Investing Unit 7: Tax-Advantaged College Savings Plans

January 06, 2009 Print Friendly and PDF



In addition to retirement, one of the most frequently reported investment goals is funding college or post-secondary education. Fortunately, there are several tax-advantaged investment products that make the savings process easier. Before deciding where to invest for college, calculate how much savings is required and how much should be set aside on a regular basis. A downloadable college planning worksheet can be found at the following Web site: http://njaes.rutgers.edu/pubs/publication.asp?pid=FS634. An interactive online College Cost Calculator can be found at www.collegesavings.org/collegeCostCalculator. The calculator provides an estimate of the savings required based on the following key variables: a child’s age, the type of college (e.g., in-state public college), the number of years that a child plans to attend school, and the specific expenses being covered (e.g., “tuition and fees only” or “tuition, fees, room, and board”).

Once you know how much money you need to accumulate for college expenses, the next step is to figure out where to invest. Available options include state-operated 529 college savings plans (named for a section of the federal tax code), prepaid tuition plans, Coverdell Education Savings Accounts (ESAs), and custodial accounts (often called Uniform Transfers to Minors (UTMA) or Uniform Gifts to Minors (UGMA) by financial institutions). Each type of plan has specific advantages and disadvantages so it may be wise to fund more than one investment account. Detailed information about, and side by side comparisons of, available college savings plans can be found in the Financial Industry Regulatory Authority (FINRA) publication Smart Saving for College-Better Buy Degrees at http://apps.finra.org/investor_Information/Smart/529/000100.asp. Below are some general recommendations about investing for college provided by investment experts.

Recommendations

  • Consider funding a 529 college savings plan and start saving early. Every state offers at least one type of 529 plan and specific details about each state’s plan features can be found at the College Savings Plans Network Web site. 529 plans offer a number of advantages to investors, the most important of which is that withdrawals from 529 accounts for qualified educational expenses are tax-free. Meanwhile, earnings on plan contributions grow tax-deferred, allowing investors to maximize the power of compound interest. In addition, while 529 plans are funded with after-tax dollars (meaning there is no up-front federal income tax deduction for the amount of the investment, similar to how Roth IRAs operate for retirement savings), over 30 states provide some type of state income tax write-off. To narrow down available plan options, look for 529 plans with appealing features such as state income tax benefits, low investment expenses, high contribution caps, affordable minimum contributions, and “age-based tracks” where the asset allocation becomes more conservative as an account beneficiary gets older. The alternative to this is “fixed tracks” where the 529 plan portfolio composition stays the same over time.
  • Also consider funding a Coverdell Education Savings Account (ESA) up to the maximum annual limit of $2,000 per beneficiary per year. Like 529 plans, earnings grow tax-deferred and are tax-free if used for qualified education expenses. However, unlike 529 plans, which are limited to investments within state-run programs, Coverdell ESAs allow a wide variety of investment choices. In addition, tax-free withdrawals are allowed for elementary and secondary school expenses as well as post-secondary education (529 plans only cover college). Another key difference is that balances in a Coverdell must be spent by the time the beneficiary reaches age 30 or gifted to another family member under 30. There are also maximum income limits to qualify to make an ESA contribution. 529 plans do not have either of these last two restrictions.
  • Weigh the pros and cons of prepaid tuition plans, which are offered in about a third of states, as well as by individual colleges and universities. An advantage is that investors can lock in current tuition and fees when the plan is opened as a hedge against future inflation. A disadvantage is that most state plans have some type of residency requirement for the parent or child and other plans are tied to a specific academic institution.
  • Consider several potential disadvantages of UTMA/UGMA (custodial) accounts. First, the money is technically the child’s at age of majority (18 or 21, depending on state law) and could be used for expenses other than college. Second, since funds belong to the child, they could reduce available financial aid. Third, changes in tax laws have extended the “kiddie tax” on college students’ investment earnings to age 24.
  • Don’t be overwhelmed by the amount of savings required for college. Any amount of savings is better than none, even if it doesn’t cover the full cost. Break your college savings goal down into small “bite-sized” pieces and remember that even small regular deposits will grow to sizable sums over time. Consider the following example from the FINRA publication described above. If someone saves $200 a month for a newborn and averages an 8% return, there will be over $96,000 for college when the child turns 18.

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This work is supported by the USDA National Institute of Food and Agriculture, New Technologies for Ag Extension project.