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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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