College Funding – Part II

Last month we discussed paying for college. This month we are backtracking, looking at the various avenues for saving, so that when the college bill does arrive, the challenges for paying it are minimal.

As most of our clients know, StrategicPoint has long been an advocate of section 529 college savings plans for their tax advantages and beneficiary flexibility. We continue to believe they are the best vehicle for college funding.

With 529 plans, after-tax money is invested in a portfolio model of the participant’s choice. The money grows tax-deferred and if used for post-secondary education, it is withdrawn tax free. 529 plans are counted as a parental asset for financial aid purposes – with 5.6% of the account balance being deemed each year available for college expenses. Since money placed in a 529 plan is intended for college, the financial aid assessment is very reasonable. We strongly urge clients to use self directed 529 plans, ones that do not carry an advisor commission, since added costs can eat into performance. In addition, it is advisable to look for 529 plans with low management and investment expenses. And, finally, it can be advantageous for some families to invest in a home-state plan for the state income tax deduction.

Other alternatives for education funding include the Roth IRA and EE Savings bonds. Roth IRAs work best when the owner is over 59 ½ at the start of the student’s college career. Withdrawals made after five years and age 59 ½ are tax-free. But even if the owner is under 59 ½, Roth distributions can be used for education with some tax advantages -- they are subject to income taxation, but escape the 10% penalty for early distributions. Roths also have flexibility because they can be used for college or for retirement and can be invested in a wide range of asset choices.

The downside to the Roth is that it can hurt financial aid – the principal and the earnings from distributions are included as income on the FAFSA application, impacting eligibility. And Roths do not have a state income tax deduction for contributions. But don’t ignore Roths! Their broader investment options and potentially lower costs make them a viable option for college savings.

EE/I Savings bonds are a third savings option, but are less preferable, at least in the current interest rate environment. Interest on EE Savings Bonds no longer fluctuate with interest rates, but are locked in at the time of purchase. If you buy an EE savings bond between now and November 1, 2008, the fixed interest rate will be a measly 1.4% for the life of the bond. And I bonds, which contain a life-long fixed coupon as well as an inflation adjustment, are currently offering $0 (yes, zero) return on the fixed premium. If you already own these bonds and they qualify for the college tax advantage, you will be able to use the bonds tax-free for qualified education expenses. Time the cashing in of these bonds carefully, however, because - like Roths - reported income (taxable or not) can hurt financial aid eligibility.

The Coverdell IRA, which remains an option, has lost its luster. Beginning in 2010, the annual contribution limit will fall from $2,000 a year to $500, while distributions will no longer be eligible for primary and secondary education – a nice advantage over 529 plans that the Coverdell used to have. If you have a Coverdell IRA, you can hold it and use it for college or you can roll it into a 529 plan, if you wish to consolidate.

And finally, you have the UTMA and UGMA accounts. These accounts are owned by the child and must be used for the benefit of that child. The child assumes full control of any remaining balance at the age of majority, which can present a bit of a challenge if the child wants to spend the money on something other than college. In addition, UTMA/UGMA accounts count heavily against financial aid. If your child owns an UTMA account, you can transfer it to an UTMA 529 plan and eliminate the financial aid disadvantage.

StrategicPoint Working with You

There are other sources of savings for college funding (cash value from life insurance policies, stock options, trust accounts, etc.). However, we remain committed to the 529 savings plan as the top choice for education funding. If you are interested in learning more which vehicle makes sense for your college savings plan, please feel free to call us and set up an appointment.