DES MOINES, Iowa — Talk about sticker shock.
Many parents set on helping send their kids to college have to catch their breath when they think about meeting the projected expense. After all, if a private liberal arts college costs $35,000 or more in tuition and fees, what will it charge years from now when Junior’s graduating high school?
It’s an important question because parents still pay the biggest portion of college costs, says Sallie Mae, the nation’s largest student lender. Nearly half of the cost of college comes from the income, savings and borrowing of parents. Grants and scholarships pay 23 percent, and student borrowing covers another 14 percent. Help from relatives, student savings and income pay smaller portions of the college bill.
With the recession and slow economic recovery of the last few years, the challenge isn’t becoming any easier. For instance, the top ways parents save for college are money market accounts or certificates of deposit, Sallie Mae surveys show. They’re safe but not exactly high growth options. That’s been particularly true in the last few years as interest rates remain low in hopes of jump-starting the economy.
Most families do best when they automatically transfer money from a paycheck into a 529 college savings plan, said Tom Evans, senior adviser with JNBA Financial Advisors in Minneapolis.
Of course moving money automatically isn’t limited to 529 plans. Here’s a look at three common ways families set aside money for college and a brief look at the advantages and where they may fall short.
529 savings plans
A 529 savings plan can be thought of as a 401(k) for college. It’s similar in that it offers tax advantages and you can invest your contributions in mutual funds or other investments. As a result, the balance is sensitive to stock and bond market volatility.
Every state has at least one 529 plan option and each sets its own rules, so how they operate can differ widely. A parent may invest in a 529 plan sponsored by a state other than the one in which they live, which means there is opportunity to shop around to find the plan that best suits the family’s financial situation.
Today more than $111 billion is invested in 529 savings plans, up from $2.6 billion in 2000, according to the Investment Company Institute.
• Taxes: The balance of a 529 account grows tax free and funds can be withdrawn free of federal taxes when used for college expenses. Many states also allow income tax deductions on a portion of the contributions.
• Control: The person establishing the account maintains ownership and control of the funds. That means the child named as the beneficiary cannot get at the money without permission of the account holder. If necessary the money can be used by the owner for purposes other than education, but withdrawals outside the qualified educational purposes carry a 10 percent penalty and taxes must be paid.
• Limits: 529 savings plans have very high contribution limits, typically more than $300,000, but limits vary by state.
• Financial aid: The impact on a student’s potential financial aid is less with a 529 than other options because the assets belong to the owner of the account and not the student.
• Complexity: Every state has a 529 plan and some have more than one. That provides plenty of choices, but it also means making comparisons can be daunting and confusing. Rules, fees and investment choices can differ widely.
• Fees: They can be high in some plans although, on the whole, fees have come down considerably in recent years. Some carry annual fees or enrollment fees, but in many cases these may be waived for in-state account holders.
• Investments: Options may be limited and determined by the investment company managing the plan. A lackluster group of funds to choose from can shortchange growth opportunities. Assets can be rolled over into the plan of another state if it’s determined it has better investment gains. However, generally you can only change once a year without tax consequences.
Useful Tip: If you have a specific plan in mind, check to see if you can enroll directly rather than going through a broker. Brokered accounts cost more. Consider a plan you can buy directly through major mutual fund providers such as Fidelity Investments, The Vanguard Group or Charles Schwab Corp.
Note there also are prepaid 529 plans offered by states. In addition, a group of 270 private colleges offer their own prepaid plan called the Private College 529 plan. Learn more at: https://www.private
Coverdell education savings accounts
Coverdell accounts are set up through a broker, bank or mutual fund company. They are frequently used by families with young children attending private schools. That’s because the money also can be used for kindergarten through 12th grade educational expenses.
The accounts are like Roth IRAs in that the account holder’s contributions are taxed when they go in, but the account grows tax-free and withdrawals are free of federal taxes if used for qualified educational expenses. Without congressional action, use for K-12 expenses ends on Dec. 31. The contribution limits also fall considerably unless the current law is extended — whether Congress will act remains unclear.
• Taxes: Account withdrawals are tax-free if used for qualified educational expenses such as tuition, fees, books, supplies and room and board.
• Control: The account holder tends to have more investment options than with a 529 plan — investment choices range from certificates of deposit to mutual funds and can be changed by the owner more frequently.
• Changes: Without congressional action by the end of the year, Coverdell contribution limits will fall from $2,000 a year to just $500. Only qualified college uses will be tax free, eliminating current uses for kindergarten through 12th grade educational expenses. Also, contributions to both a 529 plan and a Coverdell account, for the same beneficiary in the same year, will trigger penalties.
• Limits: Income limits for contributors — those making more than $110,000 cannot contribute.
• State taxes: It’s not possible to deduct contributions from your state taxes.
• Control: The beneficiary may get control of the money at age of maturity, which is 18 in some states and 21 in others. At that point, the money can be used for any purpose.
Useful Tip: Keep an eye on congressional action. A bill has been introduced that would keep the $2,000 annual contribution limit permanently and make other changes, but it’s unlikely to be considered before Election Day in November. If no action is taken, consider rolling over any Coverdell funds into a 529 plan before Dec. 31 or spend down the account on qualified educational expenses, says Susie Bauer, the college account manager for Robert W. Baird & Co., a Milwaukee-based financial adviser.
These trust accounts are often used by grandparents to help fund education for their grandchildren. The accounts are known formally as Uniform Transfer to Minors Act (UTMA) accounts and Uniform Gifts to Minors Act (UGMA) accounts. They were designed to allow adults to transfer ownership of securities, real estate and other assets to children without tax consequences and are often used as college savings tools.
The person funding the account for a minor must name a trustee to oversee the account. Once the money is given to the trust it cannot be taken back.
• Limit: There are no contribution or income limitations.
• Investments: Trustee has flexibility to decide how the money is invested but must follow prudent management guidelines that benefit the minor.
• Control: The money need not be used for educational expenses. The account is turned over to the minor at the age of maturity, which is 18 in some states and 21 in others. At that point, the money can be spent for anything.
• Taxes: The tax advantages are significantly less than with 529 plans or Coverdell accounts. Just the first $950 of investment gains are free of federal taxes, after that the gains are taxed at either the child’s rate or the parents’ rate.
Useful Tip: Be aware that these trust accounts may be considered assets of the child when applying for financial aid, which means they could weigh more heavily against eligibility for aid.