It seems like saving for college should be an easy thing to do. Unfortunately, in an effort
to help parents save, Congress has approved a wide variety of savings vehicles that
have made the whole process confusing. To help sort things out, following is a brief
overview of the different ways to save. We’ll discuss the pros and cons of these
programs in future articles.
Most states now have programs such as the Michigan Education Trust (MET) that allows
you to purchase tuition in today’s dollars for any state-supported college. Regardless of
inflation, you are then guaranteed to have your child’s tuition paid for at a public
university (not including room & board, books, etc.). A fairly conservative rate of return
is inherent in these state plans, so you it’s not unreasonable to expect to do better
utilizing other savings methods. The other methods, however, involve more risk. Funds
in the Trust are considered the students’ assets and therefore reduce any potential
student aid, dollar for dollar. Distributions are tax-free.
Other legislation established a type of plan called the Coverdell Education Savings
Account (ESA, formerly called an Education IRA) No tax deduction is provided and only
$2,000 per year can be contributed to each beneficiary. Funds grow tax-free and
distributions are tax-free as long as they are used for qualified college expenses.
The contribution limit is phased out for single contributors with Adjusted Gross Incomes
(AGI) above $ 95,000 and above $ 190,000 for married couples. Coverdell ESAs are
considered an asset of the student beneficiary (assessed at 35%) and therefore reduce
potential financial aid. Coverdell ESAs are also like UGMAs (Uniform Gift to Minors Act
accounts) in that they become the property of the student when the student reaches
age 18. An advantage of Coverdell ESAs is that there is basically no limit to the type of
investments one can make in an ESA account. This makes ESAs more flexible than
some of the other savings vehicles. Another nice feature is that they can be used for
education expenses for Kindergarten through high school.
Distributions from traditional IRAs can also be used to fund college expenses without
incurring the 10% early distribution penalty if used for qualified college education
expenses. Given the impact this approach has on retirement saving, however, and with
the other options available, this method should be discouraged and used only as a last
resort.
Uniform Gift to Minors Act accounts (UGMA) provide still another way to save for
college. One drawback for UGMAs is loss of control of the funds when the beneficiary
becomes an adult (18 years of age in Michigan). At that point funds can be used for
whatever the beneficiary wants. At one time, an advantage of UGMA accounts was that
once the beneficiary turned 14, any earnings were taxed at the beneficiary’s usually low
tax rate. Until age 14, any earnings over $750 were taxed at the parents’ tax rate.
Unfortunately, this advantage was recently eliminated. Another downside of UGMAs is
that like Coverdell ESAs, the assets in the accounts are considered the students for
financial aid purposes (assessed at 35%). Funds in a UGMA account can be used for
anything that benefits the child.
Another option available is the state 529 programs such as the Michigan Education
Savings Program (MESP). Distributions for tuition, room and board and books are also
tax-free at both the federal and state level (although that could change in 2010 if
Congress doesn’t act). Also available on the Michigan plan is a state tax deduction.
Joint filers can subtract up to $10,000 of their contributions to the plan from their
Michigan adjusted gross income. There is no income limit to make contributions to the
plan. Funds can be transferred to another family member if the beneficiary decides not
to go to college or does not use up the entire account. Funds withdrawn and not used
for qualified college expenses are subject to a 10% tax penalty.
Parent’s contributions to 529 plans are considered gifts and subject to gift taxes. Each
parent, however, can currently gift $12,000 annually to each child (i.e. $24,000 per
couple). In addition, individuals can gift up to $ 60,000 to a beneficiary in one year and
have it treated as made over five years.
MESP is very good for those who don’t want to take the time to manage the asset
allocation of their children’s education accounts. In the first contribution year, MESP
matches one dollar for every three dollars contributed up to a $200 match for families
with household income under $ 80,000 a year and beneficiaries 6 years old or younger.
Plans similar to the MESP plan are offered by a variety of other companies for other
states. Even though they are considered the plans of other states they can be used by
Michigan residents. Additional information on the Michigan MESP can be found at www.
misaves.com.
Savings bonds can also be used for higher education expenses. The interest earned is
tax-free if used for qualified higher education purposes. Annual contributions are limited
to $ 30,000 per owner. Assets are considered the parents for financial aid purposes
(5.6%).
Parents can also use taxable accounts for college savings. Until 2010, capital gains and
dividends will be taxed at 15% and assets are considered the parents for financial aid
purposes (assessed at 5.6%). These funds can, of course, be used for anything.
Finally, there are two credits available for college students. The HOPE Scholarship Tax
Credit provides a non-refundable tax credit for eligible higher education expenses
(tuition and related expenses but not room and board or books). The credit is for 100%
of the first $1,100 of expenses and then 50% of the next $1,100 for the first two years of
post-secondary education, up to $1,650 for each year.
Another credit called the Lifetime Learning Credit is equal to 20% of qualified tuition and
fees. Up to $ 10,000 of qualified tuition and fees are eligible.
One cannot claim both the HOPE Scholarship Credit and the Lifetime Learning Credit in
the same year.
As you can see, there are a myriad of ways to save for college, some better than
others. While they all have their pros and cons, over all, it’s difficult to beat 529 savings
plans. Regardless of the method you choose, start early. Waiting until the last minute is
not recommended!
David C. Patterson, CFP® and Erin Patterson, CFP® are the owners of Patterson Advisors, LLC, a fee-
for-service-only financial advisory firm. Patterson Advisors, LLC is a Registered Investment Advisor,
registered with the State of Michigan, helping clients in Waterford, Clarkston and Royal Oak, Michigan
as well as other Oakland County, Michigan communities . Visit www.pattersonadvisorsllc.com for more
information or call 248-674-2108.
Published in the Oakland Insider, January, 2008, Re-titled: Crash Course in 'Saving for
College 101'
Saving for College
By David and Erin Patterson