Saving for college is hard not just because it's a
huge expense, but because you can't predict how much, if any, financial
aid you'll get.
That's why you need to
save what you can now. Fortunately, you have a number of tax-advantaged
federal and state college-savings vehicles at your disposal. The best
option is the state-sponsored 529 plan, which comes in two flavors: the prepaid tuition plan and the savings plan.
A
state's prepaid plan allows you to pay now at today's rates for school
tomorrow. In return, your account (or contract as it's often known) is
guaranteed to pay for the tuition and fees at the state's public
universities and colleges by the time your child graduates from high
school. A pre-paid plan often does not, however, cover the costs for
room and board.
Your child also may use
the pre-paid account to attend a private or out-of-state school but you
might risk forfeiting some of its value depending on how the plan values
its contracts. Note, too, that most pre-paid plans require that the
account owner (you) or the beneficiary (your child) be a resident of the
state in which the plan is offered.
The
529 college savings plan, now offered in most states, is far more
flexible. The money may be used at any school you choose and for all
qualified higher education expenses, including room and board.
Each
state determines what the lifetime contribution limit or account
balance cap will be in its 529 plan, but typically such limits range
between $100,000 and $270,000. Investment minimums are low (most plans
let you sock away as little as $25 a month), and there is no restriction
on how much you may contribute every year unless the account is nearing
the lifetime cap. However, since 529 contributions are treated as gifts
subject to gift-tax limitations, if you want to make a tax-free
contribution, it shouldn't exceed $12,000 annually ($24,000 if you're
contributing with your spouse). Actually, you may contribute as much as
$60,000 tax-free in one year ($120,000 with your spouse), but that
contribution will be treated as if it were being made in $12,000
installments over the next five years. That means you can't make other
tax-free gifts to the beneficiary during that time.
Most
529 savings plans offer a menu of age-based portfolios, and some also
offer a small selection of stock and bond funds. In the former case,
your annual contributions get invested in a pre-selected portfolio of
stocks and bonds. Early on, the portfolio is tilted toward stocks, and
as the time for college nears, the weighting shifts more heavily toward
bonds. Note, however, that once you choose an investment track, it can
be cumbersome to change.
The quality of
529 college savings plans may vary by state, but in most instances you
may open an account in any state you'd like.
All
529 plans offer generous tax breaks, provided you use the money for
qualified expenses. While your contribution is not deductible on your
federal taxes, your investment will grow tax-free and withdrawals will
not be subject to federal tax. In prior years your money had grown
tax-deferred and earnings withdrawals were taxed at the student's income
tax rate. (Note, however, this federal tax-free provision is set to
expire in 2010 unless Congress passes a law to extend it.) What's more,
you may get state-tax deductions on contributions or exemptions on
withdrawals.
One caveat: Having a 529 is
likely to reduce your chances of getting financial aid. The 529 college
savings account is considered the parent's asset, and hence is assessed
at a much lower rate than if it were the child's. Yet withdrawals from a
savings plan are considered the child's income, which is assessed at a
50 percent rate for financial aid assessment purposes. A prepaid tuition
plan is treated somewhat differently. The amount in benefits paid out
essentially reduces dollar-for-dollar the amount assessed as your
child's financial need.
Another tax-advantaged option is the Coverdell Education Savings Account (formerly
known as the Education IRA). The contribution limit is $2,000 and
withdrawals are tax-free. To qualify for a full or partial contribution,
your adjusted gross income must be less than $110,000 if you're single;
$220,000 if you're married and filing jointly. One of the drawbacks is
that the annual contribution cap is per child, meaning if you and your
parents want to contribute to an account for your daughter, your
combined contributions can't exceed $2,000.
You
may contribute to both a 529 and a Coverdell Education Savings Account
on behalf of the same beneficiary in the same year without penalty, but
your contributions will be treated as gifts subject to gift-tax
limitations.
Friday, February 12, 2016
