the child when you enroll. The administrative costs of the plan are typically built in to the cost. A prepaid plan is treated as a ‘resource’ for financial aid purposes (see this post for details). What that means is that financial aid is reduced on a dollar-for-dollar basis if you have a prepaid plan.

It’s important to note in the case of both types of 529 plans (savings and prepaid), you don’t have to be a resident of the state to sign up for its plan. The tax benefits, if any, will be negated though if you use another state’s plan.

UTMA/UGMA

The UTMA and UGMA (which are essentially the same thing) are an irrevocable gift to a child put into a custodial account managed by you or anyone you designate. The word ‘irrevocable’ is key. Once designated, the funds are put into trust for that child and at the age of majority, he or she owns that money. As such, your child doesn’t have to use it for the purpose you dictate (e.g. college). The main advantages of UTMA/UGMA are the flexibility they afford and the fact that they are taxed at the child’s reduced rate. Unfortunately, besides the aforementioned ownership issue, the earnings are taxed each year (albeit at the child’s rate). Also, since they are owned by the child, their value weighs much more heavily in the calculation of financial aid. See this post on how the federal government determines your expected contribution to college costs.

So there are your options for saving for your kids’ higher education. I use the 529 savings plan for our little girl and baby-to-be. Since I don’t have a chunk of money to put down at once, I couldn’t take advantage of the prepaid plan and the 529 seemed more advantageous than a Coverdell to me. As with any savings goal, the key is time - start early and let compounding do the work for you.

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This entry was posted on Wednesday, April 18th, 2007 at 3:21 pm and is filed under College saving. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.