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Nontraditional Options for College Savings

Bonds & UGMA accounts

Nontraditional Options for College Savings

Traditional methods of saving for college are still popular, but there are some newer and more creative methods of saving, as well.

You really should sit down with a financial advisor, who will assess your financial situation and recommend a plan that best suits your situation. So you know what the advisor is talking about, some information about other options for saving for college is given in the following sections.

EE Bonds

Money Morsel

In order to cash in on the income tax exemption of EE bonds, they can only be used for educational expenses for you, your spouse, or your dependent children. The bonds can be used to pay for tuition, room and board, and books.

A method of saving for college that's gaining in popularity is utilizing EE Bonds. These bonds are special because the interest accrues on them from the time the bonds are purchased until they are cashed, with the proceeds used toward college exempt from federal income tax liability. This is a beneficial tool, but you should know that it's not available to everyone.

A person over the age of 24 must purchase the bonds in the name of the parents of the child for whom the money is earmarked—not in the child's name. And the bonds must be held for at least five years before they can be used for college costs. That means you can't go out and buy them when your child is 17 and expect to use them to pay for college costs.

When you cash in the bonds to pay for educational expenses, the entire interest amount is tax free, provided your joint household income is less than $79,650. The amount is pro-rated up to a maximum of $109,650 of family income, and, once you're over $109,650, the accrued interest is taxed.

EE bonds can be a nice supplement to your college savings, but not a practical means of funding an entire college education. If your child doesn't go to college, the bonds remain in your name.

Uniform Gifts to Minors Act (UGMA) Accounts

These are older style accounts that are set up to lower the income tax liability that individuals pay for funds in their children's names. Funds set aside for college, or given as gifts to your children, are placed into an account in the child's name under the Uniform Gifts to Minors Act. The funds belong to the child. Since the child is a minor, however, the funds must have a custodian—usually a parent. The funds accumulate and are invested, with the child earning investment income. The nice thing about these kinds of accounts is that the first $750 of investment income the child earns is not taxed, and the next $750 is taxed at the lowest tax bracket. After that, the rate increases and is paid at the parents' tax rate. After age 14, the rate is always taxed at the rate of the child's tax bracket.

Don't Go There

Life insurance is not a good investment for a college account. Neither are limited partnerships or tax deferred annuities. These are long-term investments that aren't suitable for college savings. If your financial advisor recommends any of these investment tools, run and find another advisor.

A possible downside of these funds is that the money belongs to your child. If Rob decides to buy a motorcycle and ride through Europe instead of going to college, as long as he's no longer a minor, you can't stop him from taking his “college” money with him. It's a good idea to only invest enough in these types of funds to get the income tax advantage, and put the rest of your child's college money somewhere else.

The custodian of a UGMA account can set it up as a savings account in the local bank, and change it to a brokerage account as the account grows. You can even buy stocks or bonds with the money, but not unless you know what you're doing.

Gift tax limitations dictate that a maximum of $10,000 a year can be placed in a UGMA account. That amount can be doubled if a couple is gifting.

IRAs & tax credits

Education IRAs

The recent tax law change will increase the annual limit on contributions to an education IRA from the current $500 per year to $2,000 per year. Thank goodness! It was hardly worth the hassle of setting up one of these accounts for a measly $500 a year. With a $2,000 limit, however, you can reach, or get close to your college goal if you start saving as soon as your child is born.

As with all IRAs, the income and capital growth are deferred within an education IRA until the funds are withdrawn for college.

Education IRAs have income limits for the parents, but you can change the beneficiary designation to another child if your first child decides not to go to college. One of the problems with education IRAs is that you can only use the funds for your children, so if none of your children go to college, the funds become taxable to the last named beneficiary when they reach 30 years of age. Unfortunately, you can't roll the unused education IRA over into a personal IRA, the accumulated capital gain and income are taxed to the beneficiary.

Tax Credits for Parents of College Students

Money Morsel

If you qualify (by attending a college or post-high school at least half time), you could use the HOPE credit for your child's freshman and sophomore years, and the Lifetime Learning Credit for her junior and senior years.

There are two tax credits that may be available to you during the time that your children are in college. As with so much of the income tax code, these tax credits are not cut and dried, but depend on your annual income and some other stipulations.

As you know, there are tax deductions and then there are tax credits. The difference is where they can be used on your tax return. A deduction is listed on Schedule A of your income tax return, and if your deductions are large enough to exceed your standard deduction, you can subtract the deductible sum from your adjusted gross income. After you've subtracted out your exemptions, this figure is called your taxable income and used to calculate your tax.

A tax credit is usually better because you don't have to itemize your deductions to use the credit. You can file your return using a standard deduction and still use a credit. Once you've calculated your tax, a credit is subtracted from this tax to lower what you owe the IRS.

The HOPE (Higher Opportunities for Performance in Education) credit has been available since 1998. It's a tax credit for qualified tuition and related expenses during a student's first two years of college. The student must attend college or other post-high school courses at least half time.

The credit is for 100 percent of the first $1,000 of qualified expenses paid during the year, plus 50 percent of the next $2,000, for a maximum of $3,000.

A Lifetime Learning Credit is a credit for expenses that don't qualify for the HOPE credit. The Lifetime Learning Credit is available for any school year for courses aimed at acquiring or improving job skills. The credit may be for undergraduate, graduate, or professional degree courses.

The Lifetime Learning Credit is equal to 2 percent of expenses up to $5,000, for a maximum credit of $1,000 per year. After the year 2003, the credit will rise to 20 percent of $10,000, for a maximum credit of $5,000 per year.

The Lifetime Learning Credit is for you, your spouse, and your children or other dependents. It's intended to be used for tuition and related fees—not room and board, commuting, or other expenses. And, of course, there are income limits.

What the IRS giveth, the IRS taketh away. The credit begins to phase out with adjusted gross income over $80,000 per year and is completely gone if your income is more than $100,000 per year (for married filers, the figures are halved for single filers). We're not talking about $80,000 in taxable income, we're talking adjusted gross income—the total of all your income, with some adjustments.

State tuition plans

Qualified State Tuition Plans

There are two types of qualified state tuition plans, both of which are 529 plans. That means they fall under section 529 of the tax code, which permits investing for college in a tax-deferred vehicle. One type of qualified state plan is known as a Prepaid Tuition Plan or Tuition Assistance Plan. The other is simply called a 529 Plan.

The 529 Plan was revised in 1997 and again in 2001. This plan is the newest way to save for a child's college education. Basically, it's an account that's set aside for a child's education, and is tax deferred until it's used. The money, however, can't be accessed by the child. If Rob buys that motorcycle and takes off for Europe, he can't grab the money from the account on the way out.

Adding It Up

Tax-deferred income is earned, but not taxed until the income is used. Tax-free income is never taxed.

A 529 Plan is even more appealing under the most recent Tax Act, which in 2002 made all earnings within a 529 Plan tax free, not just tax deferred. And, up to $50,000 can be contributed to a 529 Plan each year by an individual, or up to $100,000 by a couple. Contributions to these plans are considered gifts. The person setting up the account and depositing money is called a contributor, and remains in control of the money. If the child for whom the money is intended does not go to college, the money can be passed along to another beneficiary (within the large family unit—nieces and nephews rather than just brothers and sisters like an education IRA), or retained by the contributor.

At that point, if the contributor retained the money, it would become taxable, and there would be a 10 percent penalty. The penalty is meant to be a deterrent to people using a 529 Plan as a convenient way to stash away tax-free money, never intending to use it to pay for college.

The Prepaid Tuition Plan is intended to fund tuition expenses only. Money in these plans can't be used to prepay room, board, books, fees, and so forth. It's strictly for tuition. That means you'll probably need to have another college investment vehicle, as well.

The governments of various states normally set up these Prepaid Tuition Plans, which are guaranteed against losses in the stock market. You probably will need to be a resident of the state in which you set up a plan.

A Prepaid Tuition Plan guarantees that your tuition credits will pay for your child's tuition. No matter what happens to tuition costs, your purchase “locks in” the cost of future tuition. The plan can be used for tuition at any accredited, public or private college or technical school in the United States.

This plan may keep you eligible for financial aid, since it only covers the cost of tuition. You'll still need to come up with the money for room and board.

The funds you contribute to a Prepaid Tuition Plan are used to buy tuition credits that equal credit hours paid at different types of institutions. You'll need more credits for a four-year college or university, for instance, than you would for an area community college. You'll need to purchase more credits if your child is interested in a university, while you'll need to purchase less if your child is interested in a community college.

If your child doesn't use all the tuition credits you've purchased, you may be able to get a refund.