College Savings Plans 101

By Clifton Linton
Senior Writer, mPower

In This Story Education IRAs 529 Plans Your IRAs Financial Aid The Answer?

Finding money to save for college is tough for many families. Recognizing this, the government has created a variety of tax-advantaged accounts designed to make it easier.

But, that raises a new challenge — figuring out the right one to use.

minute: read this article at a glance.

Technical Terms IRA Tax deferral

Should you save in an education IRA, a state-sponsored savings plan, a prepaid tuition plan, your IRA, or some other account? The advantage of the first four is that they all have some tax benefit associated with them. Knowing what they offer can help narrow your decision.

This article is a general overview of some options you can consider. It doesn't discuss custodial accounts or insurance policies.

Education IRAs

The education IRA is one of the easiest plans to understand. Created in 1997, this plan lets you or a relative save, using after-tax dollars, a total of $500 a year per child for college.

One advantage it has is that you can use almost any investment. The tax advantage is that assets grow tax-deferred and withdrawals are tax-exempt when used for qualified educational expenses.

But, the education IRA has several serious disadvantages. One is that the annual contribution limit is so low that few families will be able to use it to fully pay for four years of college. That said, President Bush has proposed raising the annual limit to $5,000 and separate legislation, currently before Congress, calls for raising it to $2,000.

"We do encourage parents to start saving early for college ... even if it's $25 a month. ... It's better to take control over your own destiny." — Richard Flaherty, president of College Parents of America.

Further, children of couples with an annual adjusted gross income (on a joint return) of more than $160,000 or single parents with adjusted gross income of more than $110,000 can't have education IRAs opened in their name. If a child has an education IRA already and mom and dad get raises that put them over the limit, the child can keep the IRA but no new contributions can be made as long as the parents' income is too high.

529 Plans

There are two types of state-run plans allowed under Section 529 of the Internal Revenue Code: prepaid tuition plans and savings plans. Just about every state offers one or both plans. Two states, Georgia and South Dakota, don't offer either.

Originally, these plans were designed for in-state residents to pay for in-state schools. Newer plans have more liberal rules, allowing out-of-state contributors and use at any college. Many plans are based on similar principles but are tailored to the specific needs of the state's residents. You should check with your state treasurer for details about your state's plan.

The prepaid tuition plan is the oldest version of the 529 plan. You pay for your child's education in today's dollars (either in a lump sum or by regular installments) and the state guarantees that the tuition costs will be covered when your child reaches college age. These plans often only cover tuition.

In the fall of 1999 when the stock market was booming, this plan fell out of favor with some college savings experts because it often had low rates of return. The reason: Governments invest the money with a single goal of keeping up with tuition inflation at state-run schools.

Pre-paid tuition plans and education IRAs are more ideally suited "for those higher income (families) that assume kids won't get much aid based on need." — Gary Klott, a syndicated tax columnist and editor at Taxplanet.com.

But, times change. In today's market, a guaranteed return might be an advantage. The plan's tax advantage is that assets grow tax-deferred and some states exempt withdrawals from state income taxes.

This might be right for you if you want a guarantee that Junior's tuition costs will be paid without the hassle of figuring out how to invest the money.

College savings plans were created by the same 1997 law that created the education IRA. Unlike a prepaid tuition plan, the returns aren't guaranteed, but you have greater investment flexibility. You contribute after-tax dollars (lump sum or regular installments) to an account managed by either the state or an investment advisor it hired.

The biggest tax tax advantage is that your contributions grow tax-deferred. Some states offer additional benefits, such as tax deductions on contributions or a tax exemption on earnings. And, most states' contribution limits are higher than for education IRAs and prepaid tuition programs — some state programs allow for a total contribution of $100,000.

According to the College Plan Savings Network, the following states permit some or all of your contributions to be deducted from state income tax: Colorado, Idaho, Kansas, Maryland, Michigan, Mississippi, New Mexico, New York, Ohio, Rhode Island, Virginia, and West Virginia.

The following states have specifically listed the contribution amounts that are deductible: Iowa (a deduction of $2,000 per account), Missouri ($8,000 per year), Montana ($3,000 per taxpayer), Oregon ($2,000 per year), and Utah ($1,315 per year).

These states exempt plan earnings from taxes upon withdrawal: Alabama, Arizona, Arkansas, Colorado, Connecticut, Illinois, Iowa, Kentucky, Louisiana, Maine, Maryland, Mississippi, Missouri, New Jersey, New Mexico, New York, North Carolina, Ohio, Pennsylvania, South Carolina, Tennessee, Utah, Vermont, Virginia, and Wisconsin.

Your IRAs

You can also save for college in your own IRA. The IRS allows you to make a penalty-free withdrawal from your account prior to age 59½ for qualified college expenses for you or a family member. You will still owe applicable income tax on the withdrawals.

Remember that money saved in an IRA should be used primarily for your retirement.

However, the advantage of using your IRA instead of an education IRA is that it has a $2,000 maximum annual contribution limit. The contribution's deductibility depends on whether you participate in a work-sponsored retirement plan and your income level. Your money grows tax-deferred, but both the contributions (if deductible) and earnings are taxed upon withdrawal.

Financial Aid

While financial aid is not a savings plan, any discussion of savings strategies needs to address this topic. The reason is that the plans listed above can affect your child's ability to qualify for financial aid.

When aid needs are assessed, the federal government, which is the largest provider of financial aid, looks at the income and selected assets of both the child and the parents.

Prepaid tuition plans are counted separately from assets and income. That means this money will reduce a child's financial need dollar-for-dollar based on the balance in the plan. Other plans, like education IRAs, college savings plans and your IRAs, are assessed proportionately according to the need formula.

Assets in the child's name are given more weight than assets in the parents' name(s).

Key Links State Tax Treatment of Qualified State Tuition Programs

That's the big strike against the education IRA, said Richard Flaherty, president of College Parents of America. "Education IRAs are terrible for financial aid qualification. They are a child's asset and when you take money out, it's counted in their income," he said.

Prepaid tuition plans and education IRAs are more ideally suited "for those higher income (families) that assume kids won't get much aid based on need," said Gary Klott, a syndicated tax columnist and editor at Taxplanet.com.

In comparison, the college savings plan, which is held in the parents' name(s) and counted among their assets, has a smaller impact on qualifying for aid.

Your IRAs aren't counted as assets in determining need. But, withdrawals from the plan are counted as your taxable income, which could affect that element of the need formula.

Related Reading Education IRA Limits May Increase Expand College Savings with Education IRAs Your 401(k) Is Not a College Savings Plan — Here's What Is IRABCs: College Expense Withdrawal Rules

The Answer?

So, what's the best strategy? Don't count on financial aid. And, don't decline to save because you think it will only hurt your chances of qualifying for financial aid, experts say.

The problem with relying on financial aid is that money, which may seem plentiful today, may not be around in the future, Flaherty warned. That's reason enough to try to add some kind of college savings plan to your budget.

"It's better to take control over your own destiny," said Flaherty. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

College Savings Plans 101

By Clifton Linton
Senior Writer, mPower

In This Story Education IRAs 529 Plans Your IRAs Financial Aid The Answer?

Finding money to save for college is tough for many families. Recognizing this, the government has created a variety of tax-advantaged accounts designed to make it easier.

But, that raises a new challenge — figuring out the right one to use.

minute: read this article at a glance.

Technical Terms IRA Tax deferral

Should you save in an education IRA, a state-sponsored savings plan, a prepaid tuition plan, your IRA, or some other account? The advantage of the first four is that they all have some tax benefit associated with them. Knowing what they offer can help narrow your decision.

This article is a general overview of some options you can consider. It doesn't discuss custodial accounts or insurance policies.

Education IRAs

The education IRA is one of the easiest plans to understand. Created in 1997, this plan lets you or a relative save, using after-tax dollars, a total of $500 a year per child for college.

One advantage it has is that you can use almost any investment. The tax advantage is that assets grow tax-deferred and withdrawals are tax-exempt when used for qualified educational expenses.

But, the education IRA has several serious disadvantages. One is that the annual contribution limit is so low that few families will be able to use it to fully pay for four years of college. That said, President Bush has proposed raising the annual limit to $5,000 and separate legislation, currently before Congress, calls for raising it to $2,000.

"We do encourage parents to start saving early for college ... even if it's $25 a month. ... It's better to take control over your own destiny." — Richard Flaherty, president of College Parents of America.

Further, children of couples with an annual adjusted gross income (on a joint return) of more than $160,000 or single parents with adjusted gross income of more than $110,000 can't have education IRAs opened in their name. If a child has an education IRA already and mom and dad get raises that put them over the limit, the child can keep the IRA but no new contributions can be made as long as the parents' income is too high.

529 Plans

There are two types of state-run plans allowed under Section 529 of the Internal Revenue Code: prepaid tuition plans and savings plans. Just about every state offers one or both plans. Two states, Georgia and South Dakota, don't offer either.

Originally, these plans were designed for in-state residents to pay for in-state schools. Newer plans have more liberal rules, allowing out-of-state contributors and use at any college. Many plans are based on similar principles but are tailored to the specific needs of the state's residents. You should check with your state treasurer for details about your state's plan.

The prepaid tuition plan is the oldest version of the 529 plan. You pay for your child's education in today's dollars (either in a lump sum or by regular installments) and the state guarantees that the tuition costs will be covered when your child reaches college age. These plans often only cover tuition.

In the fall of 1999 when the stock market was booming, this plan fell out of favor with some college savings experts because it often had low rates of return. The reason: Governments invest the money with a single goal of keeping up with tuition inflation at state-run schools.

Pre-paid tuition plans and education IRAs are more ideally suited "for those higher income (families) that assume kids won't get much aid based on need." — Gary Klott, a syndicated tax columnist and editor at Taxplanet.com.

But, times change. In today's market, a guaranteed return might be an advantage. The plan's tax advantage is that assets grow tax-deferred and some states exempt withdrawals from state income taxes.

This might be right for you if you want a guarantee that Junior's tuition costs will be paid without the hassle of figuring out how to invest the money.

College savings plans were created by the same 1997 law that created the education IRA. Unlike a prepaid tuition plan, the returns aren't guaranteed, but you have greater investment flexibility. You contribute after-tax dollars (lump sum or regular installments) to an account managed by either the state or an investment advisor it hired.

The biggest tax tax advantage is that your contributions grow tax-deferred. Some states offer additional benefits, such as tax deductions on contributions or a tax exemption on earnings. And, most states' contribution limits are higher than for education IRAs and prepaid tuition programs — some state programs allow for a total contribution of $100,000.

According to the College Plan Savings Network, the following states permit some or all of your contributions to be deducted from state income tax: Colorado, Idaho, Kansas, Maryland, Michigan, Mississippi, New Mexico, New York, Ohio, Rhode Island, Virginia, and West Virginia.

The following states have specifically listed the contribution amounts that are deductible: Iowa (a deduction of $2,000 per account), Missouri ($8,000 per year), Montana ($3,000 per taxpayer), Oregon ($2,000 per year), and Utah ($1,315 per year).

These states exempt plan earnings from taxes upon withdrawal: Alabama, Arizona, Arkansas, Colorado, Connecticut, Illinois, Iowa, Kentucky, Louisiana, Maine, Maryland, Mississippi, Missouri, New Jersey, New Mexico, New York, North Carolina, Ohio, Pennsylvania, South Carolina, Tennessee, Utah, Vermont, Virginia, and Wisconsin.

Your IRAs

You can also save for college in your own IRA. The IRS allows you to make a penalty-free withdrawal from your account prior to age 59½ for qualified college expenses for you or a family member. You will still owe applicable income tax on the withdrawals.

Remember that money saved in an IRA should be used primarily for your retirement.

However, the advantage of using your IRA instead of an education IRA is that it has a $2,000 maximum annual contribution limit. The contribution's deductibility depends on whether you participate in a work-sponsored retirement plan and your income level. Your money grows tax-deferred, but both the contributions (if deductible) and earnings are taxed upon withdrawal.

Financial Aid

While financial aid is not a savings plan, any discussion of savings strategies needs to address this topic. The reason is that the plans listed above can affect your child's ability to qualify for financial aid.

When aid needs are assessed, the federal government, which is the largest provider of financial aid, looks at the income and selected assets of both the child and the parents.

Prepaid tuition plans are counted separately from assets and income. That means this money will reduce a child's financial need dollar-for-dollar based on the balance in the plan. Other plans, like education IRAs, college savings plans and your IRAs, are assessed proportionately according to the need formula.

Assets in the child's name are given more weight than assets in the parents' name(s).

Key Links State Tax Treatment of Qualified State Tuition Programs

That's the big strike against the education IRA, said Richard Flaherty, president of College Parents of America. "Education IRAs are terrible for financial aid qualification. They are a child's asset and when you take money out, it's counted in their income," he said.

Prepaid tuition plans and education IRAs are more ideally suited "for those higher income (families) that assume kids won't get much aid based on need," said Gary Klott, a syndicated tax columnist and editor at Taxplanet.com.

In comparison, the college savings plan, which is held in the parents' name(s) and counted among their assets, has a smaller impact on qualifying for aid.

Your IRAs aren't counted as assets in determining need. But, withdrawals from the plan are counted as your taxable income, which could affect that element of the need formula.

Related Reading Education IRA Limits May Increase Expand College Savings with Education IRAs Your 401(k) Is Not a College Savings Plan — Here's What Is IRABCs: College Expense Withdrawal Rules

The Answer?

So, what's the best strategy? Don't count on financial aid. And, don't decline to save because you think it will only hurt your chances of qualifying for financial aid, experts say.

The problem with relying on financial aid is that money, which may seem plentiful today, may not be around in the future, Flaherty warned. That's reason enough to try to add some kind of college savings plan to your budget.

"It's better to take control over your own destiny," said Flaherty. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.