As I write this, Penn State students will be returning to our own Happy Valley en masse for the fall 2010 semester. This week and the next will be a busy time for downtown stores that cater to the student population.
Nestlerode & Loy, Inc., remains busy all year long as we cater to local firms, non-profits and individuals. So what part do I play in the college drama? We help our clients pay for college. No, I don’t provide grants, loans or scholarships. For families that like to plan ahead, we can guide them through the myriad investments and vehicle options for saving for higher education.
In my circle, it seems many folks have new additions to their families and/or children heading into high school, making this time of year a wake-up call to save money now to help make painful tuition payments later.
The cost of higher education has increased exponentially in the last 10 years. I will use Penn State as an example. Based on the annual increases for Penn State over the last decade (2001-2010) the tuition for incoming freshman at University Park campus increased a compound 7.0773% (data from Post-Gazette.com). This is almost twice our national average inflation rate over the last 50 years, which runs at four percent. Given this statistic, saving wisely and early for college is vital.
There are many ways to save for a child or grandchild’s college experience. The oldest way to save is a Uniform Gift to Minor’s Account (UGMA is the shorthand). This vehicle is set up with a custodian (the adult) and the minor. The person who puts money into a UGMA account gifts this asset to the minor, and it is non-refundable. The adult (or custodian) controls the assets inside the UGMA until the child reaches the age of majority, which is 21 in the state of Pennsylvania.
The upside of this account is that it can be used for anything that benefits the minor, except essentials (food, clothing, etc.) The UGMA can be used for private high schools on through to weddings. The downside of a UGMA is that assets permanently become the property of the child. When he or she hits 21, they can use the money to buy a Corvette, a tattoo or a condo.
Another issue with the UGMA is that earnings are taxable. Typically, earnings are taxed as follows: the first $950 is tax-free; amounts from $950-$1,900 are taxed at the child’s rate; and amounts of more than $1,900 are taxed at the parent’s tax rate. Therefore, gifting large amounts into a UGMA account can lead to tax consequences that can be avoided using other vehicles.
If one parent is a graduate of a university, that alone increases the chance that their child will also attend college. Because of the high rate of tuition increases, it is advantageous to save tax-deferred for college. This means the money invested toward the minor’s education is not taxed on the growth of the investment. Two investment vehicles are available to provide tax-advantaged education savings. They are 529 Plans and the Coverdell Education Savings Account.
A Coverdell Education Savings Account (formerly known as the Coverdell IRA) has a contribution limit of $2,000 per year until the minor reaches the age of 18. This contribution is not tax-deductible and is limited by the parents’ adjusted gross income, so for higher-income taxpayers this vehicle is not an option. The advantage to this plan is that earnings grow tax-free and allow for tax-free withdrawals for education expenses. The education expenses that qualify include private kindergarten through and including college. If a balance remains in the account after the beneficiary (recipient) completes his or her education, another beneficiary within the same family may replace the original beneficiary. If the beneficiary reaches age 30 with the account still funded, the account must be dissolved and a 10 percent penalty plus income tax paid on the balance.
The latest alternative and most-talked-about vehicle for education is the 529 Plan. A 529 can be funded by a family with any income level and thus is much more accessible to higher-income couples. In addition, more money can be contributed to a 529, up to $13,000 per year ($26,000 from a couple). A special election can be made to speed up these contributions by placing $65,000 ($130,000 for a couple) at one time instead of over five years. A 529 is limited to higher-education expenses, including college, graduate and post-graduate courses. A 529 may not be used for pre-college education expenses. This is a great vehicle if there is more than one child in the family. Chances are, one child will go to college or a technical school after high school. The beneficiary can be changed within the 529 to another family member without tax consequences. A word of warning: if the money in a 529 Plan is withdrawn for any expense other than qualifying higher-education expenses, the amount faces a 10 percent penalty along with federal income tax.
The great idea if you are a parent, grandparent, godparent, aunt or uncle is to start off the newest addition to the family with a plan. Everyone can contribute with as little as $50. While others give toys, frilly clothes or Tonka trucks, you can build toward the baby’s future.
