College Saving Options
You're ready to start saving, but where should you put your money?
There are several college savings options, but to come out ahead in the college savings game, you should opt for tax-advantaged strategies whenever possible.
529 plans are one of the most popular tax-advantaged college savings options. They include both college savings plans and prepaid tuition plans. With either type of plan, your contributions grow tax deferred and earnings are tax free at the federal level if the money is used for qualified college expenses. States may also offer their own tax advantages.
With a college savings plan, you open an individual investment account and select one or more of the plan's mutual fund portfolios for your contributions. With a prepaid tuition plan, you purchase tuition credits at today's prices for use at specific colleges in the future--there's no individual investment component. With either type of plan, participation isn't restricted by income, and the lifetime contribution limits are high, especially for college savings plans.
Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about specific 529 plans is available in each issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.
Coverdell education savings accounts (formerly known as Educational IRAs)
A Coverdell education savings account is a tax-advantaged education savings vehicle that lets you contribute up to $2,000 per year. Your contributions grow tax deferred and earnings are tax free at the federal level (and most states follow the federal tax treatment) if the money is used for the beneficiary's qualified elementary, secondary, or college expenses. You have complete control over the investments you hold in the account, but there are income restrictions on who can participate.
UTMA/UGMA custodial accounts
An UTMA/UGMA custodial account is a way for your child to hold assets in his or her own name with you (or another individual) acting as custodian. Assets in the account can then be used to pay for college. All contributions to the account are irrevocable, and your child will gain control of the account when he or she turns 18 or 21 (depending on state rules). Earnings and capital gains generated by assets in the account are taxed to the child each year.
Under the kiddie tax rules, for children under age 19, and for full-time students under age 24 who don't earn more than one-half of their support, the first $1,000 of earned income is tax free, the next $1,000 is taxed at the child's rate, and anything over $2,000 is taxed at your rate.
A last word on financial aid
Many families rely on some form of financial aid to pay for college. Loans and work-study jobs must be repaid (either through monetary or work obligations), while grants and scholarships do not.
Most financial aid is based on need, which the federal government and colleges determine primarily by your income, but also by your assets and personal information reported on your aid applications. In recent years, merit aid has been making a comeback, so this can be good news if your child has a special talent or skill.
The bottom line, though, is don't rely too heavily on financial aid. Although it can certainly help cover college costs, student loans make up the largest percentage of the typical aid package. Generally, plan on financial aid covering the following percentage of expenses: loans--up to 50%, grants and scholarships--up to 15%, work-study--varies. The lesson: the more you focus on your savings now, the less you may need to worry about later.