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The Cost of Funding a College Education
by Parveenn Kumarr
The cost of funding a college education continues to rise. The cost of a
college education has continued to rise at a rate greater than general
inflation or CPI. With these continued spiraling costs, the question is,
what is the best way to provide for a college education? Mutual funds,
government bonds, qualified retirement plans, educational IRAs and Section
529 plans are the most common funding vehicles. Each of these tolls has its
own tax and economic advantages and disadvantages.
Families who choose to invest in mutual funds do so because they feel that
they receive professional management and that it gives them diversification,
which protects them from substantial loss. There are no limits on the amount
they can invest. Although these might be sound economic reasons for
investing in mutual funds, there are no tax advantages because all the
income is taxed currently and the full fair market value of the funds are
included in their estates for tax purposes.
Federal Series EE&I Bonds are another common investment vehicle because of
their obvious security and tax advantages. The income from these bonds is
tax-free for state purposes. For qualified taxpayers, the income is fully or
partially exempt for Federal purposes if used for qualified higher education
cost. Federal taxes can be deferred currently on these bonds. Like the
mutual funds, these bonds will be included in the owner's estate for estate
tax purposes. There is a limit of $30,000 annually that can be invested in
these bonds. Since the built in growth rate of these bonds has been
substantially less than the rise in the annual increase in college cost,
they are a questionable investment in the long term.
Borrowing from one's 401(k) Plan is also popular. Since the funds in these
plans grow tax free until paid out to the beneficiary, they have definite
economic advantages. If the funds are taken out to fund the education cost,
they are not treated as a taxable distribution, hence no income tax. The
major drawback is that the borrowings are limited to the lesser of $50,000,
or 50% of the fund's balance. Borrowing from one's 401(k) plan would
probably be more suitable for funding state tuitions rather than the higher
private school tuitions.
Individual Retirement Accounts (IRAs) are also utilized as a college funding
mechanism. There are different types of IRAs and they have different tax
ramifications and contribution limits. Contributions to a regular IRA are
tax deductible if certain requirements are met. The income is not taxed
currently but is taxed when withdrawn. The Roth IRA does not provide for a
current deduction but the withdrawal of the original contributions and
earnings are completely tax-free if taken out after the owner reaches 59 1/2
years of age. The taxpayer must satisfy certain income level requirements in
order to be eligible to contribute to a Roth IRA. The current contribution
level to the regular and Roth IRAs is $3,000 per year. This will be
increased over the next four years to $5,000, exclusive of catch up
contributions.
The Coverdale Education IRA is the most attractive IRA because not only are
its earnings exempt from tax if used for education purposes, but it can be
used to fund education costs from kindergarten through higher education. The
funds can also be used for such items as books, supplies and computers.
Unlike the previously discussed funding vehicles, the value of this account
is not included in the owner's estate for estate taxes. The major drawback
to the Education IRA is that its contributions are limited to $2,000 per
year, but this low limit still makes it attractive to family members,
especially grandparents.
The most popular and advantageous method of funding a college education is
the Section 529 Plan. There are actually two types of plans established by
Internal Revenue Code [section]529. One is a prepaid tuition plan and the
other is a savings account plan. One or both of these plans are offered by
almost every state. The prepaid tuition plan is really a hedge against
inflation. It allows you to purchase future credits for the student at
today's credit cost. In effect, you are betting that the cost of the future
education will grow faster than the invested funds. The tuition savings
account functions like any other investment account, except neither you nor
the beneficiary control the investments, however you do choose the
investment portfolio options. The contributions to these plans are completed
gifts and therefore, are covered by the $11,000 annual exclusion. In fact,
you can front-load the plan by making up to five years of gifts ($55,000 or
$110,000 if married) at one time. There are numerous advantages to these
plans, but the primary ones are the aforementioned front-loading, the
tax-free status of the earnings, and the tax-exempt withdrawals of the funds
if used for education purposes. In other words, you can put the funds in
tax-free, they can grow tax-free and they can be withdrawn tax-free. There
is a definite estate tax advantage as well, because they will not be
included in the donor's estate for estate tax purposes. If the funds are not
used for education purposes and are withdrawn by the owner, then they will
be taxed at that time and also be subject to a 10% penalty. The cost of the
penalty would probably be offset by the benefit of the tax deferral. You can
choose the plan of any state; therefore, you should be able to select a
group of investments and a portfolio adviser that satisfies your objectives.
These plans are also appealing to older students who choose to return to
school after working several years or retired individuals, because they do
not have age limits. However, Congress is considering a 35 year age limit as
well as penalties greater than 10% for non-educational withdrawals.
It should be kept in mind that these various funding vehicles could also
impact your child's ability to receive financial aid because all
institutions weigh the availability of funds to the student. That is, funds
owned by the parent are treated differently from funds owned by the student.
Some of these funding vehicles result in the parent being the owner, while
others transfer the ownership to the student. Before making any investment
decisions, you should discuss with your financial advisor the complete tax
and economic ramifications to you as well as their impact on financial aid.
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