Parents who are saving for their children's college education face a confusing maze of funding options. This publication discusses some of the options available and provides Web sites containing more information and changes that may occur during the year.
There is no "best" strategy to pay for college and most families won't be able to save enough money to pay the full bill. To add to the confusion, the rules and regulations that govern funding options change over time. Tax benefits of some of these strategies may disappear if your household income rises above a certain amount, and new options for funding higher education may be created before your child attends college. The younger your child, the more time you have to save and invest, but there also is more time for new regulations.
A key to receiving financial aid is the Free Application for Federal Student Aid (FAFSA). This form should be completed in January or February of your student's senior year in high school and requires tax return information from the parents as well as the student. It must be completed annually thereafter. FAFSA is used to qualify for federal and most state grants, scholarships, low-interest student loans, and work-study programs, as well as many school-based student aid programs. Learn more about FAFSA.
Saving Before College
Starting to save and invest for college when your children are young gives you the most options. As the child ages, your options become more limited and the amount of principal needed to meet your goal increases dramatically. Your options include not only the type of account, but also the types of investments within that account. The Saving For College website can help you start learning about your choices.
State and federal income taxes are deferred on earnings in most college investment options. In fact, most of these options are free of federal taxes.
Coverdell Education Savings Accounts
You can deposit up to $2,000 (after taxes) per year per child under the age of 18. To be free of federal income, withdrawals from the account must be used for qualified education expenses by the child's thirtieth birthday, or the money can be transferred to the Education Savings Account of a family member under age 30. Qualified expenses include public, private, and religious elementary- and secondary-school expenses.
Series EE and I U.S. Savings Bonds
If you meet certain guidelines, bonds used for qualified education expenses are exempt from federal, state, and local income taxes. To be tax-exempt, bonds must be issued after 1989 to parent(s) over age 23 who fall within income guidelines. Children cannot be listed as co-owners, but they can be listed as beneficiaries on bonds that are cashed in during the year they're used to pay for qualified higher-education expenses. Visit the Treasury Direct site for more information.
nowU Pennsylvania 529 College Guaranteed Savings Plan (GSP)
This Pennsylvania Department of Treasury plan allows you to purchase tomorrow's tuition today. The credits you purchase can be used for tuition at any trade, technical, or accredited college in the United States. An enrollment fee of $50 generally will apply. Once established, you can contribute as little as $25 per account, and anyone can add to it. To learn more, visit the PA 529 website.
Pennsylvania taxpayers can deduct up to $12,000 per beneficiary per year from their Pennsylvania taxable income in contributions to a 529 tuition account. For married couples, contributions up to $24,000 per beneficiary are deductible, provided each spouse has a taxable income of $12,000.
Custodial Accounts: Uniform Gifts to Minors Act (UGMA) and Uniform Trust to Minors Act (UTMA) Accounts
Custodial accounts are a means of allowing minors to own forms of property they would not normally be permitted to own such as stocks, bonds, mutual funds, or annuities. The so-called "kiddie tax" rules apply to tax treatment of investment income of these accounts for dependents under the age of 18. It also applies to children under age 19 and to full-time students under age 24 who do not have earned income equal to half of their support. These limits will be adjusted annually for inflation. In 2008, the first $900 of a child's investment income is tax free and the next $900 is taxed at the child's rate. Unearned income in excess of $1,800 is taxed at the parents' tax rate.
Keep in mind that custodial accounts are considered assets of the student when calculating financial aid. Furthermore, once children turn 18, they have legal access to this money and may use it for purposes other than funding college.
A 2002 change in legislation permits a custodial arrangement to continue until the child is 25 years old. The transfer of custodial assets may be delayed until age 22, 23, or 24. After the twenty-fifth birthday, all custodial assets must be transferred to the child.
Programs such as Upromise and BabyMint can help you accumulate money for college expenses when you make everyday purchases.
When you register your credit cards and buy things online or at stores and restaurants, a percentage of each purchase is forwarded to a tax-free 529 account you have established. These small amounts can really add up over time. You can also enlist friends and relatives to help by registering their cards with your child's account. For more information about these programs, visit their web sites.
Survivors' and Dependents' Educational Assistance Program
Administered by the U.S. Department of Veterans Affairs, this program offers up to 45 months of education benefits, which may be used for degree and certificate programs, apprenticeship, and on-the job training. Eligibility is limited to those who are the son, daughter, or spouse of a veteran who died, is permanently disabled, missing in action, a prisoner of war, or in similar service-connected circumstances. Details of this benefit are available at the GI Bill website.
Don't be disappointed if you are not able to fully save and invest for your scholar's full college costs. Most families can't.
While many scholarships exist, qualifying for them might be tricky due to unique application criteria. Check with your high school guidance counselor on the availability of local scholarships. Ascertain if your employer and local fraternal and social organizations offer scholarships. Internet for sites such as FastWeb can help you search for scholarships appropriate for your child.
Grants are a great resource because you don't need to pay them back. Grants are generally awarded to individuals with limited financial resources. Pell Grant amounts are available up to $4,731 for the year July 1, 2008, to June 30, 2009. The award amounts can change each year. More information is available by calling 1-800-4-Fed-Aid or at the Pell Grant site. Supplemental Educational Op-portunity Grants (SEOG) provide low-income students between $100 and $4,000 each year. Students must apply for this grant at their college's financial aid office. Visit the SEOG site for more information.
Teach Grant Program is a new program created by Congress in 2007 that provides grants up to $4,000 per year to students that agree to teach in a high-need field such as foreign language, mathematics, science and as a reading specialist in a public or private elementary or secondary school that serves low-income students. The funds come with the primary requirement a student must teach full-time for four years after completing academic requirements. The first Teach Grants will be awarded to eligible students for the 2008-2009 academic year. Visit the Federal Student Aid website.
Federal Work Study Program
In this program, students get paid to work part time while they attend college. Work-study jobs may be relevant to the student's field of study, thus providing paid work experience that complements formal education. Contact the financial aid office at your college to learn more about work-study positions.
This program is similar to the Peace Corps but provides opportunities for volunteer service learning within the United States. After one year of service, AmeriCorps volunteers receive an education award of $4,725 to pay for college or graduate school or to repay student loans. Volunteers also receive health insurance, educational programs, and student loan deferment. About half of the members also receive a modest annual living allowance. To learn more, visit the AmeriCorps website.
Student loans that finance college education can be quite attractive when low-interest rates on loans subsidized by the federal government are available. Students who consolidate loans and choose automatic payment options can benefit from reduced interest rates once they leave school. Visit FinAid to learn more about student loans.
Pennsylvania Higher Education Assistance Agency is an important resource for Pennsylvania residents in understanding various aspects of financing college.
Stafford Loans are the primary loan source for most students. Depending on financial needs, students may be eligible for either subsidized or unsubsidized loans. Students eligible for subsidized loans benefit from the federal government paying the interest before the repayment period begins and during times of deferment. Students may borrow a maximum of $23,000 with loans in the amount of $3,500 for the first year, $4,500 for the second year, and $5,500 for the third and successive years. The National Student Loan Data System (NSLDS)--the U.S. Department of Education's central database for student aid--receives data from schools, agencies that guarantee loans, the Direct Loan program, and other U.S. Department of Education programs and gives borrowers a centralized, integrated view of Title IV loans and grants that are tracked from aid approval through closure. Visit the site for more information.
The Federal Perkins Loan Program provides low-interest loans to help students finance the costs of postsecondary education at any one of approximately 1,800 participating institutions. Borrowers who undertake certain public, military, or teaching service employment are eligible to have all or part of their loans canceled.
Tax Benefits for Higher Education
IRS publication 970 provides detailed up-to-date information about many of the college funding options mentioned in this publication, particularly their federal income tax implications.
Hope Scholarship Credit
Available during the first two years of postsecondary education, this credit provides a maximum allowable credit per student equal to the first $1,100 of tuition and fees and half of the next $1,100 and will be adjusted annually for inflation.
Lifetime Learning Credit
More liberal than the Hope Scholarship Credit, the Lifetime Learning credit applies to tuition and fees for undergraduate, graduate, and continuing education course work and is calculated on a per-family rather than per-student basis. A family can claim a credit equal to 20 percent of $10,000 of qualified education expenses annually.
Student Loan Deduction
In 2007, you could deduct up to $2,500 in loan interest paid on higher education loans, regardless of the source of the loan.
Deduction for Higher-Education Expenses
You may be able to deduct up to $4,000 of higher-education expenses for yourself, your spouse or a dependent, even if you do not itemize deductions on Schedule A, Form 1040. This particular tax deduction benefits taxpayers whose income exceed eligibility limits for the Hope or Lifetime Learning Credits. To learn more, see IRS Publication 970, Tax Benefits for Education.
The following table is a summary for comparative purposes only and additional benefits, restrictions, or qualifications may apply.
|Funding vehicle||Tax advantages||Maximum benefit||Restrictions||Effect on financial aid|
|nowU Pennsylvania 529 Investment Plan||PA taxpayers can deduct contributions from PA taxable income up to $12,000 per beneficiary per year.|
Tax-deferred growth while in the account.
Federal and PA tax exempt withdrawals when used for qualified expenses
|Maximum account balance for all plan accounts of $368,000 per beneficiary.||Earnings on non-qualified withdrawals may be subject to federal, state, and local income tax and 10% penalty||Typically considered parents' money|
|nowU Pennsylvania 529 Guaranteed Savings Plan||PA taxpayers can deduct contributions from PA taxable income up to $12,000 per beneficiary per year.|
Tax-deferred growth while in the account.
Federal and PA tax exempt withdrawals when used for qualified expenses.
|Usually the cost of tuition at one of the 5 levels depending on the type of school for which you want to save.||Earnings on non-qualified withdrawals may be subject to federal, state, and local income tax and 10% penalty||PA 529 GSP account does not affect eligibility for financial aid provided by PA|
|Coverdell Education Savings Account (formerly Education IRA)||Earnings are federal tax free if used for college; if not, funds are subject to income tax and a 10% penalty when withdrawn.||Up to $2,000 a year can be invested per child under 18||High impact under student's name; low impact under parents' name|
|Roth IRA||Earnings grow tax deferred|
No penalty if principal used to fund college
|May invest up to $5,000 per year ($6,000 if age 50 or over)||No restrictions||Counted as parents' asset unless the child funded the Roth IRA|
|Custodial Accounts (UGMA/UTMA)||First $850 in income not taxed|
If child is under 18, next $850 taxed at child's rate; rest taxed at parents' rate
At age 18, unearned income taxed at child's rate
|Unlimited but only up to $11,000 per child (or $22,000 if married, filing jointly) can be transferred||Child gets control of money at 18 or 21, depending on state laws||Considered student's asset|
|U.S. Savings Bonds||Interest is tax free if bonds are used for qualified expenses (tuition and fees at Title IV post-secondary educational institutions)||Unlimited||Qualified expenses are reduced by any amount of financial aid received in same tax year including scholarships, Hope Scholarship, Lifetime Learning Credit, and Coverdell and 529 Plan withdrawals||Value of bonds considered parent's asset|
|Hope Credit||Credit of up to $1,650 a year per student||$3,300 credit per student or $1,650 a year for the first two years of college||Cannot use in same year you take a Lifetime Learning Credit for the same student||None|
|Lifetime Learning Credit||Credit of up to $2,000 a year per household.||$2,000 credit a year per household for unlimited years||Cannot use in same year you take a Hope Credit for same student||None|
The Last Resort
If, despite your best efforts, you have exhausted all the preceding funding strategies and still need additional college funds, there are a few other sources of money. These strategies, however, are not without risks. Tapping into the following funds may jeopardize your retirement security. Carefully consider the long-term impact on your financial future if these accounts are not reimbursed. Using money from these sources should truly be your last resort. Although you can borrow to finance your child's education, you cannot borrow to finance your retirement.
Traditional Individual Retirement Account (IRA)
These distributions taken prior to age 59 1/2 to pay for qualified higher-education expenses will avoid the 10 percent early distribution penalty but will be taxed as income at your highest marginal income tax rate. See IRS publication 590-B.
You may withdraw the principal contributions to your Roth IRA free of taxes and penalties if the account has been open for at least five years. If, however, you withdraw interest accumulations before age 59 1/2, the interest withdrawals will be taxed.
Home Equity Loans
Homeowners can generally borrow up to 80 percent of their home's equity. In addition, up to $100,000 in interest on such loans is tax deductible.
If you have a 401(k) or some other qualified retirement plan, you can often borrow against the plan with certain stipulations:
- You can borrow up to 50 percent of account assets up to $50,000.
- The loan and interest must be repaid within five years.
- Tax consequences of this decision include paying taxes on the loan and interest earnings when you cash out your plan.
If you are at least age 59 1/2 while your child is still in college, you could use money from any of your retirement accounts without incurring a penalty, but you may owe the income taxes on them.
If you own whole-life policies you can borrow from the cash surrender value tax free. Interest rates are set by the insurance company, and the loan amount decreases the face amount of the policy should you die before repaying the loan.
In Whose Name Should You Save?
In general, assets held in the child's name limit their eligibility for financial aid. When financial aid calculations are done, student assets are weighted more heavily than parental assets. Currently, 20 percent of student assets are considered, compared to parental assets, which are on a bracketed system with a top rate of 5.64 percent. Compare the 14.46 percent savings of using the parents' name with the difference in the income tax brackets of the parents and child. The total value of the assets, both principal and accumulated interest, is considered. Visit Saving For College.
What If Your Child Decides Not to Go to College?
Some of the funding options mentioned here can be used to fund other goals other than college. A child who decides not to attend college immediately following high school may still use the saved funds up to age 30--or the funds can be used to benefit another family member who is attending college. While there may be a penalty for withdrawing the money and not using it to pay for college, you will still have benefited from growth of the invested money in a tax-deferred account.
How Can I Find Money to Save and Invest for My Child's College Fund?
Try to include college savings as one element of your family budget. Make saving for this goal automatic by having the payments deducted each month from your checking or savings account. Start with a small amount, such as $25 a month. Over time, take advantage of some of the following events to increase that savings amount:
- baby food
- potty training
- salary increases
- overtime pay
- gift money
- child tax credits
- loans paid off
These events provide you with opportunities to apply funds toward the college goal. For instance, once a child is potty trained, the money previously spent on disposable diapers could be put toward college savings.
There is no one "best" investment. Each investment type has its advantages and disadvantages. Before you choose a particular investment, take some time to learn more about its pros and cons, particularly the risks involved. Generally, the longer the time between when you invest the money and when you need it, the more risk you can take. As your child grows and nears college age, consider shifting your money into less risky investments. For example, for children in elementary school you might consider a stock index, growth, or growth and income mutual fund. When the child enters high school, gradually shift the money to bond and money market funds. By diversifying your college funds across several investment types, you reduce the risk of losing your principal and increase the chances of seeing your invested funds grow. The 529 investment accounts offer age-based plans that automatically make these adjustments.
Prepared by Robin L. Kuleck, extension educator in Elk County, and Robert J. Thee, extension educator in Chester County, in consultation with Marilyn M. Furry, associate professor of financial education and literacy.