RSM Resources

Would the prospect of your child attending Harvard make you feel proud or fearful? Tuition and room and board for the Ivy League college will run nearly $42,000 this year.

Post-secondary-school tuition has been increasing 8 percent per year on average, according to the College Board, which administers the SAT college-entrance exam. That means a four-year Harvard education for today’s newborn child could reach $550,000.

Whether your child is destined for Harvard or a less expensive alternative, tax-advantaged savings programs abound to help finance college costs. These options include Coverdell IRA education savings accounts, various 529 college savings plans, custodial accounts and prepaid tuition plans. Tax credits and various other financial steps also may help make education more affordable. With so much at stake, and so many complex choices,it’s never too early — or late — to chart an education investment strategy.

Savings plans
Coverdell IRA education savings accounts.You can open a Coverdell IRA at most banks, brokerages and mutual-fund firms.These IRAs permit after-tax contributions totaling $2,000 per year per child up to the age of 18, provided the contributor’s adjusted gross income is less than $190,000 for taxpayers filing a joint income tax return. Contributions grow tax-deferred, meaning gains are taxed only after making withdrawals.

Education savings accounts can fund elementary, secondary and college educational expenses — including tuition, room and board,fees, books, and educational computer software. The beneficiary must use or transfer the funds before turning 30. Note that, because the Coverdell IRA is in the child’s name, it may affect his or her financial-aid eligibility.

With its $2,000 annual contribution limit, Coverdell IRAs can be useful tools if your child is a newborn, you anticipate supporting your child’s education at a public college or university where the cost is generally lower, or you use it as a supplement to other savings plans. A student can be the beneficiary of only one Coverdell IRA but can combine it with a prepaid state plan or one or more 529s.

529 college savings plans. State-sponsored 529 plans are solid options for both long-and short-term college savings. A parent or other establisher controls the 529 plan, with the child as a beneficiary. You can withdraw the earnings tax-free for qualified educational expenses (including tuition, room and board, books,and transportation) and roll the account over to another family member if the original beneficiary decides not to attend college. Contribution limits vary by state.

Anyone can open a 529 account for a child and make after-tax contributions regardless of their income. Contributions to 529 college savings plans are tied to the gift exclusion limit of $11,000 per individual recipient this year. However, you may make up to five years’ worth of gifts, or $55,000, in one year.

Experts say the state-specific requirements of 529 plans often confuse parents. For example, some states permit students to attend out-of-state schools without penalty, others do not. An excellent resource for more information on 529 plans is The Best Way to Save for College: A Complete Guide to 529 Plans, by Joseph F. Hurley. The book ranks the various 529 plans and explains state-specific options. It also provides information on each plan’s expense ratios, or the amount of money you’ll pay in administrative fees. Some plans have expense ratios as high as 2 percent, which can put a significant drain on investment gains.

Custodial accounts. Traditional custodial accounts are known as "UGMA" accounts, for the Uniform Gifts to Minors Act. Up to certain limits, these accounts are taxed at the child’s lower rate, you are able to freely choose your investments, and fees are likely to be lower than 529 plans. You can make withdrawals for any expense that benefits the child, not just educational expenses. However, a child who reaches age 18 or 21, depending on the state, gains control of the account and can spend the money for any purpose. Custodial accounts also can affect financial-aid eligibility because most schools count both the student’s and parents’ assets.

Prepaid college savings plans. Available in approximately 20 states, prepaid plans let you pay future college tuition bills at today’s price. Some states require participants to designate prepaid tuition for a specific school, but most allow prepaid tuition for any school in the state. If your child is in high school and knows where she’d like to attend college, you can opt for a prepaid plan —which essentially offers a return equal to future tuition increases. If you ultimately cash in the tuition instead of using it for higher education, expect a return at the money-market rate. The prepaid plan may be too conservative or inflexible for younger children who have longer-term investment horizons and less certain education plans.

Tax credits
Once your child has reached college age, the Hope and lifetime-learning tax credits also can help pay for college education expenses. The credits are designed to give parents, filing jointly with modified adjusted gross income of $105,000 or less, a break during the years they’re paying educational expenses. Unlike deductions, which reduce the amount of taxable income, these credits reduce the total tax bill.

Hope credit. This credit of up to $1,500 per eligible student is limited to two years per eligible student. The student must be pursuing an undergraduate degree or other recognized educational credential.

Lifetime-learning credit. This credit of up to $2,000 is calculated on a per-family basis with no limit on the number of years you can claim the credit. The student does not have to be pursuing a degree.

You can choose only one credit per student, and you can claim the credits during the same year you make tax-free withdrawals from an education savings account or 529 college savings plan.

Sensible strategies
Professionals recommend that as your child approaches age 18, your portfolio should become more conservative, although each individual’s risk tolerance is different. Other tips include:

• Estimate your child’s eligibility for financial aid using the tools available on the Free Application for Federal Student Aid (FAFSA) Web site. All public and private schools use FAFSA to determine financial need.
• Look for scholarship opportunities, including business or community organizations you may be involved in that offer aid. Many scholarships go unused due to a lack of applicants.
• Encourage your child to enroll in advanced-placement programs during high school. Any advanced-placement exams students pass reduce the number of college credits they’ll need to complete, and pay for, later.
• During your child’s senior year in high school, consider his or her eligibility for financial aid when you make other financial decisions. Actions such as deferring bonuses and maximizing 401(k) and flexible spending accounts will affect your taxable income — the primary factor in determining financial-aid eligibility.

Your retirement vs. your child’s education
Parents with college-bound children share a common financial dilemma: how to save for their own retirement while helping fund their children’s education. Some experts advise taking care of your retirement first.

Who will save more for retirement: someone who contributes $2,000 to an IRA annually between ages 20 and 30, then stops, or someone who contributes the same amount annually between ages 30 and 65? Due to the power of compounding interest, the answer is the first person.

Building on the concept of compounding interest, parents should consider maximizing their 401(k) and IRA contributions until their child is ready for college rather than saving for a child’s college education. When the child is in school, the parents could stop making contributions to their retirement plans, pay cash for college expenses and resume retirement contributions after the child has graduated from college. If the parents do not have enough money to pay college expenses from their cash flow or other sources, they can withdraw principal penalty-free from their IRAs (but subject to income taxes), take a loan from their 401(k)s, or examine home equity and student loan options. However, parents must carefully examine their options. If a child has access to reasonably priced funds through financial aid, the family’s aggregate financial future may be better if the parents continue to save for their retirement and the student uses financial aide to pay for college.

This easy, flexible plan reduces taxable income before children enter college and is likely to maximize a family’s qualification for college financial aid when it’s needed. Money saved in retirement accounts is often not counted against a family’s eligibility for financial aid.

Additional options for business owners
Business owners have several additional options when it comes to funding a child’s college education.

Add your child to the company payroll. It is possible to shift income to a lower tax bracket when you place your child on your company’s payroll, because the child’s earned income will be taxed at a lower rate than yours. The wages paid to your child must be kept at a reasonable level and be directly related to services provided by the child. With this method, you child’s salary is not subject to the gift tax, and your child gains work experience. Accumulated wages and high annual earnings may reduce your child’s financial-aid award, however, and the child must work to support their education.

"Gifting" company stock to your child. If you’re the owner of a corporation, have appreciated stock and are interested in selling part of it to fund your child’s education, you can save on taxes by gifting the stock to your child and having him or her sell it. The resulting capital gains will be taxed at the child’s lower tax rate. This strategy has several tradeoffs: It may be difficult to sell stock in a closely held business, assets held by your child can affect financial-aid eligibility, gift restrictions may limit your tax savings, and, once the transfer is made, the child controls the stock and resulting funds.

Parents often have difficulty deciding what college savings plan is right for their family. Experts warn that uncertainty can cause the loss of valuable investment time. Regardless of which option you choose for your family, the most important thing is to get started, preferably early, and consistently add to your savings.