One of the most important steps to take when determining how much to save for your children’s education is to have a picture in mind of the education environment you wish to provide.
Will your child go to a four year college, two year state school, technical center, or a combination thereof?
Will your child attend an out of state school with room and board requirements or an in-state school where commuting is a possibility?
Do you intend to pay for graduate level expenses?
Once you determine the specific college experience you intend to provide, you can then begin the process of setting a target dollar goal and the methods and strategies to reach it. We’ve put together this guide to help you plan for your and your children’s future. If you have any questions about financial planning for education, please call us to set up a consultation with one of our financial advisors.
|Stocks||Able to keep pace with inflation of tuition expenses. Account could be affected by a market downturn when funds are needed if poorly planned.|
|Mutual Funds||Also able to keep pace with tuition inflation and are more diversified. May be better able to withstand drawdowns but will still be susceptible to market swings.|
|Bonds||More stable growth of investment. Can be used as child gets closer to age of college entrance. Some plans provide age based asset allocation. Returns may be limited by market interest rates. Some plans limit the investment choices available.|
|529 Savings Plans||Allow for tax advantaged growth of investment within the plan. May provide for state tax benefits also. Have some penalties if funds withdrawn are not used for education.|
|Coverdell ESA||Can be used for K through 12 education expenses as well as college costs. Contributions currently limited to $2,000 per year.|
|UGMA/UTMA||Investments can grow in the account and a large portion of the earnings are taxed at the child’s tax rate, which is usually much lower than the parents. Account reverts to the child’s control at age 18.|
|Prepaid College Plans||Set up by states to lock in current tuition levels. Each state has its own requirements and rules. May have negative consequences if child does not attend college in that state.|
In order to help defray some of the costs of college for students, the U.S. Congress has passed various measures over the years, mainly as income tax breaks. These include tax credits, allowable deductions, and exclusions from income.
A tax credit reduces the amount of income tax you may have to pay. Examples of tax credits allowed are the American Opportunity Tax Credit and the Lifetime Learning Credit. Both of these programs allow for a dollar amount to be subtracted from the tax you owe for the year.
A deduction reduces the amount of your income that is subject to tax, thus generally reducing the amount of tax you may have to pay. Examples of deductions to be applied against your adjusted gross income are Tuition and Fees deductions, Loan Interest deductions, Books and Supplies, and some work related education expenses.
An exclusion from income means that you won’t have to pay income tax on the benefit you’re receiving, but you also won’t be able to use that same tax-free benefit for a deduction or credit. Some employers can set up an Employer Provided Education Assistance Program where up to $5,250 may be excluded from your income on your W-2.
Certain savings plans, such as 529 Plans, allow the accumulated earnings of the investments within the plan to grow tax-free until money is taken out (known as a distribution), or allow the distribution to be tax-free, or both. Distributions from state sponsored 529 Plans are tax free as long as they are used to pay higher education expenses. Certain states allow a state income tax deduction on part, or all, of the contribution.
Prepaid Tuition Plans, operated on a state level, also provide for tax-free distributions. Usually, each state has various requirements for participation and should be investigated for the best program.
Coverdell Education Savings Accounts (ESA) also provide for tax-free distributions for use towards eligible education expenses. An advantage to Coverdell’s is that withdrawals can be applied to elementary and secondary education expenses, as well as college expenses.
Students are also able to participate in many scholarship, fellowship, and grant programs that provide for payment of tuition and fees on a tax-free basis. In most cases, you must be a degree candidate at an eligible institution. Room and board expenses are not included as qualified expenses.
If your child decides not to attend college or does not need all of the monies that have grown inside a 529 plan, the plan assets can be removed. However, in most cases, taxes will be owed on the amount withdrawn. A 10 percent withdrawal penalty may also apply. A way to avoid these penalties is to transfer the 529 to another family member or to keep the plan intact for education expenses incurred later in life.
The U.S. Congress authorized a tax credit for qualified education expenses paid for an eligible student for the first four years of higher education called the American Opportunity Tax Credit. You can receive a maximum annual credit of $2,500 per eligible student. Also, if the credit brings the amount of tax you owe to zero, you can have 40 percent of any remaining amount of the credit (up to $1,000) refunded to you.
In order to qualify, you, your dependent, or a third party must pay qualified education expenses for higher education. The eligible student must be enrolled at an eligible educational institution, and must be yourself, your spouse, or a dependent that you list on your tax return.
In addition, the student must:
The amount of the credit is 100 percent of the first $2,000 of qualified education expenses you paid for each eligible student and 25 percent of the next $2,000 of qualified education expenses you paid for that student. But, if the credit pays your tax down to zero, you can have 40 percent of the remaining amount of the credit (up to $1,000) refunded to you.
In order to claim the full credit, your modified adjusted gross income must be $80,000 or less ($160,000 or less for married filing jointly). You can receive a reduced amount of the credit if your adjusted income is over $80,000 but less than $90,000 (over $160,000 but less than $180,000 for married filing jointly) However, you will not receive any credit if your MAGI is over $90,000 ($180,000 for joint filers).
Congress also authorized the Lifetime Learning Credit for qualified tuition and related expenses paid for eligible students enrolled in an eligible educational institution. This credit can help pay for undergraduate, graduate, and professional degree courses—including courses to acquire or improve job skills. There is no limit on the number of years you can claim the credit. It is worth up to $2,000 per tax return.
As with the American Opportunity Tax Credit, to qualify, you, your dependent, or a third party must pay qualified education expenses for higher education. The eligible student must be enrolled at an eligible educational institution, and must be yourself, your spouse, or a dependent that you list on your tax return.
In addition, the student must:
To claim the full credit, your modified adjusted gross income must be $52,000 or less ($104,000 or less for married filing jointly). If your adjusted income is over $52,000 but less than $62,000 (over $104,000 but less than $124,000 for married filing jointly), you receive a reduced amount of the credit. However, if your adjusted income is over $62,000 ($124,000 for joint filers), you cannot claim the credit.
The amount of the credit is 20 percent of the first $10,000 of qualified education expenses or a maximum of $2,000 per taxpayer and is not refundable. Therefore, you can use the credit to pay any tax you owe but you won’t receive any of the credit back as a refund.
A chart is available that outlines the differences between the two education tax credits at the IRS.gov website.
Trying to juggle scarce resources can be difficult when it comes to choosing between saving for your children’s college education versus your own retirement. However, in most cases, it makes more sense to prioritize your own retirement savings as opposed to college funding.
From a practical standpoint, your children will have much more flexibility and many more resources to pay for a college education than you will in funding your retirement once you no longer work.
Opportunities available to help with tuition include:
Also, decisions can be made to take advantage of lower cost options versus more expensive college options such as online study, community college, and in-state programs.
You will not have that flexibility when it comes to your retirement. So your retirement funding is typically a higher priority than college funding.
As with most savings plans, starting early makes it much easier to reach your goal. College tuition costs, as well as room and board expenses, are rising at a much faster rate than inflation. So the more time available to add to the account and benefit from compounding of growth will help keep pace with rising costs.
First, take a good look at your budget. See if there is any flexibility to free up an amount every month to dedicate to college savings. Then run some projections on expected investment returns over the number of years available until the funds are needed for tuition expense. Factor in tax benefits now available for college purposes. Match this up with your goal for the total education cost of your child. This will give you a good indication of any adjustments needed.
Saving for college has become a very important and significant expense for most parents. When you consider the potential cost of a four year, higher education degree, the numbers can be daunting. Plus, factors such as the many investment alternatives, tax complexities, and qualification rules make it even scarier. That’s why teaming up with an experienced advisor can make such a difference. An advisor can help you set goals, work out a plan, and get you started on taking action. A trusted professional, who knows you and your family, can help you navigate through the many decisions you will face along the way, from the time your child is born to the day they graduate from college. With that comes the peace of mind and confidence that you are providing the best possible options to your children regarding their education.