Sorting through higher education funding options

If you're like many parents, helping your children pay for college is an important long-term financial goal. However, as college costs rise each year, many families wonder how they can save enough money to pay for higher education while meeting other financial priorities.

The spiraling cost of college

According to CollegeBoard.com, average college tuition and fees for 2007–08 range from $23,712 for a four-year private college to $6,185 for a four-year public college and $2,361 for a two-year public institution. In the past 10 years, the average cost of tuition and fees has risen by 57% at four-year private colleges and 69% at four-year public colleges.¹ Adding costs for room and board, books and supplies, personal expenses and transportation significantly boosts these annual expenses.

**Source: U.S. Census Bureau, Current Population Survey, Educational Attainment in the U.S.: 2006

While escalating tuition costs may seem overwhelming, the cost of not earning a college degree can be much greater than the cost of attending college. Average earnings increase measurably with higher levels of education, and these financial benefits tend to increase over time. Typical college graduates earn over 60% more than typical high school graduates, and those with advanced degrees earn two to three times as much as high school graduates.² Other long-term payoffs include more career options, better health and retirement benefits, increased promotion opportunities and lower unemployment.

Education savings vehicles

Although the value of a college education is clear, finding ways to pay for it can be more ambiguous. A variety of education savings options are available including:

529 plans — These tax-advantaged savings vehicles are operated by state or educational institutions and are usually categorized as prepaid tuition plans or savings plans, although some have elements of both. Savings plans offer no restrictions on state residency, income or age, and some plans may allow contributions in excess of $200,000 per beneficiary. Each individual plan offers a mix of investment options, and account owners may switch plans or make new investment elections once per year. Under most 529 savings plans, tuition, fees, books, supplies, room and board and graduate school are considered qualified education expenses. Earnings are federal income tax-free when used for qualified higher education expenses. Certain states offer tax benefits on contributions to their own 529 plans. The Pension Protection Act of 2006 made permanent this special tax treatment for 529 plans. For financial aid purposes, 529 plans are considered an asset of the parent(s).

Coverdell Education Savings Accounts (ESAs) — With these savings vehicles, you can contribute up to $2,000 per year per beneficiary for your child's elementary and secondary (through 2010 unless Congress acts), and college education expenses including private school tuition, tutoring and computers. Parents can make contributions to the account up until the day before the child's 18th birthday and the child must use the funds before age 30 unless they fit the federal government's description of a special needs individual. While contributions are not tax deductible, amounts deposited in the account grow tax-free until distributed. Distributions are tax-free when used for qualified higher education expenses, however the tax treatment for distributions for K-12 expenses is uncertain after 2010. Investment options typically include a broad range of securities and other choices. For financial aid purposes, ESAs are considered an asset of the beneficiary.

Qualifying U.S. savings bonds — Interest received from eligible Series EE and I savings bonds issued after 1989 is tax-free if used to pay for qualified educational expenses (tuition and mandatory fees) at an eligible institution. When using U.S. savings bonds to pay for education, the bonds must be purchased by someone at least age 24 and used by you, your spouse or dependent. To qualify, married couples must file jointly. Exclusions phase out depending on income levels. For financial aid purposes, savings bonds are considered an asset of the bond owner.

Traditional/Roth IRAs — Penalty-free distributions are allowed from IRAs for eligible educational expenses (tuition, books, supplies, fees and room and board if you are more than a half-time student) at qualifying educational institutions for you, your spouse, your children and grandchildren. However, you may owe income taxes on the taxable portions of withdrawals from Traditional and Roth IRAs. IRA accounts are not counted as assets for financial aid calculations. Be sure to fill out IRS Form 5329 if you choose this distribution option to show how much, if any, of the distribution is subject to the 10% additional tax.

Custodial accounts — In most states, minors cannot own stocks, bonds, mutual funds, annuities or life insurance policies, and parents cannot simply transfer assets to their minor children without establishing a trust. Custodial savings accounts such as UGMA or UTMA accounts provide families with broad investment flexibility by allowing minors to own securities and types of property without preparing documents or requiring the court appointment of a trustee. However, investment earnings over $1,800 in 2008 are taxed at the parent's income tax rate from the opening of the custodial account until the year the child turns 18. The investment income of full-time students ages 19-23 is also taxed at their parents' rate if the student's earned income is not more than one-half of their support. The accounts are considered an asset of the student in financial aid calculations. Further, your child assumes control of the custodial account upon reaching 18 (or the age of majority in your state) and may spend the assets at his or her discretion.

Other ways to finance college

Most families pay for college through a combination of savings, current income and borrowing. The more you save, the less you'll need to borrow and the less you'll need to take from current income. As an example, a family that saves $50 a month from the time their child is born will amass more than $16,000 in savings by his or her high school graduation.³ Other ways to pay for higher education include financial aid from federal, state and local government, work-study opportunities from your child's college, loans, scholarships and grants, family gifts and part-time student jobs.

Financial aid — Your family's income and assets are considered when financial aid is calculated for your child. According to the College Board, in 2006–2007, loans comprised 40% of all undergraduate financial aid. There are federal, private and college-sponsored loan options for students and parents. Consider how much debt you and your child want to take on and how you plan to repay it. For parents, experts suggest limiting total debt repayments to 37% of gross income. For students, monthly loan repayments should not exceed 10 – 15% of a new grad's starting monthly income.

Gifts from grandparents — Industry surveys reveal that a majority of grandparents would prefer to contribute money for college education rather than traditional gifts. Grandparents may have different financial goals than parents including reducing estate tax exposure, retaining control of funds in case of unexpected expenses and the flexibility to save for multiple grandchildren. Many college savings vehicles have features that can help grandparents achieve a variety of goals and invest for their grandchildren's education. Also, parents and grandparents who make payments of tuition directly to the school can exclude those amounts from gift tax.

Tax credits and deductions — There are numerous tax benefits for educational expenses including the Hope Scholarship Tax Credit, the Lifetime Learning Tax Credit and a deduction for student loan interest. Keep in mind that tax credits operate more like rebates than discounts — they're made available once you've paid tuition and not directly applied to tuition bills.

There are complex rules regarding the order in which the various tax benefit provisions are used against education expenses. IRS Publication 970, Tax Benefits for Education, discusses these rules. You may want to discuss coordination restrictions with your tax advisor, as well as how to allocate your qualified education expenses to maximize your total tax benefits.

Saving for retirement vs. saving for college

As college costs continue to rise, students are borrowing larger amounts of money to finance their education. In turn, parents are borrowing larger amounts of money to prevent their children from starting adulthood with crippling debt. Some parents borrow from their retirement accounts, while others reduce their retirement savings contributions. By paying your child's college bill instead of investing in your retirement, you may end up with a shortfall at retirement or need to work longer than you planned. While it may be difficult to see your child graduate with student loan debt, consider that he or she has a longer period of time to pay off the debt while there are no loan programs for your retirement.

Your financial advisor can help

Saving for college can seem overwhelming and complicated. You may be unsure how much to save, how to invest your money and how to prioritize your savings goals. Your financial advisor can help you clarify your goals and develop a financial plan to help you realize your dreams. He or she can also explain the various vehicles and strategies for saving for college and help you develop a savings plan that meets your needs. Although it's common for parents to take out loans to pay a child's college expenses, you may want to talk with your financial advisor before tapping your home equity, spending your retirement assets or using your credit cards to pay tuition. If you don't have a financial advisor, contact us at 1-800-AMERIPRISE or search for an advisor in your area.