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Planning and Paying for Higher Education
The more time you have before you begin paying for higher education, the more opportunities you
have to accumulate and save money to reach your goal.
If you can accumulate funds for higher education on tax free or tax deferred basis you may benefit
by delaying or never paying taxes on your earnings and gains on investments. There are also ways
to "lock in" the cost of higher education, protecting your family from future tuition increases.
Education IRAs or Coverdell Education Plans
Coverdell education savings accounts (ESAs) used to be known as education individual
retirement accounts (IRAs). The name was changed because these accounts have nothing to
do with retirement. However, the ESAs have many of the same features of IRAs in terms of
how much you can save, tax benefits, and penalties.
Any individual (with modified adjusted gross income of less than $110,000) can contribute up to $2,000
a year to an ESA that will benefit any person under age 18. In fact, a child may contribute
$2,000 to his or her own ESA. Since there is no limit on the number of ESAs that can be
established for a minor, the money can really add up if you get family members to contribute.
ESA withdrawals that are used to pay for qualified education expenses are tax-free. Qualified
education expenses include tuition, room, board, fees, and supplies related to attendance at a
qualified elementary, secondary, or post-secondary (college) institution. The money must be
used by the time the beneficiary reaches the age of 30. However, the account can be
transferred to a relative under that age.
There are some negatives to consider. No tax deduction is allowed for contributions to an
ESA. Earnings withdrawn from an ESA and not used for qualified education expenses are
subject to tax and a 10-percent penalty. Finally, the money in an ESA is considered part of the
assets of the beneficiary. This will generally reduce the amount of need-based financial aid
that will be available to the student.
You can open a Coverdell ESA at most banks, credit unions, and other financial institutions.
Qualified Tuition Plans (529 Plans)
Qualified Tuition Plans, also called "529" college savings plans, are established by individual states, but most are available through
financial services companies. You do not have to open the account in your state of residence
or the state in which the beneficiary will attend school, so it's best to shop around for the best
plan. Many financial services companies offer plans from a number of states.
| Main advantages of 529 college savings plans |
Main disadvantages of 529 college savings plans |
- no adjusted gross income limits-anyone, even the beneficiary, can contribute to these plans
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- education expense restrictions-to get the tax benefit, the funds can be used only for higher-education (college-level
and above) expenses
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- very high contribution limits-depending on the state, amounts as much as $100,000 to
$300,000 can be contributed
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- penalties-if you use the funds for purposes other than higher education, you will
pay taxes on the earnings and pay a 10-percent penalty
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- tax-free earnings-gains and income on the funds are tax free if used for
qualified higher education expenses
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- state taxes-you may not get a deduction if you are not a resident of the state
that established the plan
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- professional management-the money is managed in mutual fund-type investments that
participants choose
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- costs-the fees for setting up and maintaining the plans can add up; be sure to
shop around before investing
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- flexibility-the funds can be used to pay tuition at colleges in other states some
states allow state tax deductions for contributions
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- financial aid-large amounts of funds in a 529 college savings plan may disqualify
a student from need-based financial aid (but it may not be available, otherwise)
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- some states allow state tax deductions for contributions
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Savings Bonds
Savings bonds are an excellent way to accumulate funds for
education expenses because the interest earned over the life
of the bonds can be tax-free if you plan properly.
For those in the 15 percent federal tax bracket, this means
that 100 percent (instead of just 85 percent) of the interest
earned on the eligible bonds will be available to pay tuition
and fees for you and your family.
Interest earned on Series
I and Series EE Bonds issued after 1989 and used to pay for
education may be partially or fully excluded from Federal
income tax, provided that certain conditions are met.
You do not have to designate the bonds for education when
you purchase them. This gives you the flexibility to use the
bonds for retirement or other purposes if it turns out that
they are not needed for education. It also allows you to use
bonds that you already own—for education expenses that you
would have paid from other funds—to take advantage of the
tax benefit.
Qualifying for the full interest exclusion
For 2007, if your modified adjusted gross income is less than $98,400 on a joint
return (or $65,600 for single taxpayers), you may qualify for the full interest
exclusion. The exclusion is then phased out gradually until it is eliminated
at income levels above $128,400 (joint) and $80,600 (single).
You must use all of the
proceeds from cashing the bonds to pay qualified education expenses in order to
receive the full benefit. If your qualified education expenses are less than the
proceeds of eligible bonds, then the interest exclusion is pro-rated.
Summary of the fine print for using Savings Bonds for Education
If it appears that you can take advantage of this tax benefit, see the instructions
for IRS form 8815 at http://www.irs.gov/pub/irs-pdf/f8815.pdf
for complete details.
To be eligible for the education interest exclusion:
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Series I and Series EE Bonds must have been purchased in 1990 or later.
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You must have been at least 24 years old in the month in which the bonds were purchased.
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If you use the bonds for your dependent child's education, the bonds must be registered in your name
or your spouse's name. (The bonds may not list your child as owner or co-owner. However, the child
may be named as a beneficiary of the bond).
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If you use the bonds for your own education, they must be registered in your name.
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If you are married, you must file a joint return; you can't file as Married Filing Separately.
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Payments for education expenses must be made to a college, university, or post-secondary vocational
school that qualifies for federal assistance.
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Education expenses include tuition and fees only, not books or room and board. Scholarships or any
form of tuition assistance must be deducted from your expenses.
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Tuition for sports and hobby-related courses can be included only if they are required for a degree or
certificate.
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Education expenses must be paid in the same year that the bonds are cashed.
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As the time approaches for payment of tuition bills, you should consider what financial aid may be
available, which funds to use first, and whether you will need to borrow money.
Paying for Higher Education
When you or a family member is ready to start in college or another institution of higher learning
(or if someone has already started), your first step is to investigate the financial aid for which you
may be eligible.
A reliable and objective source of information about all
types of financial aid for education is The
College Board. Their "Pay for College" section has comprehensive
information on scholarships, financial aid and loans, as well
as calculators and tools for decision-making. The site even
has links to apply for financial aid and loans.
The Free Application for Federal Student Aid (FAFSA) is standard financial form used to apply
for federal and state student grants, work-study, and loans. After your FAFSA is processed, you
will receive a Student Aid Report (SAR). The most important number on the SAR is the Expected
Family Contribution (EFC).
Your EFC is the amount of money that you are expected to provide for the next year of education.
The EFC is often more than most families expect. Although you may receive more aid than
anticipated from some sources and you may be able to appeal the EFC, it is best to start thinking
about which financial resources you will tap.
It is usually preferable to first use any funds earmarked for education, such
as Education IRAs and 529 Plans.
Since funds in these accounts must be spent on education (in
order to avoid taxes and penalties) they are your initial
source to pay upcoming tuition bills. The only exception would
be for situations in which you decide to re-designate some
of these accounts for family members that will enter college
later.
Next, you should look to funds that may be withdrawn without tax consequences. These would be
After all the above sources are used, you still have options.
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A variety of parent loans for education, including Federal
PLUS are available. See The
College Board for more information.
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Parents may use a home equity
line of credit or loan with some possibility of tax-deductible
interest. Ask your tax advisor for details.
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Savings and investments may be liquidated. But plan any sales of investments carefully to
avoid substantial taxes.
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Parents may tap TSPs, Pension Plans, and IRAs with loans or withdrawals for education
purposes. However, these options should be seen as a last resort because there may be adverse
tax consequences and because these funds are earmarked for retirement.
A good source of information about various plans is http://www.collegeboard.com/article/0,1120,6-29-53-8851,00.html?orig=sub.
One of the best Web sites for comparing 529 plans is http://www.savingforcollege.com.
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