College tuition and fees are costly and on the rise. But even with 4-year private schools running on average $36,000 per year, the cost is well worth it. According to the US Census Bureau, individuals with a bachelor's degree earn more than double those with just a high school diploma.
How much to save depends on how much you think your child's education will cost. The best way is to start saving before they are born. The sooner you begin, the less money you will have to put away each year.
Example: Suppose you have one child, age six months, and you estimate that you'll need $120,000 to finance his college education 18 years from now. If you start putting away money immediately, you'll need to save $3,500 per year for 18 years (assuming an after-tax return of 7%). On the other hand, if you put off saving until the child is six years old, you'll have to save almost double that amount every year for twelve years.
Another advantage of starting early is that you'll have more flexibility when it comes to the type of investment you can use. You'll be able to put at least part of your money in equities, which, although riskier in the short run, are better able to outpace inflation than other investments in the long run.
Financial Calculator: College Savings Planner
Use this calculator to help develop and fine-tune your child's college education savings plan.
How Much Will a College Education Cost?
Based on the survey completed for the 2009 Trends in College Pricing, the average cost for tuition, fees, and room and board for 2009-2010 was:
$15,200 per year for 4-year public (in state) colleges and universities.
This is an increase of 6.3% from 2008-2009 findings.$35,600 per year for 4-year private colleges and universities.
This is an increase of 4.4% from 2008-2009 findings.
It should be noted that on average, full-time students receive $14,400 of financial aid per year in the form of grants and tax benefits for private 4-year institutions, $5,400/yr for public 4-year institutions, and $3,000/yr for public 2-year institutions.
Section 529 Qualified Tuition Plans
Many parents are looking at ways to save for college. Section 529 plans, also known as Qualified Tuition Programs (QTP), are a popular college savings vehicle for parents.
Every state now has a program allowing persons to prepay for future higher education, with tax relief. There are two basic plan types, with many variations:
- The Prepaid Education Arrangement. You essentially buy future education at today's costs, by buying education credits or certificates. This is the older type of program, and it tends to limit the student's choice of schools within the state.
- Education Savings Accounts. You contribute to an account earmarked for future higher education.
Tip: When approaching state programs, one must distinguish between what the federal tax law allows and what an individual state's program may impose.
You may open a Section 529 plan in any state. But when buying prepaid tuition credits (less popular than savings accounts), you often need to apply the credits to a specific college or group of colleges.
Unlike certain other tax-favored higher education programs, such as the Hope and lifetime learning tax credits, federal tax law doesn't limit the benefit only to tuition. Room, board, lab fees, books, and supplies can be purchased with funds from your 529 Savings Account. (Individual state programs could be narrower.)
The key parties to the program are the Designated Beneficiary, the student-to-be, and the Account Owner, who is entitled to choose and change the beneficiary and who is normally the principal contributor to the program.
There are no income limits on who may be an account owner. There's only one designated beneficiary per account. Thus, a parent with three college-bound children might set up three accounts. (Some state programs don't allow the same person to be both beneficiary and account owner.)
Contributions must be in cash, and they must not total more than reasonably needed for higher education (as determined initially by the state). Neither account owner nor beneficiary may direct investments, but the state may allow the owner to select a type of investment fund (e.g., fixed income securities), and to change the investment annually, and when the beneficiary is changed. The account owner decides who gets the funds (can pick and change the beneficiary) and is legally allowed to withdraw funds at any time, subject to tax and penalties (discussed later).
Funds in the account not yet distributed at the account owner's death pass as part of the probate estate under state law - though this is not the result for federal estate tax purposes (see below).
What's New?
529 plan distributions are tax-free as long as they are used to pay qualified higher education expenses for a designated beneficiary. Qualified expenses include tuition, required fees, books, supplies, equipment, and special needs services. For someone who is at least a half-time student, room and board also qualify. For 2009 and 2010, the American Recovery and Reinvestment Act (ARRA) added expenses for computer technology and equipment or Internet access and related services to be used by the student while enrolled at an eligible educational institution. Software designed for sports, games, or hobbies does not qualify, unless it is predominantly educational in nature. In general, expenses for computer technology are not qualified expenses for the American opportunity credit, Hope credit, lifetime learning credit, or tuition and fees deduction.
Federal Tax Rules Relating to 529 College Savings Plans
Income Tax. Contributions made by the account owner or other contributor are not deductible for federal income tax purposes. Earnings on contributions grow tax-free while in the program.
Distributions from the fund are tax-free to the extent used for qualified higher education expenses. Distributions used otherwise are taxable to the extent of the portion that represents earnings.
A Section 529 distribution can be tax-free even though the student is claiming a Hope or lifetime learning credit, or tax-free treatment for a Section 530 Coverdell distribution, if the programs aren't covering the same specific expenses.
Distribution for a purpose other than qualified education is taxed to the one receiving the distribution. In addition, a 10% penalty must be imposed on the taxable portion of the distribution, comparable to the 10% penalty in Section 530 Coverdell plans.
The account owner may change beneficiary designation from one to another in the same family. Funds in the account roll over tax-free for the benefit of the new beneficiary.
Gift Tax. For gift tax purposes, contributions are treated as completed gifts even though the account owner has the right to withdraw them - thus they qualify for the up-to-$13,000 annual gift tax exclusion. One contributing more than $13,000 may elect to treat the gift as made in equal installments over that year and the following 4 years, so that up to $65,000 can be given tax-free in the first year.
A rollover from one beneficiary to another in a younger generation is treated as a gift from the first beneficiary, an odd result for an act the "giver" may have had nothing to do with.
Estate Tax. Funds in the account at the designated beneficiary's death are included in the beneficiary's estate - another odd result, since those funds may not be available to pay the tax. Funds in the account at the account owner's death are not included in the owner's estate, except for a portion thereof where the gift tax exclusion installment election is made for gifts over $13,000. For example, if the account owner made the election for a gift of $65,000 in 2010, a part of that gift is included in the estate if he or she dies within 5 years.
Tip: A Section 529 program can be an especially attractive estate-planning move for grandparents. There are no income limits, and the account owner giving up to $65,000 avoids gift tax and estate tax by living 5 years after the gift, yet has the power to change the beneficiary.
State Tax. State tax rules are all over the map. Some reflect the federal rules, some quite different rules. For specifics of each state's program, see http://www.collegesavings.org.
Professional Guidance
Considering the wide differences among state plans, the federal and state tax issues, and the dollar amounts at stake, please call us before getting started with a 529 plan.
Have questions? Confused? Please always feel free to contact us. We are your financial partners, and we are always here to help. Give us a call today.
Security Tax Services LLC
North Sound South Sound
2802 Wetmore Ave, Suite 212 33530 1st Way S, Suite 102
Everett, WA 98201 Federal Way, WA 98003
425.339.2400 253.237.0751
fax 425.259.1099 fax 253.237.0701
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