by Greg Hilton
MFI Correspondent

Education beyond high school is an expensive proposition, and fewer than one-third of students receive any form of financial aid. Your college bound child will expect and need help from you to get that educational advantage in life.

Parents have, most often, waited until their kids registered for the SAT test before giving thought to financing this education. Now there seems to be a general interest in planning when the kids are in grade school, or earlier. Whether you are a parent planning for the higher education of your children or an adult planning your own advanced education, you will want to think through the best ways to finance that education and to make the most of the opportunities open to you.

Help from the Tax Code

Realizing that parents are not always ahead of the college saving curve, the federal government has installed some tax-favored ways to save.

Tax Credits. Congress gives us the Hope Scholarship Credit and the Lifetime Learning Credit for college expenses incurred and paid after 1997. The Hope Credit is equal to 100% of the first $1,000 and 50% of the next $1,000 of qualified expenses (max. credit $1,500). This credit can be claimed for every student, in a degree program, who has not completed the first two years of post-secondary education (i.e., freshmen and sophomores). The Lifetime Learning Credit is equal to 20% of the first $5,000 of any educational expenses (max. credit = $1,000). These credits can be a big help but they are subject to limitations:

qualified expenses only include tuition and enrollment fees, not room and board;

the education can be for the taxpayer, spouse, or child, but the child must be a dependent on the return; and

the credits are phased out for taxpayers with gross incomes between $40,000 and $50,000 ($80,000 and $100,000 for married couples).

The Education IRA. If you qualify, you can put up to $500 every year in an IRA opened for a child under 18. You cannot deduct your contribution, but the earnings are entirely tax free if used for higher education. If the child does not use the money for school, the account can be transferred to another one of your children or grandchildren. Their drawbacks include:

a phase out for taxpayers with gross income greater than $95,000 ($150,000 for married couples);

distributions are taxable to the extent they exceed qualified higher education expenses (including room and board) and, if taxable, are subject to a 10% penalty;

assets must be withdrawn and included in income when the beneficiary dies or turns age 30; and

only $500 can be contributed annually!

Regular IRA and Roth IRA Withdrawals. A recent major tax code revision allows withdrawals from regular and Roth IRAs to pay for college expenses for yourself, your spouse, a child, or grandchild. The withdrawals will be subject to regular income tax but not the 10% early withdrawal penalty. Qualified expenses include tuition, books, and fees, but not room and board.

EE Savings Bonds. Series EE savings bonds are perhaps the best investment for that crucial four years before tuition is due. Taxes on the interest are deferred until paid out, and then they are only subject to federal tax, not state or local taxes. The interest escapes tax altogether if you bought the EE bond after January 1, 1990, were at least 24 years old at the time, and you redeem the bonds in a year when you, your spouse or your child paid tuition. The rate on series EEs is attractive as well—90% of the rate on 5-year Treasury securities. Qualified expenses include tuition (but not room and board), contributions to education IRAs and qualified state tuition plans. The exclusion of interest is subject to phase out for taxpayers with gross incomes over $53,100 ($79,650 for married couples filing jointly).

Qualified State Tuition Programs: Several states and colleges have education prepayment plans. Parents or grandparents put up money for a particular child. The state, or college, guarantees that this sum will cover a fixed portion of the tuition or certain number of college credits when the child goes to school. No matter how fast tuition might rise, the prepayment covers the agreed amount of education. Drawbacks include:

there is no guarantee that your child will be accepted or want to attend the institution;

the difference between what you pay in and the value of the education you receive will be taxed as capital gain;

these programs only cover tuition, not room and board.

Ownership Issues

College savings can be accumulated in either your own name or your child’s. The Uniform Transfers (or in some states, Gifts) to Minors Act makes giving to a child quick and easy. There are good reasons, however, that make it a better course of action to keep the money in your own name. First, there is little benefit under current tax law. There is not a great tax rate differential and the kiddie-tax imposes your tax rate on all but the first $1300 of income for less than 14 year olds. Second, kids take control of their money at age 18 and you cannot stop them (short of parental influence) from buying a car with it. Finally, saving in the child’s name hurts his or her ability to qualify for college financial aid.

Allocating Your Assets

Once you are convinced of the need for college planning, you need to understand the investment vehicles that are best to finance the plan. If you are starting early—your child is in junior high or younger—you can afford to be a little more aggressive and invest in things like stock mutual funds. You have enough time to ride out ups and downs in the stock market. Stock-owning mutual funds have averaged 10 to 12 percent annually on money invested for at least a decade. Since college costs are inflating at about 5%, college for stock buyers gets cheaper over time because their investments are rising faster than tuition.

As the tuition bills get closer (within four years) you want to start shifting your investments from more aggressive vehicles, like stocks, toward less volatile investments, like bonds. As you get close to needing the money, you do not want to run the risk of having to withdraw it at a market bottom. If you do not start saving until your children are older, the money should be kept in investments that are absolutely safe.