Saving for College

There are many options for how to better prepare to pay for the costs of college. From Qualified Tuition Plans (or 529s), to Coverdell Education Savings Accounts, to U.S. Treasury Bonds, the range of ways in which to put away money for you or your child’s college education has greatly expanded during the last decade.

What’s key to remember is that the earlier you start planning (and saving), the better off you’ll be in the long run.

Savings Plans

Qualified Tuition Plans (QTP or 529 Plans)

A QTP can take the form of a prepaid tuition plan or a savings plan. The prepaid tuition plan, administered by a state or a qualified school, allows parents to buy tuition at today’s prices for use in the future. QTP savings plans are available in many states—you don’t have to be a resident to participate. There is no yearly limit on contributions, although some plans have a lifetime limit. Interest earnings on these accounts are not taxed as they accumulate or when the money is withdrawn to help pay for college, as long as the distribution is less than the qualified education expenses.

Coverdell Education Savings Accounts (ESAs)

Coverdell ESAs may be set up for beneficiaries under the age of 18, or those with special needs, to pay for their education expenses. Friends and family may deposit money into the account, but the total contributions for the year may not exceed $2,000. As with Qualified Tuition Plans, the earnings in Coverdell ESAs accumulate tax-free and are not taxed at the time of distribution unless the amount withdrawn exceeds eligible educational costs.

U.S. Treasury Savings Bonds

Savings bonds generally earn lower interest rates than other investments, but because they are fully backed by the federal government, their security is guaranteed. Generally, accumulated interest on bonds included in the government’s Education Bond Program is free from federal income tax (also state and local taxes) when used to pay qualifying educational costs. Bonds from the education program may be redeemed and rolled over into a Qualified Tuition Plan, with no tax on the interest earnings.

Custodial Accounts

Custodial Accounts hold money and other assets until a named minor beneficiary reaches a certain age (usually 18 or 21), with a custodian managing the money until that time. Deposits to the account become the permanent property of the beneficiary. Interest earned on the account is taxed at the beneficiary’s rate and included on their tax return. Although similar to a trust, these accounts are preferred when the amounts involved are relatively small, and because they do not have the complicated legal structure of a trust (or the attorney’s fees).

The Uniform Gift to Minors Act (UGMA) and Uniform Transfer to Minors Act (UTMA) are custodial accounts. UGMA covers cash and securities; UTMA covers these assets as well as real estate, intellectual properties and virtually all other assets.

Home Equity Loan and Home Equity Line of Credit (HELOC)

A Home Equity Loan is basically a second mortgage. Borrowers may receive up to the current value of their home minus the amount they owe on it (which equals the owner’s equity in the house). So, if the current value of the house is $200,000 and the amount outstanding on the original loan is $120,000, then the borrower could receive up to $80,000 in a Home Equity Loan. The loan amount will be reduced by fees and closing costs.

Interest rates for a Home Equity Loan are usually fixed over the life of the loan (from 10 to 15 years). Unlike Federal PLUS Loans, however, these loans have no deferment or forbearance privileges. That means that if the borrower fails to make the loan payments, the lender can take the house to recover its money.

A Home Equity Line of Credit (HELOC) is a revolving credit line with a maximum limit based on the borrower’s equity in their home. So, if the current value of the house is $200,000 and the amount outstanding on the original loan is $120,000, then the homeowner would have $80,000 as their maximum line of credit. Funds can be borrowed as needed, with interest charged only on the amounts used (like a credit card).

HELOCs have a variable interest rate, and may charge maintenance fees, inactivity fees or transaction fees. Some HELOCs require a balloon payment at the end of the loan term. Again, if the borrower fails to make the loan payments, the lender can take the house to recover their money.

Withdrawals from Retirement Accounts

Usually, if an Individual Retirement Account (IRA) account holder takes money from an IRA before the age of 59 and 1/2, the earnings portion of the withdrawal is subject to a 10% penalty. This penalty is waived, however, if the withdrawal is used to pay qualified education expenses. Remember that, generally speaking, the earnings portion of the money withdrawn will still be subject to income tax.