Paying for a child's college education is an expensive proposition – but not an impossible one. With an appropriate strategy, you can go a long way to meeting this challenge whether your child is still in preschool or already in high school.
An Early Start
If your child is young, establishing a savings plan now can put time on your side. Consider alternatives to the traditional savings account.
- Mutual Funds. Setting up a custodial account in your child's name funded with a mutual fund and making regular contributions to that account can help you reach your college finance goals. Choose investments with a potential for long-term returns.
- Coverdell Education Savings Account (formerly Education IRAs). If you are eligible, you can contribute to an Education Savings Account for each of your children or grandchildren under age 18. All withdrawals – including investment earnings – that are used to pay the child's qualified education expenses are income-tax free*.
*The earnings portion of distributions that are used for non-qualified education expenses are subject to ordinary income tax, plus a 10% penalty.
- Qualified Tuition Programs: Section 529 of the Internal Revenue Code authorizes two types of tax-favored qualified tuition programs.
- Pre-paid Tuition Plans. Many states and individual colleges offer tuition prepayment plans. With these plans, you make a series of payments or pay a lump sum now for your child's education. In return, the plan guarantees that your investment will cover a specified amount or percentage of the child's expenses when he or she is ready to attend. Some plans lock in the cost of future education at today's prices. Both states and private educational institutions can create tax-favored plans. Before choosing this route, though, be sure to find out what will happen to your investment if your child doesn't attend the sponsoring college.
- Education Savings Plans. This is the more commonly used type of qualified tuition plan. Unlike pre-paid tuition accounts, only states may sponsor education savings accounts. State-sponsored accounts provide you with a way to invest for a child’s college education that is federally income tax-free upon withdrawal. Any earnings generated will be federal (and possibly state) income tax-free as long as withdrawals are used for qualified higher education expenses. Any earnings withdrawn that are not used for qualified higher education expenses are subject to federal income tax and may be subject to a 10% additional federal tax, as well as applicable state and local income taxes. Section 529 plans are established by various states and offered to residents of all states. Depending on the laws of the customer's home state, favorable tax treatment may be limited to investments made in a Section 529 plan offered by the customer's home state. Therefore investing in a 529 plan outside your domicile state may deny you the opportunity to take advantage of favorable state tax treatment. Unlike pre-paid tuition plans, funds in these plans generally can be used for expenses at any qualified school nationwide. However, it is important to note that there is no guarantee that funds in an education savings account will be enough to cover the cost of tuition. If a contribution to a beneficiary's account, in one year, exceeds the federal gift tax annual exclusion, you may elect to take the aggregate contribution into account ratably over five years beginning with the year of the contribution. If you die before the end of this five-year period, the contributions allocable to periods after death are included in your gross estate. Other than this exception, a 529 education savings plan should not be included in the donor's estate.
Never Too Late
If your child will be starting college within the next couple of years or has already started, there are still financing methods available for you to consider.
- Financial Aid. Most schools have a limited pool of funds, so you should file financial aid forms as soon as possible. Generally, the school will calculate how much aid your child will receive based on your financial situation. Also, your child should apply for all available governmental or private grants and scholarships.
- Loans. Your child’s aid package may include loans from the federal or state government, the college or a commercial lender. The loan offers may vary considerably, depending on the program, so be sure to carefully check the interest rates and terms of each. Home equity loans, retirement plan withdrawals, and the cash value of your life insurance are other possible loan sources you might consider.
- Tax Incentives. If you do take out a qualified higher education loan, some of the interest paid may be tax deductible this year. (Certain restrictions may apply.) You also may be eligible for the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit, although both of these credits are phased out at higher income levels.
- New Above-the-Line Deduction for Higher Education Expenses. Eligible taxpayers can claim on above- the-line deduction for qualified higher education expenses. However, the deduction is subject to certain income limitations. The deduction may also be unavailable or limited if other education tax benefits are utilized for the tax year.
While it's best to get an early start, it is never too late to plan for the cost of your child's education. For assistance, call your professional financial advisor. He or she can help you plan today for your child's education tomorrow.
Mutual funds are offered by prospectus and 529 Plans are offered by an offering circular. An investor should carefully consider the investment objectives, risks, charges and expenses of an investment before investing. Read a mutual fund prospectus or an offering circular carefully before you invest. The investment return and principal value of an investment will fluctuate with changes in market conditions so that an investor's shares when redeemed may be worth more or less than the original amount.