In accumulating funds for college, one of the first questions a family will face is, "Where do we invest the money?" Many financial professionals will recommend that money for college be placed in relatively low-risk investments. If there is a long enough time frame, the savings may be placed initially in higher risk (and potentially higher return) investments. As the time for college gets closer, the funds can be shifted into more conservative choices.
The ultimate decision will depend on a range of factors such as the number of years until college begins, the amount of money available to invest, a family’s income tax bracket, risk tolerance and investment experience. A few of the more traditional approaches are:
- Savings accounts: Including CDs, money market accounts and regular savings.
- Tax-free municipal bonds: Held either directly or through a mutual fund.
- U.S. Treasury securities: Such as treasury bills or treasury bonds.
- Growth stocks/growth mutual funds: For the long-term investor.
Under federal income tax law (state or local income tax law may differ), there are a number of tax-advantaged strategies available to accumulate funds for college expenses. The rules surrounding these strategies can be complicated and they should only be used after careful review with a tax or other financial professional:
- IRC Sec. 529 qualified tuition program: These plans allow an individual to either prepay a student's tuition, or contribute to a savings account to pay the student's qualified education expenses. Contributions are not tax deductible, but growth in an account is tax-deferred. If certain requirements are met, distributions to pay qualified educational expenses are excluded from income. 529 plans involve investment risk, including possible loss of funds, and there is no guarantee a college-funding goal will be met. The fees, expenses and features of 529 plans vary from state to state.
- Coverdell education savings account: Up to $2,000 per year may be contributed to a Coverdell ESA for an individual. Contributions are not tax-deductible, but growth is tax-deferred. Distributions are excluded from income if used for qualifying educational expenses. Other restrictions may apply.
- Cash value life insurance: Cash value life insurance can be an attractive, tax-favored means of accumulating school funds. If an insured dies before the student starts school, the policy proceeds can be used to pay educational expenses.
- U.S. savings bonds: Interest on series EE savings bonds issued after 1989, or Series I savings bonds, may (certain limits apply) be excluded from income if qualifying education expenses are paid in the year the bonds are redeemed. The exclusion also applies to savings bond interest contributed to an IRC Sec. 529 qualified tuition program or a Coverdell ESA.
Who owns the funds?
A second issue facing families planning for college is the question of "Who will own the funds?" The answer to this question involves issues of control, income and gift taxes and can impact a future application for financial aid:
- Parents: Either in accounts specifically earmarked for college or as a part of a general family portfolio.
- Child: Often a custodial account is used, under either the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA).
- Trust: In certain situations, usually involving wealthy families, specialized types of trusts may be used, such as a Crummey trust or charitable remainder trust.
Impact on financial aid
For need-based financial aid purposes, assets considered to be owned by the parents have a relatively small negative impact. Assets considered to be owned by the child have a much greater negative impact. Trust assets are often considered to be owned by the child, but this can vary widely. Frequently, trust provisions restrict access to principal, thus forcing inclusion of the trust assets in the eligibility process each year that a student is in school. Non-trust assets can be "spent down" in a year or two, limiting their financial aid impact.
How do 529 plans compare with Coverdell Education Savings Accounts?
For many Americans, providing an education for their children has long been an important family goal. And individual savings are an important source of school funds. Federal tax law encourages such savings by providing for several different types of tax-advantaged education savings plans. The table below summarizes how these plans work and illustrates the differences between them.
|Benefit or Feature||"529" Prepaid Tuition Plan 1||"529" Education Savings Plan 1||Coverdell Education Savings Account|
|Basic concept||Buy tomorrow’s tuition at today’s prices||Tax-advantaged savings account to accumulate funds for education.||Tax-advantaged savings account to accumulate funds for education.|
|Federal income tax treatment||Contributions are not deductible; growth is tax-deferred; withdrawals for qualified education expenses are exempt from tax.||Contributions are not deductible; growth is tax-deferred; withdrawals for qualified education expenses are exempt from tax.||Contributions are not deductible; growth is tax-deferred; withdrawals for qualified education expenses are exempt from tax.|
|State or local income tax treatment||Varies. Some states follow federal income tax law, while others do not.||Varies. Some states follow federal income tax law, while others do not.||Varies. Some states follow federal income tax law, while others do not.|
|Level of investment risk||Generally a low level of risk. Sponsoring state or organization typically promises to invest funds to match tuition increases. Later contributions may be required.||Varies, depending on the underlying investments. An investment manager typically manages the funds. Both gains and losses are possible.||Varies, depending on the underlying investment. A wide range of self-directed investments is available. Both gains and losses are possible.|
|Where to purchase||Directly from the state or private institution involved.||Investment brokers, banks, credit unions, insurance companies or directly from the state involved.||Investment brokers, banks, credit unions and insurance companies.|
|Who can contribute?||Generally, anyone. Residency restrictions may apply.||Generally, anyone. Residents in one state can often invest in another state’s plan.||Generally, anyone.|
|How much can be contributed?||Contributions must be in cash and may not exceed what is needed to fund the beneficiary’s education expenses. The program sponsor will specify the maximum amount.||Contributions must be in cash and may not exceed what is needed to fund the beneficiary’s education expenses. The program sponsor will specify the maximum amount. 2||Contributions must be in cash and may not exceed $2,000 per beneficiary per year.|
|Beneficiary age limits for contributions?||None||None||Before age 18 unless a special needs student.|
|How are payments made?||In a lump-sum or periodic payments.||In a lump-sum or periodic payments.||Typically, in periodic payments.|
|Do income limitations apply to the donor?||No||No||Yes. Contribution is phased out for donors whose AGI exceeds certain limits. 3|
|Who controls the funds?||Generally, the donor. 4 If the account is a custodial account, the beneficiary becomes the owner when he or she reaches age 21 (18 in some states).||Generally, the donor. 4 If the account is a custodial account, the beneficiary becomes the owner when he or she reaches age 21 (18 in some states).||Generally, the donor. 3 If the account is a custodial account, the beneficiary becomes the owner when he or she reaches age 21 (18 in some states).|
|What expenses are covered? 5||Tuition and fees for primary, secondary and post-secondary education are covered. Some plans include a room and board option or allow excess tuition credits to be used for other qualified expenses.||For primary and secondary schools, tuition and fees are covered. For post-secondary education, costs such as tuition, fees, books, supplies, computers, software and internet access are covered. Reasonable costs for room and board also qualify if the student is attending school at least half time.||A wide range of expenses is allowed, to attend Kindergarten thru 12th grade, as well as post-high school educational institutions. May include tuition, fees, books, supplies and equipment, as well as reasonable costs for room and board.|
|What schools may the beneficiary attend?||Prepaid tuition plans typically limit attendance to same-state schools or colleges.||Funds accumulated in the savings plan of one state may usually be used at institutions of higher education throughout the U.S. Some foreign schools also qualify.||For K-12, any school that qualifies under state law, including public, private or religious schools. For post-high school, most institutions in the U.S. qualify.|
|Effect on financial aid?||Generally reduces financial aid. Account owned by student penalized more than parent-owned account.||Generally reduces financial aid. Account owned by student penalized more than parent-owned account.||Generally reduces financial aid. Account owned by student penalized more than parent-owned account.|
|May account be rolled-over to other family members?||Yes||Yes||Yes|
There are a number of excellent references and guides to investments and college planning available in bookstores and public libraries. State and federal agencies involved in higher education also are excellent sources of information. In addition, there are a number of sites on the Internet which can provide information, including the following:
- The College Board .
- FinAid! The SmartStudent® Guide To Financial Aid.
- College Savings Plan Network — links to state-run web pages on prepaid tuition or college savings plans.
- Federal government.
Begin early and seek professional guidance
Developing a plan to save for a child’s college education can be complicated. Questions can arise involving income tax, estate and gift taxes, investment issues and the impact of asset ownership on financial aid eligibility. Individuals are strongly advised to begin a savings program as early as possible, and seek professional guidance.
1 “529” refers to Section 529 of the Internal Revenue Code, the section of federal law which authorizes these plans.
2 In some education savings programs, more than $250,000 may be contributed for a single beneficiary.
3 For unmarried individuals, the contribution is phased out when adjusted gross income (AGI) is between $95,000 - $110,000. For married couples filing jointly, the phase-out range is an AGI of $190,000 - $220,000.
4 With a “529” prepaid tuition plan or a “529” savings plan, if the assets are not used for education they may be returned to the donor. In a Coverdell Education Savings Account, if the assets are not used for education, they will ultimately become the property of the beneficiary.
5 Technically, under IRC Sec. 529, the same definition of “qualified education expenses” applies to both prepaid tuition plans and education savings plans. In practice, however, for prepaid tuition plans, the sponsoring entity will limit the use of the funds to the types of expenses shown above.