Tax credits, tax breaks, and more -- here's how they work.
Painful as it may seem, you're better off knowing what your child's college education will cost. Right now, one year's tuition, fees, and room and board at the average four-year public university costs $10,636, according to the College Board. At a private college, the average is $26,854; at highly selective schools, such as Stanford or Yale, the cost is even greater. In recent years, tuition at public and private schools has increased as high as 8 percent per year.
Yes, those figures are staggering. Why not just ignore the subject entirely and trust that financial aid will kick in? Here are two compelling reasons:
Keep in mind that college financial aid is reduced by the amount you and your child can contribute. Annual income aside, parents' assets reduce aid eligibility by a maximum of 5.65 percent; assets in a student's name reduce aid eligibility by 35 percent. Here's how it works: If parents have $10,000 in an account, colleges reduce aid eligibility by up to $565 per year. If the account is in the student's name, that same $10,000 reduces financial aid eligibility by $3,500 in the first year alone.
Read on for an overview of college financing strategies. We've included some tax credits and breaks; however, your adjusted gross income typically determines if you're qualified to participate in these programs, so it's best to consult an investment adviser or read IRS materials about the programs before setting your sights on them.
1. Buy mutual funds. By their nature, mutual funds diversify your college nest egg, even if it's a small one to start with. You can schedule automatic deposits from your checking account into a fund, making investing easy and relatively painless. Mutual fund choices are many: You can choose from low- to higher-risk stock funds, lower-risk high-yield bond funds, or tax-free municipal bond funds. U.S. government and blue-chip corporate bonds are less risky, but you'll need to reinvest the interest.
Drawback: The money will be in taxable accounts, requiring you to pay capital gains taxes each year.
2. Buy zero-coupon bonds. Interest on EE savings bonds -- which can be bought in very small denominations -- can be tax-free provided certain conditions are met. Among the conditions: the proceeds must be used to pay for post-secondary education, the bonds must be purchased in the parent's name (with the child as the beneficiary), and the parents must be in a qualifying income-tax bracket when the bonds mature.
Drawback: You shouldn't rely solely on zero-coupon bonds to finance a college education, since the interest earned from these bonds doesn't keep pace with tuition increases.
3. Take advantage of the HOPE Credit. Created by the Taxpayer Relief Act of 1997 and updated with the 2001 tax legislation to soften the bite of college costs -- along with the Lifetime Learning Credit (LLC) -- the HOPE credit allows a full tax credit for the first $1,500 in tuition paid for each of the first two years of undergraduate study.
4. Take advantage of the Lifetime Learning Credit. The LLC offers a 20 percent credit for the first $10,000 in tuition paid per taxpayer for the third year of undergraduate study and beyond.
5. Contribute to an education IRA. If your adjusted gross income is below $150,000 for married filers or $95,000 for single filers, you can contribute up to $2,000 of after-tax income per student per year to an education IRA (known as a Coverdell Education Savings Account, or ESA), and the funds will grow tax-free if they're used for higher education costs. But withdraw from this IRA and you can't claim the HOPE or LLC for the student in that year. The annual contribution limit is so low, many mutual funds either won't accept your contribution or will charge higher fees that drag down your return.
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.
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.
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.