Financial Planning - College Savings Plans
Saving for a child's college education today is not what it used to be. Tuition at both state and private schools has increased drastically over the past few decades. The only way parents can secure educational opportunities for their children is by establishing college savings plans early. Like a 401(k), a 529 college saving plan allows for regular contributions and tax-free growth. Moreover, parents and grandparents can also take advantage of Coverdell education savings accounts and United States savings bonds.
529 College Savings Plans
529 plans were created in 1996. There are two kinds of plans. The first is a college savings plan that is a tax-advantaged plan that allows a parent to save money in an individual investment account. The second type of plan is a prepaid tuition plan. It allows a parent to pay tuition at today's rates even if the child won't be ready for college for many years.
A 529 college savings plan offers several features for both the parent and the student. There are federal tax advantages because earnings grow tax-deferred. If the money is used to pay for qualifying college expenses, withdrawals are tax-free. If the money is withdrawn for purposes other than college costs, the earnings portion of the withdrawal is taxed at the owner's income tax rate and is subject to a 10% federal penalty. This is the same tax and penalty structure as an individual retirement account.
There are also state tax advantages because many states provide incentives for students to attend college within the state. The high contribution limit, up to a lifetime maximum of $300,000, is quite helpful for those students seeking to attend private colleges where tuition, room and board, and books can exceed $50,000 per year.
Anyone can open and fund a 529 college savings plan. Parents and grandparents, regardless of income level, can establish a plan and benefit from a professional money manager who specializes in college savings plan administration. However, like any investment account, a 529 plan can lose money. That said, there is usually no better way to take the sting out of college tuition than starting a plan early and funding it often.
529 Prepaid Plans
Prepaid tuition plans also offer federal and state tax advantages. They are open to everyone, regardless of income, and they provide the opportunity of changing the plan beneficiary and the ability to roll over the plan once per year.
Prepaid plans can be run by the state or by a college. If the plan is run by the state, tuition is prepaid at one or more of the colleges within the state. If a college runs the plan, tuition is paid directly to that school. Rather than choosing investment options like you would with a 529 college savings plan, a prepaid plan purchases tuition credits. No matter how much the tuition increases between the time the credits are purchased and the time the child uses them, they are guaranteed to be worth a certain amount in the future. This offers at least some protection over rising rates of a college education.
One point to consider when funding a prepaid plan is the likelihood that the child will in fact attend that school or a school within that state. Plans differ on the amount that will be returned if the child doesn't attend college, or if he or she attends a different school.
Coverdell Education Savings Accounts
Coverdell accounts can be used for college savings accounts and also qualified elementary and secondary schools. The school can be public, private, or religious. While Coverdell education savings accounts are also tax-advantaged accounts, the maximum amount that can be contributed per year is $2,000. Even if a parent, grandparent, aunt, or uncle makes a contribution, the total amount cannot exceed $2,000.
Whereas contributions to a 529 savings plan can be made at any time of the year and at regular intervals, contributions to a Coverdell account can only be made up until April 15 of the year that follows the tax year for which the contribution to the account is being made. Investments can be made in stocks, bonds, certificates of deposit, mutual funds, or any other vehicle the parent sees fit. And unlike a 529 plan, the parent has complete control over how the money is invested.
Coverdell education savings accounts grow tax-deferred. If the money is withdrawn for a qualifying educational expense, it is tax-free at the federal level. (While the withdrawals are tax-free in most states, be sure to check the tax rules in your state.) Withdrawals made for non-qualified reasons are taxed at the beneficiary's tax rate and also subject to a 10% federal penalty.
Coverdell accounts can be rolled over into another Coverdell account without penalty for another family member. This is helpful for families with more than one child, as any money that remains in the account after the first child has finished school can be rolled over to each subsequent child.
Coverdell accounts are subject to income limitations. Single and head of household filers with a modified adjusted gross income of less than $95,000 can make a full contribution. Joint filers must have a modified adjusted gross income of less than $190,000 in order to make the full contribution.
United States Savings Bonds
United States savings bonds used to play a major role in saving for college. Grandparents everywhere gave Series EE and Series I savings bonds to their grandchildren for holidays and birthdays. To children, savings bonds were only a little bit more exciting than a deposit made into a college savings account because they could at least be unwrapped.
But over time, as college expenses have increased and the rate of interest paid on bonds has decreased, savings bonds aren't used as often as 529 college savings plans. Savings bonds, however, still offer ease of purchase. They're available at just about every bank and savings and loan, or can be purchased directly from the United States government. Bonds range in value from $50 to $10,000.
Bonds that are used to pay for qualified educational expenses are exempt from federal income tax if the bondholder meets certain income requirements. Modified adjusted gross income for single filers is $70,100 or less, and $105,100 or less for married filers. Bonds pay a modest yield, but they are backed by the full faith and credit of the United States government. They are one of the safest forms of investment, and the Series EE pays a variable rate that is adjusted twice each year for inflation.
While we've covered the basics of financial planning here, there is much more to implementing a financial plan. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
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