Education Savings 101: Ways to Save

Every year, pride and joy fills the hearts of millions of parents as their offspring receive their colleges acceptance letters. Then inevitably, the tuition bills start ariving and the harsh truth sets in: education isn’t cheap.

The average price for a four-year private college for the 2009-2010 school year is $26,273, a 4.4% increase from last year, according to the College Board. A four-year degree at a public school will cost you an average $7,020, up 6.5%. If your child is one year old today, once you factor in tuition inflation over the next 18 years, you can expect the cost of that college degree to increase exponentially, to as much as several hundred thousand dollars.

The good news: there are different ways to save for that higher education and with some advance planning and effort, you can help your child defray at least part of that cost. The earlier you start socking money away the better financial position you’ll be in come college time.

Obviously, how much you need to save will depend on where you want to send your kid. To state the obvious, Harvard costs more than your local community college. A good place to start is researching the tuition rates at some schools where you may want to send your kids (though when that time comes, where they study may not be entirely up to you). Then, start saving. “If you put a regular amount aside on a monthly basis you’ll get into that habit,” says Ken McDonnell, director of the Choose to Save program, an outreach program to educate people on the benefits of saving.

And just like you would do a lot of research in choosing a school, you should thoroughly review your different college-saving options.

529 College Savings Plans

For many people, putting money in a regular savings account isn’t the optimal way to save for college. More attractive is a 529 college savings plan. Named after Section 529 of the Internal Revenue Code, 529 college savings plans offer attractive tax benefits. Most states offer a state-tax deduction if you save in your home state’s plan, and under federal law, the money in those accounts grows tax-free. Withdrawals are also tax-free, as long as they are used to pay for qualified expenses, which include tuition, room and board, as well as books, supplies and equipment. If your child doesn’t go to college or gets a scholarship, the money can be transferred to another family member. Withdrawals used for non-qualified expenses are subject to income tax and a 10% penalty.

There are two types of 529 plans: savings and prepaid plans.

With a 529 savings plan, the state, or a money manager hired to run the plan, offers several investment choices that are treated like mutual funds. Assets are invested in a basket of stocks or bonds (or a mix of both), similar to the investing options in your 401(k) or IRA. If you choose to invest in stocks with this type of plan, you are at the mercy of the gyrations of the stock market. Many of the plans will invest aggressively in the early years of your child’s life and then become more conservative as the child nears college. Each state’s plan varies so you may want to shop around. Even if your state offers a tax deduction, you may better like the investing options and expenses in another state’s plan. Typically you can invest as little as $50, up to a $300,000 or so account maximum.

With a prepaid 529 plan, you pre-pay some or all of the costs of schools in your state. Basically you’re locking in the cost of a specified number of semesters or academic courses in the future at current rates. These accounts offer somewhat less flexibility: you will maximize your investment if your child goes to an in-state public school, but should he or she choose to go out of state — or to Harvard — you will get less value for those prepaid tuition credits.

Coverdell Education Savings Accounts or ESAs

A Coverdell ESA, previously known as the Education IRA, is a trust or custodial account set up to pay for the education expenses of a child. With an ESA any individual can contribute up to $2,000 a year. Just like with an IRA, you have more say in where the money is invested, whether its stocks, bonds or mutual funds. The money grows tax-free, as long as it is used for education.

One benefit of Coverdell ESAs is that you can use those savings to cover the cost of attending elementary and secondary schools, whether it’s a uniform or laptop computer. You are in control of the account until your child turns 18.

Like any other investment account, you can open a Coverdell ESA at a bank, brokerage firm or mutual fund company, which means there could be fees associated with it. If you are single and make more than $110,000 or married and make more than $220,000, you can’t participate in an ESA. If the money isn’t used by the time the beneficiary reaches 30, it has to either be distributed within 30 days or rolled over to another family member. If it is distributed it will be taxable and subject to an additional 10% tax.

Uniform Gifts to Minors and Uniform Transfers to Minors Acts or UGMA/UTMA Accounts

Just like the Coverdell ESA, the UGMA and UTMAs are accounts you set up for your child that allow you to invest in mutual funds, stock and bonds. But unlike the ESA, once you’re child turns 18 or 21, depending on the state, he or she take control of the money and can use it in any way they see fit. Also, the money has to be spent on the child the account was set up for and can’t be transferred to another family member.

One of the advantages of these accounts is potentially more favorable tax rates. Since the account is technically owned by the child, it is taxed at the child’s rate, which is usually lower. If the child is under 19 or 24 and is a full time student, up to $950 in the account is tax free while the next $950 is taxed at the child’s tax rate. Anything over $1,900 is taxed at the parent’s rate, according to mutual fund company T.Rowe Price.

Keep in mind that since the account is considered the child’s asset, it could impact the amount of financial aid the child can get.

Tags: education