EVEN IF YOUR CHILD is an Einstein, no parent can safely bet that their student will receive a full ride to the college of his or her choice. That means, if you want to help foot the bill, you need to save. Here are some options.
The 529 plan, named for the IRS code that permits the program, is the most popular savings vehicle for college because of its tax-favored status.
“It allows families to save money in an account that grows federal income tax-free and comes out federal income tax-free if used to fund qualified higher education expenses for the beneficiary,” says Jody D’Agostini, a certified financial planner with AXA Advisors/The Falcon Financial Group in Morristown. She also notes that distributions from most plans are not subject to state tax.
Those “qualified expenses,” listed in IRS Publication 970, generally include tuition and fees, room and board, books and supplies, as long as the student is enrolled at least half-time at eligible institutions.
Earnings from distributions that are not for “qualified expenses” are subject to income tax, plus a 10 percent penalty tax, says Gerard Papetti, a certified financial planner and certified public accountant with U.S. Financial Services in Fairfield.
The plans are offered by individual states or educational institutions. In New Jersey, the program is called NJBEST, but you can enroll in any state’s 529 plan, and the funds can be used at in-state or out-of-state colleges. Unlike other states, New Jersey doesn’t offer additional tax breaks for investing, but it does offer a possible tax-free scholarship of up to $1,500 for those attending state colleges and universities.
Another advantage is that 529s are not counted as heavily on the Free Application for Federal Student Aid (FAFSA).
“They become an asset of the parent, since they ‘own’ the account and the child is the beneficiary,” D’Agostini says.
The 529 plans are assessed at a maximum rate of 5.64 percent on the FAFSA form, so there is limited impact on financial aid.
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As the owner of the account, you retain control of the funds. Each 529 plan offers its own investment options, but most offer popular “age-based plans,” for which the fund changes the account allocation to be more conservative as the beneficiary — the student — nears college age.
Each 529 plan has its own investment limits, but most allow you to save hundreds of thousands of dollars. Another plus is that you can change the beneficiary at any time. Let’s say you have a kid who decides not to go to college, or receives scholarships and grants so the money isn’t needed for college. You can change the beneficiary to another child, or even grandchildren, cousins and other relatives.
Or maybe your older child needs more for college, so you can pull funds from your younger child’s account to pay for current college bills.
This must be weighed against the opportunity for the funds to stay in the younger child’s 529 account and grow tax-free over several more years, says Bryan Smalley, a certified financial planner with RegentAtlantic in Morristown. “The compounded growth that may be given up could far outweigh the immediate need to pay the older child’s tuition bill, especially if that growth will be needed to fund the younger child’s college education.”
529 plans are also an attractive tool for estate planning.
“Gifts to a 529 plan are subject to the annual gift tax exclusion — currently $14,000 — however, you can elect to accelerate five years of gifting in year one, but then cannot make any tax-free gifts until after five years,” Papetti says. “Gifts to a 529 plan are removed from the owner’s estate yet the owner remains in control (of the funds).”
COVERDELL EDUCATION SAVINGS ACCOUNTS
Similar to a 529 plan, distributions from Coverdells are tax-free if used for qualified higher education expenses, and they also can fund expenses related to grades K through 12. Coverdells also allow you to make beneficiary changes, the same as with a 529 plan. But you can only put away $2,000 per year per beneficiary.
“The contributions need to be made before age 18 and used by the beneficiary by age 30,” D’Agostini says. “If withdrawn for nonqualifying expenses, it’s subject to federal tax, plus a 10 percent penalty.”
Before the 529 plans came to town, custodial accounts were popular savings options. Known either as Uniform Transfer to Minors Act (UTMA) accounts or Uniform Gift to Minors Act (UGMA) accounts, they are still used by many but lack the tax advantages and flexibility of a 529 plan.
When you save in a UTMA account, for example, the money is no longer owned by you, but by the child. This means when the child reaches the age of majority, you cannot stop the child from spending the funds on a sports car instead of a college education.
Custodial accounts also are subject to taxation. For 2015, the first $1,050 of earnings is tax-free, the second $1,050 is taxed at the child’s tax rate and anything more than $2,100 is taxed at the parent’s higher tax rate.
You can invest the money in most mutual funds, stocks and bonds.
These funds are counted more heavily for financial aid. While schools assume 5.64 percent of a parent’s assets will be earmarked for college, they also assume 20 percent of a child’s assets will be for college. That could mean less financial aid for a student with custodial accounts.
SERIES EE SAVINGS BONDS
Series EE Savings Bonds are attractive because the interest earned is federal and state tax-free if used to pay for college.
There is, however, a phase-out depending upon your income, D’Agostini says. Phase-outs begin at $115,750 for singles and $145,750 for joint filers.
The maximum investment would be $10,000 per year per owner, and can be used to pay tuition and fees only. The bonds are owned by the parent.
“These are very safe investments backed by the full faith and credit of the U.S. government,” D’Agostini says.
But such a “safe” investment will reap far smaller returns than a mutual fund, which can be owned within other college savings vehicles. If you have a long horizon for college bills, you’re probably better off with stock market exposure.
While the primary purpose of a Roth IRA is to save for retirement, you can avoid the 10 percent penalty for early distributions if you use the funds for qualified education expenses.
Make sure you only take out your contributions, however. The rules don’t apply to earnings.
And take care not to raid your retirement plans for college. While you can always borrow for college, no one will lend you money for retirement.
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