When is the best time to start saving for college? If you have a child, the answer is now, or perhaps yesterday. Due to many factors including increasing capital spending, expanding administration and the withdrawal of state funding from public universities over the last 20 years, tuition is increasing at rates outstripping normal inflation. University of Texas at Austin’s undergraduate tuition increased by 40 percent since 2004 to 2013, outstripping the 23 percent increase in the Consumer Price Index during the same time.
The trend makes it increasingly difficult to save for college, but there are still plenty of options available to help you plan ahead, assuming you have a bit of money to set aside. Here, we outline three common options many people use to save for college – traditional savings, Coverdell Savings Accounts and state-sponsored 529-savings plans. Each has tradeoffs regarding the flexibility of funds and tax benefits.
We’ll start the discussion with the most flexible option with the least tax benefits – traditional savings – and move through Coverdale accounts and finally to 529 plans – which have the least flexibility but the greatest tax advantages. Table 1 outlines the basic differences, while the article discusses the plans in greater detail later.
|Table 1: Comparing several common methods of saving for college|
|Plan Type||Simple Savings||Coverdell Savings||529 Savings Plans|
|Who can contribute?||Anyone||Anyone with an adjusted gross income of under $95,000 ($190,000 for couples)||Varies according to plan|
|Contributions tax deductible?||No||No||No|
|Contribution Limit?||None||$2,000 annually per beneficiary||Varies with plan|
|Interest taxable?||Yes, at standard income tax rates||No||No|
|Use restrictions?||None||for any qualifying educational expense, both K-12 and college||For any qualifying educational expense college|
|Age limits?||none||Contributions must stop after beneficiary turns 18, account must be used up by beneficiary’s 30th birthday||Varies by plan|
Note that all of these options have a mechanism where an outside party can make contributions. So grandparents or other relatives can make contributions on behalf of your child, while taking advantage of similar tax benefits.
- Simple savings
This one is the most straightforward of the three methods; all that it takes to start one is a simple trip down to the bank or a few clicks of the mouse. You open up a simple savings or money market account and put money away. Make a monthly budget with a savings goal for college. Even as little as $25 a month can add up over time. The benefits of this method are its flexibility. It’s easy to adjust the amount of money going into the fund as your financial means change. If other needs come up, there’s no penalty to withdrawal of funds.
But that flexibility comes with a price. Any interest you make on the account is subject to income taxes each year. Also, interest rates at ~.5% for standard savings accounts are far below the rate of college inflation, (though consider online savings accounts, which tend to have better rates).
- Coverdell Education Savings Accounts (ESAs)
Coverdell accounts have less flexibility than simple savings accounts, but more than college-savings 529 plans discussed below. But in return for committing your money to educational purposes, you get several tax benefits.
Unlike simple savings, Coverdell account funds must be used for educational expenses – withdrawals from the fund that don’t go toward education are subject to early withdrawal penalties. However, those expenses don’t necessarily have to be for college tuition and fees. Coverdell funds can cover books or other educational materials. Additionally the savings can be used for K-12 educational needs (including private school tuition), which makes a Coverdell more flexible than 529 plans.
In exchange for less flexibility, Coverdell accounts receive certain tax benefits. Contributions to the account are not tax deductible, but the interest accrued to the account is tax free – as are withdrawals at a later date. The tax rules governing Coverdells are quite similar to those governing Roth Individual Retirement Accounts.
Anyone can set up a Coverdell account in the name of the student – parents, grandparents, or just about any legal entity. However contributions to all accounts cannot exceed $2,000 annually for all combined accounts. Any annual contributions in excess of $2,000 are subject to IRS penalties. All monies in a Coverdell account must contributed before the beneficiary’s 18th birthday and must completely be withdrawn by the beneficiary’s 30th birthday or be subject to penalties.
The Internal Revenue Service has tax-specific information about Coverdale Savings Accounts posted online here. For more general information, see here.
- 529 Accounts
These specialized savings accounts are named after the section of the IRS code that created them. 529 plans allow families to save for college in a variety of investment vehicles from mutual funds to simple savings accounts. A benefit is that all of these plans are exempt from federal income tax on earnings (though not contributions) and distributions, but don’t have flexibility. Any withdrawals you make that aren’t used to pay for qualified expenses are subject to tax and additional penalties.
Within these general parameters, the plans vary greatly. At a basic level, 529s come in two major flavors, tuition promise and general savings. Tuition promise plans function to lock in the part or all of a current-year tuition rate at a school or set of school for a future year.
People who choose this style of plan pay in preset monthly installments plus an administration fee. The benefit to prepaying tuition at current level stems from current college costs increasing at faster than inflation or wages. Tuition increases add up. For example, a parent who chose a Texas pre-paid plan in 2004 for a student matriculating in 2013 would have essentially saved $1,190 annually in the cost of attendance – the difference between the 23 percent increase in inflation and the 40 percent increase in in-state tuition and fees between 2004 and 2013 as shown in Table 1:
|Table 2: Illustration of pre-paid 529 plan savings, using UT-Austin Cost of Attendance figures|
|Consumer Price Index||$7,000||$8,610||$1,610(23 Percent)|
|Tuition increase||$7,000||$9,800||$2,800(40 Percent)|
|Source for cost of attendance figures: http://www.utexas.edu/tuition/costs.html|
One drawback is that the payments are inflexible if your family’s financial situation changes. Once you commit to monthly payments, you need to make those payments every month, or you may lose out on part or all of your benefit. The details on what happens vary by plan. Another potential drawback is that the administration fee might add a hefty premium to the tuition rate – equivalent to several years of tuition increases in some cases.
Finally, many of these prepaid tuition programs have shut down due to financial difficulties caused by tuition increases outstripping projection, exacerbated by the stock market crash of 2008-09. Some states guarantee the tuition rate with their plan by backstopping any investment shortfalls with state appropriations, while others only rely on the total value of the fund.
Due to all these uncertainties, it’s important to get detailed information about the specific plan you are interested in. Read the plan’s details closely and seek help from a professional financial planner if necessary.
The second type of plan simply functions more or less like an Individual Retirement Account for college savings. Families save money into an investment vehicle offered by the plan – usually a variety of mutual funds. These plans offer considerable flexibility, but don’t lock in any tuition rates.
Plans also vary on whether or not they are exempt from state taxes and what sorts of investment limits they have. Some even are eligible for state matching grants. Most have some sort of flexibility to apply monies saved to private or out-of-state colleges if a student doesn’t end up attending an in-state public school.
There are currently three 529 plans available in Texas; one plan is a tuition promise-style plans and the other two are general savings plans. Fees and options vary, so it’s worth checking out the differences at www.collegesavings.org, which allows side-by-side comparison of plans across each state that offers them. The Web site is maintained by the College Savings Plan Network, which is an affiliate of National Association of State Treasurers.
More general information about 529 plans is available at the Federal Securities and Exchange Commission’s Web site, which outlines general types of plans and defines the types of management fees and costs as well as the investment options you might have in the plans. IRS publication 190 discusses the ins and outs of withdrawing from a 529 plan to pay for college.
Although the costs of college keeps rising faster than the general cost of living, most upper middle class families still have a variety of effective mechanisms to save for college. Combining planning with these tools above along with federal financial aid and tax credits for tuition can go a long way toward making college affordable without going into massive amounts of debt.
Please note that this article is for informational purposes only and not meant as actionable advice. You should consult a certified tax professional before taking any action on the information described above. General Academic, publisher of Thesis Magazine, is not a qualified tax adviser.