Education Financing: Saving for Your Child's College Expenses

As tuition costs continue to rise at a rate of about 6% a year, for many Americans with children paying for college has become one of their greatest financial concerns.  Colleges and universities are likely to be located in high cost urban areas and towns plus higher operating costs on campus along with increased salaries and benefits all contribute to the problem of escalating costs.  Reduced state funding means that more families must now rely upon themselves as well as private institutions to make up the gap.  For families with two or more children, the sooner they start planning and begin saving the better off they will be when the day to start writing those tuition checks inevitably arrives.

Determining Your Needs:

• How many children in the family will need financial assistance? Obviously the more children one has, the more they will be required to save.

• What are the current ages of all college bound children?  If you have toddlers you are certainly in a better position to begin planning and saving than those who have kids already in their teens.

• Guesstimate the child’s potential campus. This will be difficult to do until high school when the child’s grades and interests become evident.  However a private university in an urban environment will certainly cost more than a state college in a small town or semi-rural area.

Estimating Potential Costs:

The most prudent approach may be to adopt a worst case scenario and to use that as your target or goal.  If you assume that your child will want to apply (and will be admitted) to a costly private university, with minimal outside financial support, you should come out okay even if you fall short of reaching your goal.   It is impossible to know now the length or extent of the education that will be required based on your child’s future chosen field or profession.  Could graduate school be on the horizon also?  Let’s begin with undergraduate expenses:

Once you have completed the process of making some educated guesses about your child’s potential college expenses, the next step is planning to actually meet them.

Saving for College:

There are several methods by which funds can be contributed to accumulate for college.  Money could be set aside on either a periodic basis (i.e. quarterly, monthly, weekly) or a lump sum could be placed in an account for growth (i.e. contribution from grandparents, unexpected windfalls, bonuses set aside for education fund purposes).  Because the lump sums are more difficult to anticipate, unless they occur when a child is very young, it is probably wise to plan on making periodic contributions to your children’s education fund(s).

Vehicles for Saving:

• Educational IRAs (AKA Coverdell Education Savings Account-ESA) - contributions are not deductible (they are “after tax” contributions) however amounts deposited into the account can grow tax free until distributed.  Distributions are made tax-free as long as they are used for qualified education expenses.  Total contributions cannot be more than $2,000 in any given year regardless of how many accounts have been established.  Note that there is a phase out for Modified Adjusted Gross Income (MAGI) on this type of account for 2006 at less than $110,000 (single filers) and $220,000 (joint filers).  For more info:  http://www.irs.gov/publications/p970/ch07.html

• Qualified Tuition Programs (AKA QTPs or 529 Plans) – These plans are sponsored by individual states.  Elements of the plan which could vary by state are: contribution limits, investment options, fund expenses and fees, etc.  Accounts can be set up for each eligible child and a special provision of the plan allows contributions to be averaged over a 5 year period so that up to $146,000 to $305,000 (with a median of $235,000) can be contributed.  Most colleges and universities will look at and include 529 assets when computing eligibility for financial aid, however the good news is that any monies used from the plan for educational purposes are considered the student’s income and not that of the plan contributor’s.  The biggest drawback of the 529 plan is that the investment options are usually very limited and somewhat conservative, however for those lucky children who have wealthier contributors in their lives, it is an extremely good option. For more info: http://www.irs.gov/publications/p970/ch08.html  

• Traditional IRAs – They offer a tax deduction for contributions and the funds may be used penalty free for higher education purposes.  However you are taxed on any withdrawal at your marginal income tax rate even though you can take distributions from your IRA for qualified education expenses without having to pay the additional 10% tax on at least part of the amount distributed.  For more info: http://www.irs.gov/publications/p970/ch09.html

• 401(k) Plans – Using your 401(k) as an education savings vehicle allows you to contribute $15,500 of your earnings per year on a tax-deferred basis.  However withdrawals are subject to taxes and a 10% penalty unless the money is used as a loan from the 401(k) plan.  If your plan permits it, you can borrow up to 50% of its value to a maximum of $50,000 and then repay they loan with interest over a 5 year period. For more info see “Loans from 401(k) plans” and “Hardship distributions”: http://www.irs.gov/retirement/participant/article/0,,id=151787,00.html

• Savings Bonds – Savings bonds can be redeemed on a tax free basis for education purposes however strict rules do apply.  Bonds must be either Series EE or Series I and must be owned by yourself or jointly with your spouse, not in the child’s name.  Modified adjusted gross income limits of $78,100 ($124,700 if filing a joint return) may apply at the time of redemption to qualify for an exemption.  For more info: http://www.irs.gov/publications/p970/ch10.html

Always consult your tax advisor when establishing and/or attempting to withdrawal funds from any retirement account(s) or any other account(s) which may have potential tax implications for you.

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