Preparing for That Expensive Degree The Benefits of Section 529 Plans Take Another Look at Education Savings Accounts Getting Your Share of Financial Aid

Preparing for That Expensive Degree

There are two basic approaches to funding your children's college education costs. You can ignore the entire subject, hoping for the best when your children reach college age. Or you can actively prepare for those costs so that you have more options available. The steps involved in the second approach include:

1. Estimate how much you'll need to send your child to college.

The amount can vary significantly depending on whether you're aiming for a public, private, or Ivy League college. For instance, for the 2001-2002 school year, the average annual cost is $11,976 at a public university and $26,070 at a private university (Source: The College Board's Trends in College Pricing, 2001). Once you know the total amount needed, you can calculate how much you need to save on an annual basis to help you reach that goal.

2. Review other sources of college funds.

If you can't save the entire amount needed to meet your goal, consider other sources - you may expect your child to work part time to help defray costs or financial aid may provide assistance. Also, many colleges offer merit scholarships that are awarded without regard to financial need. A variety of student loans and government-sponsored loans are also available, offering attractive interest rates. The older your child is, the easier it will be to determine how much you can expect from these other sources.

3. Decide whether you want to save in your name or your child's name.

If you expect to qualify for financial aid, you may prefer saving in your name, since only 5.6% of your assets must be used for college, while 35% of your child's assets must be used. If you don't expect to qualify for financial aid, you can make annual gifts, up to $11,000 in 2002 ($22,000 if the gift is split with your spouse), to each child federal income tax free. By making a gift, you remove those assets from your estate and any income on those assets becomes taxable to your child. If your child is under age 14, he/she is subject to the "kiddie tax" rules - in 2002, the first $750 of investment income is federal income tax free, the second $750 is taxed at the child's marginal tax rate, and the remaining investment income is taxed at your highest marginal tax rate. If your child is 14 or older, all investment income is taxed at his/her marginal tax rate. Keep in mind that once your child reaches legal age, he/she can use the college savings as he/she wishes, which may or may not include a college education.

4. Set up a savings program.

Make saving a part of your monthly routine, using investment strategies that are compatible with your risk tolerance. Monitor your progress at least annually, making changes when necessary.

5. Start now.

Due to the large amounts involved, funding a college education is a significant undertaking. Don't ignore this goal, hoping that financial aid will pick up the bulk of the tab. For most families, a significant portion of any financial aid will come in the form of loans and work-study programs. Incurring substantial debt to put your children through college can make it more difficult to save for your retirement. Thus, it's important to start saving now for your children's college education.

The Benefits of Section 529 Plans

The Economic Growth and Tax Relief Reconciliation Act of 2001 (Tax Act) significantly expanded the tax advantages of qualified tuition programs, also called Section 529 plans. Starting in 2002, the key new features include:

• Your money can grow tax deferred in the plan until withdrawn. Distributions from state-sponsored tuition programs to pay qualified higher-education expenses are excluded from income if made after 2001, while non-state program distributions are excluded after 2003. Previously, earnings were considered income to the beneficiary.
• Public and private colleges can now sponsor prepaid tuition programs. Formerly, only states could sponsor these programs.
• You can now claim the HOPE Scholarship Credit or Lifetime Learning credit in the same year tax-free distributions are taken from a Section 529 plan, as long as the credit is not claimed for amounts paid with the tax-free distributions.
• Instead of a plan-imposed penalty on withdrawals not used for qualified higher-education expenses, a 10% federal income tax penalty will be imposed.
• Once every 12 months, you can make a tax-free transfer of funds from one plan to another for the same beneficiary. In the past, you had to change the beneficiary to make a tax-free transfer.
• The definition of family member has been expanded to include first cousins.

Other provisions that remain the same include:

• You are the account's owner and can change the beneficiary or even take the money back (if permitted by the plan). If you decide to take the money back, you will owe ordinary income taxes on earnings and the 10% federal income tax penalty.
• The money can be withdrawn without penalty if the beneficiary dies, becomes disabled, or receives a scholarship.
• You can contribute up to $55,000 in 2002 to a qualified tuition program ($110,000 if you split the gift with your spouse) in one year and count it as your annual $11,000 tax-free gift for five years. However, if you die within the five-year period, a pro-rata share of the $55,000 returns to your estate.
• No income limits exist for making contributions to these plans.
• For financial aid purposes, these plans are typically considered assets of the parents. However, even though withdrawals are tax free, they will probably be considered as the child's income.

Qualified tuition programs come in two forms:

• With prepaid tuition programs, you pay a fixed amount now for a guarantee that sufficient funds will be available to cover tuition. Many states offer these plans and this is the only option private colleges can offer.
• With college savings plans, you place money in a plan to be used for the beneficiary's higher-education expenses at any college. Your money is invested in stocks, bonds, or mutual fund options offered by the plan, with no guarantee as to how much will be available when the beneficiary enters college.

Like other provisions of the Tax Act, provisions regarding Section 529 plans are scheduled to expire in 2011 unless further congressional action is taken.

Take Another Look at Education Savings Accounts

The Economic Growth and Tax Relief Reconciliation Act of 2001 (Tax Act) significantly expanded the tax advantages of education IRAs, now called Coverdell Education Savings Accounts (ESAs). Starting in 2002, the key features of ESAs include:

• Annual contributions increased to $2,000 per beneficiary under age 18 (up from $500 previously). This amount is in addition to the annual limit for other types of IRAs.
• Contributions aren't tax deductible, but earnings grow tax free as long as they are used for qualified education expenses as defined by the Tax Act.
• Previously, tax-free distributions could only be used for qualified higher-education expenses, including tuition, certain room and board, books, and other supplies. Starting in 2002, tax-free distributions can also be used to pay elementary and secondary school tuition and expenses, including tutoring, room and board, uniforms, and extended day-care programs, and to purchase computer technology and equipment, including Internet access and services.
• Eligibility to make contributions is phased out at adjusted gross income levels of $95,000 to $110,000 for single taxpayers and beginning in 2002, $190,000 to $220,000 (formerly $150,000 to $160,000) for married taxpayers filing jointly. If your income exceeds these limits, you can ask other relatives to contribute for your children. Your child can also make the contribution to his/her own ESA since there is no earned income requirement for contributions.
• Corporations and other entities can now make contributions to ESAs, regardless of their income.
• Contributions can be made until April 15 of the following year (formerly contributions had to be made by December 31).
• Distributions must be made before the beneficiary turns 30. Any funds not used for qualified education expenses are subject to normal income taxes and a 10% federal income tax penalty. However, the ESA balance can be rolled over to another family member.
• Contributions can now be made to both an ESA and a Section 529 plan for the same beneficiary in the same year.
• You can now claim the HOPE Scholarship Credit or Lifetime Learning credit in the same year tax-free distributions are taken from an ESA, as long as the credit is not claimed for amounts paid with the tax-free distributions.
• For special needs beneficiaries, contributions can now be made after age 18 and tax-free distributions can be taken after age 30.

Like other provisions of the Tax Act, provisions regarding ESAs are scheduled to expire in 2011 unless further congressional action is taken. Before contributing to an ESA, consider the impact on financial aid. Typically, an ESA is considered your child's asset for financial aid purposes.

Getting Your Share of Financial Aid

To determine if your family qualifies for aid, you need to complete a needs analysis. After January 1 of the year your child will enter college, you must fill out the "Free Application for Federal Student Aid" as well as any other forms required by the colleges your child is applying to. The forms are used to calculate your expected family contribution, or the amount you're expected to pay annually toward college costs. Be forewarned - the formula assumes a frugal lifestyle and does not take actual expenses into account. In general, after adjustments for taxes and other factors, colleges expect students to contribute up to 70% of their income and 35% of their assets each year, while parents are expected to pay as much as 47% of their income and 5.6% of their assets (Source: Educational Testing Service, 2001).

Your contribution is a fixed amount and remains the same regardless of the cost of the college your child attends. Also, the amount is a family contribution amount and does not change based on the number of children attending college.

When college costs exceed your required contribution, financial aid officers try to find aid to make up the difference, using grants, scholarships, work programs, and student loans.

Some factors that can affect your contribution amount include:

• College savings. Carefully evaluate whether assets designated for college should be placed in your child's name or your name. While only 5.6% of your assets must be used for college, 35% of your child's assets must be used. Compare the tax savings generated from transferring income to your child with the possible reduction in financial aid.
• Debts. Loans against assets, such as mortgages, home-equity loans, and margin loans, are deducted from your net worth, while consumer loans are not deducted.
• Assets. Your net worth, as defined by the financial aid system, includes your home, bank accounts, stocks, bonds, and mutual funds, but not retirement funds, insurance, or annuities. However, individual colleges may have different criteria for certain assets.
• Investment sales. If you expect to sell assets such as stocks to pay for college, keep in mind that any capital gains will be included in income. To be excluded from financial aid formulas, your investments would have to be sold before January of your child's junior year of high school.

Your financial aid package can vary significantly between schools, so it's typically best to apply to several colleges. When evaluating the aid package, look at the types of aid offered as well as the amount. Grants, which do not have to be repaid, are more desirable than loans, which must be repaid.

If there have been significant changes in your financial situation since you filled out the forms or you don't think the college evaluated your situation properly, let the college know.

Before accepting a financial aid package, find out the answers to these questions:

• How was my expected family contribution, financial need, and award package determined?
• What financing options are available to help fund my expected family contribution?
• What are the terms and conditions of the aid package?
• Are there any conditions for renewal of the aid package?
• How will my aid package change from year to year?

Copyright © 2006. These articles intend to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.

FR1999-1230-0004