Making Sense of College Savings
Saving for college is a daunting task. Over the past decade, tuition rates have been steadily rising and student financial aid is getting harder and harder to come by. The average college graduate had $26,500 of student loan debt in 2011, up almost 5% over the year before. To help ease the pain of rising tuition costs there are several college savings vehicles that help to save for college in tax-favorable ways. Let’s take a look at some of these plans.
A 529 plan is one of the most flexible ways to steadily save for college for your child, grandchild or other future student in your life. There are no income limitations on who can contribute to a 529 plan. Anyone can be an account owner and anyone can be a beneficiary. A contribution is considered a completed gift and is therefore excluded from a contributor’s estate. The contributions into the plan are not tax deductible but the earnings grow tax-free and there is no taxation on withdrawal as long as the withdrawal is used for qualified educational expenses.
529 plans fall under two categories – prepaid and savings. Prepaid plans lock in a tuition rate at an eligible public or private university. The contributions to the plan are only eligible to cover tuition and mandatory fees. Lump-sum installment plans are set up based on the beneficiary’s age and the number of years purchased; this is an advantage because it locks in lower tuition rate for the future. However, it impacts the student’s flexibility when choosing a university. Enrollment in these plans is also often limited to a certain time of year.
Contributions into a 529 savings plan can be made to the extent of up to five times the annual gift exclusion. For 2012, this limit would be $65,000 (although it would be taken into account as part of the beneficiary’s exclusion for those next five years). For the purpose of the savings plan, qualified expenses include tuition and mandatory fees, books, supplies, required equipment, reasonable room and board costs for certain students and expenses for a student with special needs that may require more time to finish a degree. Any excess withdrawal over qualified expenses will be taxable. There are no age limits, and the total contribution limits often exceed $200,000. These plans generally have an open enrollment period. Keep in mind that once the contributions are invested they are subject to market risk.
There are clear advantages of a 529 plan, aside from the tax-free growth of contributions. If a beneficiary decides that college is not for them, 529 plans can be transferred to another beneficiary tax-and-penalty-free. Many plan administrators also have choices for an age-based strategy so the portfolio is automatically rebalanced from more aggressive to more conservative as the beneficiary nears college-age.
529 plans are not without risk or disadvantages, however. A beneficiary will be subject to ordinary tax on earnings and a 10% penalty if the money is withdrawn and not used for qualified education expenses. There is generally a limit of only one investment change per year. The accounts will be factored into a parent’s assets that will need to be disclosed for financial aid, which means that less aid may be available to a student. And of course, the account is subject to market risk and if there are losses on the account they are not easily written off.
There are also several other options to save for higher education. UTMA or UGMA accounts, a custodial investment account, allows for the most flexibility when investing. However, the contributor loses control over the account once the beneficiary reaches a certain age and the account counts towards the beneficiary’s (student’s) assets when applying for financial aid. Another option is purchasing savings bonds-any interest income can be used tax-free to pay for tuition and there is no penalty for using bond proceeds for other purposes. However, there is a limitation of $10,000 of bond purchases per year and the bonds can’t be redeemed for 12 months. Educational Savings Accounts are a flexible option for first-and-secondary education; they feature the tax-free earnings that a 529 plan has but withdrawals can be used on a broad range of expenses, including private school tuition for grades K-12, computers, books, etc. However, there is a $2,000 contribution limit into these plans per year and there is an income limitation of $220,000 or less per married couple to be eligible to contribute into an ESA.
A comprehensive website about different plans per state, including comparisons on fees and other features can be found here: http://www.collegesavings.org/index.aspx . LMGW is here to help with questions in determining if a college savings plan is right for you, setting up the plan, identifying qualified expenses, staying in compliance and more. Please contact us should you have any questions about these plans.
ShareThis