Saving For College: Will You Be Ready?

By Vincent Santilli

Saving for college is a topic some quickly avoid because it can be daunting to think about. But, before you know it, your children or grandchildren will be matriculating. The question looms, “Will you be ready?”

New England is a great place to live and work, but it’s also home to some of the most expensive colleges and universities in the nation. A quick glance at regional tuition costs for the 2003-04 school year illustrates the challenges faced by parents saving for college. During that period, a year of study at the University of Bridgeport cost approximately $26,000, about $29,000 at Sacred Heart University, and $35,000 at Fairfield University.

Long-Term Options

529 Plans — This plan is named for Section 529 of the federal tax code, which authorizes this type of investment. A parent or grandparent is the owner, and therefore controls funds in the plan for the designated beneficiary.

Each plan is state-sponsored — states enter into an agreement with an investment company to offer investment options, which are usually some type of mutual fund mix.

Though 529s are not tax deductible in Connecticut, earnings on the investments are tax-free. Many offer an age-stated investment plan that automatically invests contributions into a predetermined age-based portfolio created by the investment company for all 529 participants.

For a young child, 529 investments are more aggressive because there is a longer-term horizon. For older children, investments are more conservative.

Other 529 plans allow investors to choose from a variety of mutual funds or formulate their own investment portfolio. Most people, however, choose the age-staged investment plans, as they put your investment on “automatic pilot” and do not require self-management on the part of the investor.

Because funds in a 529 plan remain the property of the plan owner, they are not considered a child’s asset when applying for financial aid. Parents or grandparents must remember that funds invested in a 529 plan must be used only for college expenses and may not be used for private elementary or secondary schools. There are no income limits on who may open a 529 plan. You may make investment changes once a year or when you change a beneficiary. Any noncollege related use of the fund triggers ordinary income taxes and a ten percent penalty on earnings.

The Coverdell IRA — While investments in 529 plans are generally limited to less than $250,000 per beneficiary, investments in the Coverdell IRA are limited to $2,000 per year per beneficiary. Contributions to Coverdell IRA are phased out for married couples with incomes between $190,000 and $220,000 and for singles with incomes between $95,000 and $110,000. Earnings on contributes accrue tax-free.

Coverdell IRAs allow parents or grandparents to save for education expenses other than college; for example, private prep or elementary schools.

When a child reaches age 21, funds become the property of the beneficiary and must be used in full by age 31.

Investments may be made in any of a variety of ways, but investors usually work with an investment advisor to construct a portfolio that will allow them to meet their goal. Asset allocation changes are unlimited. While on some fronts this plan offers more flexibility than a 529, contributions are limited. Like the 529, earnings are taxed as ordinary income and subject to a ten percent penalty if not used for educational purposes.

Custodial Account; Uniform Gift to Minors Act — Like the Coverdell IRA, these accounts allow families to save for any use that will benefit a child, but most people who select this option use these accounts to save for education expenses. There are no income or contribution limitations associated with these accounts. Beneficiaries, however, cannot be changed and investment reallocations, although unlimited, are usually taxable events. Be sure to check with your tax advisor before selecting this savings vehicle. Beneficiaries also assume control of the funds at the age of majority, which may limit scholarship possibilities.

For children under age 14, the first $800 of earnings in this account is tax-free. Earnings between $800 and $1,600 are taxed at the child’s rate. Earnings exceeding $1,600 are taxed at the parents’ rate. If children are over 14, earnings are taxed at the child’s rate.

Saving in Parents’ or Grandparents’ Names — With this investment option, the person opening the account controls the funds. There are not many tax advantages to this account, as dividends are taxed to the owner at applicable rates and capital gains are taxed at the owner’s capital gains rate. Like a custodial account, there are no income or contribution limitations associated with these accounts, but reallocations are usually taxable events, which may be expensive.

The benefit to saving in your name is flexibility, you can use the funds for any goal. So if your son or daughter gets a good scholarship, you may use funds in this account, for example, to buy the child a house or car upon graduation — or to treat yourself. Like the 529 plan, investments are not in a child’s name and therefore may expand scholarship opportunities.

Short-Term Options

Home Equity Line — For parents who have not or could not save for a child’s education, using equity in a home may be their only option. People’s Bank, for example, has a home equity credit line product with no closing costs or fees priced at 3.24 percent or 101 basis points under the prime rate. For those who do not have a long time horizon in which to save, this may be their most attractive and well-priced alternative. There are usually limits on how much you can borrow, but you can have immediate access to funds to pay for a fall 2004 or fall 2004 matriculation.

As you can see, your options are greater if you begin saving early. But even if you wait, options like home equity loans or lines may be available to you.

You may pay now or pay later. The choice is yours, and it will be different for everyone because all financial situations are unique.

For additional information on college financial planning, visit www.salliemae.com, www.nelliemae.com, www.freegrantsources.com, and www.financialaid.com, among many other websites.