6. Make a qualified penalty-free withdrawal from a traditional IRA. The withdrawal penalty has been removed if money in a traditional IRA is used for qualified educational expenses.
Drawback: You'll have to pay taxes on the withdrawal, and the money will be counted as additional income and reduce your child's eligibility for aid, so you should avoid withdrawals at all costs.
7. Contribute to a Section 529 prepaid tuition plan or a Section 529 college savings plan. With a prepaid tuition plan (also known as a tuition account program), you can lock in your child's tuition, room, and board at current rates by paying the bill now in a lump sum or installments. Investments in these plans are usually exempt from state and local income tax, but are still subject to federal income tax. Earnings from a state-sponsored prepaid tuition plan are taxed upon withdrawal at the child's rate. And prepaid units (which represent a fixed percentage of tuition) can be purchased for your child by grandparents or even friends of the family.
- If you qualify for financial aid, your eligibility will be reduced by the full amount that you withdraw from a prepaid tuition plan.
- If your child decides to go to a different school, or none at all, you may get back just the principal and a small amount of interest -- or less.
The college savings plan (also known as a tuition investment plan) is offered in all 50 states and is also available though a number of investment companies, including Fidelity and Merrill Lynch. Through this state-sponsored program, parents can make monthly or quarterly contributions to an account (which can be opened for as little as $50 in some plans) that's run by professional money managers who automatically change the investment mix as a child ages. For example, everything might be in stocks when the account is opened, but is moved to a mixture of stocks, bonds, and cash instruments as the child gets closer to college age.
Contribution limits to the Section 529 college savings plan are generous -- an individual can contribute $55,000 per year ($110,000 per year for a married couple) without triggering the federal gift tax (although there are some stipulations involved, so check with your accountant). Withdrawals can be used for books, tuition, or living expenses in connection with attendance at nearly any type of accredited college, community college, or technical school. No taxes are due until withdrawals begin; when they do, the withdrawals are taxed at the student's lower (in most cases) tax rate.
- You don't control how the money is invested.
- There are big tax penalties if your child doesn't use cash for college and you decide to retrieve the money -- you'll pay a 10 percent penalty and taxes based on your rates.
8. Set aside money in a trust. Putting money in a custodial account for a child -- called a UGMA or UTMA (Uniform Gifts [or Transfers] to Minors Act) -- has some tax advantages. For kids under age 14, the first $750 of investment income each year is tax-free; the next $751 to $1,400 is taxed at the child's tax rate; additional investment income is taxed at the parents' rate. After age 14, all investment earnings are taxed at the child's rate. Most kids are in a lower tax bracket than their parents, so tax savings can be significant.
Drawback: After you put money in this kind of child's account, it can only be withdrawn for your child's use. Once Suzy reaches the age of majority (usually 18 or 21), she can use the money as she pleases. Even if funds are withheld from the student until she graduates, trust-fund assets must always be reported on financial aid forms, and will reduce your child's eligibility for aid, so don't put money in a kid's account until you're sure you won't qualify for financial aid. Also, warn generous relatives against giving your child money in her name before college (such as in an education IRA or a custodial account). Perhaps they could make the gift when she graduates, to help pay off loans.