Funding College - What Are Your Options?

With the price of an undergraduate education skyrocketing, it's little wonder that college tuition often tops the list of families' financial concerns. Instead of letting the high cost of college intimidate you, however, it's far smarter to create a savings plan and then put it into action. Below are a few of the powerful programs that can help you fund future college costs.

Coverdell Education Savings Accounts

One option is the Coverdell Education Savings Account (ESA), formerly known as the Federal education IRA. A Coverdell ESA allows families with adjusted gross income of less than $220,000 ($110,000 for single filers) to contribute up to $2,000 of after-tax income per student each year. As long as these funds are used for higher education, they are not taxable. (Benefits disappear for families earning more than $220,000 annually, or singles earning $110,000 per year.)

Contributions: Any individual who meets adjusted gross income (AGI) requirements can make a non-deductible contribution on behalf of a child under the age of 18. The AGI requirements are $95,000 for single taxpayers and $190,000 for married taxpayers. The $2,000 annual contribution limit is phased out for single taxpayers with AGI of $95,000 to $110,000 and for joint filers with AGI of $190,000 to $220,000. Although a child may be the beneficiary of any number of Coverdell ESAs, the total contributions for the child during any tax year cannot exceed $2,000. Contributions to a Coverdell ESA may be made until the due date of the contributor's federal income tax return, without extensions.

Withdrawals: Distributions are tax-free as long as they are used for qualified education expenses, such as tuition, books, fees, etc., at an eligible educational institution. This income exclusion is not available for any expenses for which the Hope Credit or the Lifetime Learning Credit is claimed for that student. If the distribution exceeds education expenses, a portion will be taxable to the beneficiary and will be subject to a 10% tax penalty. Exceptions to the penalty include the death or disability of the beneficiary or if the beneficiary receives a qualified scholarship.

If there is a balance in the Coverdell ESA at the time the beneficiary reaches 30 years old, it must be distributed within 30 days. A portion representing earnings on the account will be taxable and subject to a 10% penalty. The beneficiary may avoid this tax and penalty by rolling over the full balance to another Coverdell ESA for another family member.

Section 529: College Savings Plans

Another attractive option is the Section 529 college savings plan. A 529 plan is a state-sponsored education savings program that allows an individual to save in a tax-deferred account to pay for a beneficiary's post-secondary education at any accredited school in the United States. Unlike the Coverdell ESA, which excludes joint filers with adjusted gross incomes (AGIs) above $220,000 and single filers with AGIs above $110,000, there are no income restrictions on those contributing to the plan.

These prepaid tuition plans let parents lock in tuition at today's rate by paying ahead of time, either in full or by installment. They started at state colleges and universities, though now the list is expanding. Prepaid tuition "units" can even be purchased by family members or friends.

Contribution limits to the Section 529 college savings plan are generous, and withdrawals can pay for books, tuition, or living expenses. Investments in these accounts are generally exempt from state and local taxes (though not from federal income tax; but withdrawals are taxed at the student's rate). These plans are offered in all states and through several leading private investment firms.

529 plans come in two categories: Prepaid Tuition Plans and College Savings Plans. Here are some additional features of Section 529 plans.

Contribution limits: Unlike Coverdell Education Savings Accounts, which limit annual contributions to $2,000 annually, contributions to 529 College Savings Plans are essentially unlimited. Many states, however, do tend to limit contributions once plan assets have reached a specified maximum (typically $200,000 - $250,000). Further, individuals can give up to $11,000 annually (or $55,000 under a special 5-year provision) per beneficiary without incurring the federal gift tax.1

Flexibility and control: Plan assets can be used to pay for qualified higher education expenses at accredited colleges and universities nationwide that are eligible to participate in certain federal student aid programs. These include public and private colleges and universities, graduate schools, two-year community colleges, and vocational-technical schools.

The donor retains control over the account. Unlike custodial accounts, under the Uniform Gifts to Minors Act, the money in a Section 529 College Savings Plan does not automatically become property of the child at age 18. The donor also may change beneficiary as long as it is within the same family.

Minimum investment: Many plans have low initial minimums of $500 or $1,000, and can usually be set up for automatic investments of as little as $50 or $100 a month.

HOPE and Lifetime Learning Education Tax Credits

HOPE and Lifetime Learning Education Tax Credits aim to lower the financial burden on families by providing federal tax credits following payment of qualified educational expenses.2

The HOPE credit allows a full tax credit for the first $1,500 in tuition paid for each of the first two years of undergraduate study. Its benefits are reduced if a married couple's adjusted gross income is more than $87,000 ($43,000 for single parents), and eliminated altogether if that joint income is more than $107,000 (or $53,000 for singles). The Lifetime Learning Credit offers a 20 percent credit for the first $10,000 in tuition paid per taxpayer for the third year of undergraduate study and beyond. (This credit can't be claimed in the same year as a HOPE credit, and like the HOPE credit, has some income restrictions.)

You have many choices when saving for a child or grandchild's college education. Be sure to consider how Coverdell ESAs, Section 529 plans, and various tax credits can fit into your plan.

1) This requires that no further gifts are made over the five-year period and that the gift is treated as a series of five equal annual gifts on the next federal gift tax return after the gift is made. Failure to survive the five-year period may result in a portion of the gift being included in the donor's estate for estate tax purposes.

2) Parents cannot claim the Hope or Lifetime Learning Credits if they pay all college expenses from Section 529 or Coverdell Education Savings accounts; they must spend at least $2,000 out-of-pocket to claim either of these.

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