The Hassle of the Tassel

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The Hassle of the Tassel

M

ary Margaret is only 6 months old, but already she is worth a small fortune. In addition to the costs of clothing, feeding, educating, and entertaining her for the next 18 years, her parents will spend approximately $158,000 for her four-year, ivy- covered college experience.

When your student parades down the aisle on college graduation day, you will beam with pride. You may even forget the sacrifices you made to make this memorable event come true. And if you are a middle income parent, between the first day of school and graduation day, you may also forget what steak tastes like, what a new car smells like, and what your doctor and dentist look like. Welcome to the “Our cruise fund just left with our Freshman” years.

This is as good a time as any to realize that you will have four or more years of hamburger surprise, macaroni and whatever-is-left-over, and gluing together the soles of your shoes.

First, the Bad News

The current cost of an in-state, four-year public university education is approximately

$45,061.12 ($10,000 per year and an 8 percent inflation cost increase each anniversary).

That’s tuition, basic room and board, miscellaneous fees, and minimal supplies at a pub- lic university. There are no extras in this figure—no pizzas, entertainment, books, airline tickets home, car on campus, car insurance, spring trips, clothing expenditures, health insurance, gasoline, or telephone bills. And that’s the minimal cost at a public university.

For that price you would think they could name a dorm after you.

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If you are currently planning a new addition to your family, you will need between

$180,000 and $200,000 to fund the same education 18 years from now. Inflation is the number-one enemy of long-term college planning.

The further away your college-expenditure years, the more money you will ultimately need. But as long as your college fund is regularly outpacing the higher costs of educa- tion, your goals will become more attainable. You must choose inflation-fighting invest- ment vehicles that will accumulate faster than inflation deteriorates to preserve your long-term purchasing power.

Schools of higher learning operate within the same price pressures you do. There are utilities, overhead, salaries, costs for expansion and equipment to remain competitive with other institutions. All these internal expenses cost big bucks. If you and your student are considering a private school or specialized institution, double or triple the above ap- proximated figures.

Many mutual fund company Websites can help you calculate the future cost of col- lege tuition and the amount of money at certain annual rates of return that must be in- vested until college time is here.

Parents tend to make similar mistakes when planning for their children’s higher education:

1. Waiting too long to start saving.

2. Underestimating how much tuition will be needed.

3. Waiting for a child to decide on a career.

4. Diverting savings opportunities into spending for a child’s entertainment needs.

5. Thinking scholarships and grants or the government will fund the tuition bills.

6. Directing too many dollars to current consumption expenses instead of savings.

7. Allowing children to believe financial resources are unlimited.

8. Denying children a partial financial responsibility for their own education.

9. Depending on borrowing money from retirement plans or taking a second mortgage.

10. Expecting to fund college out of paychecks when the time comes.

11. Offering to foot the entire tuition, therefore, postponing saving for retirement.

12. Using inferior investment vehicles such as savings bonds or insurance products.

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Now, the Good News

The most valuable gift you can give to your new pink or blue bundle is $50 or $100 per month in a high-quality, growth-oriented mutual fund. Funding your child’s college education is a mutual problem. Why not use a mutual (funds) solution?

Now is the time to assert your financial responsibility as a parent. Your child might want designer jeans, the class spring trip to Paris, outrageously expensive tennis shoes, a cell phone, and the latest computer game, but your student needs a college investing program. If you yield to their demands today for immediate comforts, how will you tell them tomorrow that they will be pumping gas after graduation? You will find a “College Savings and Investment Plans” comparison worksheet in the Appendix.

529 Plans Sound Fabulous, But…

The latest gift from your federal and state governments sounds too good to be true.

College savings 529 plans offer tax-free earnings until the funds are withdrawn, no limits on amount of withdrawals, tax-deferred earnings, and tax-free withdrawals if funds are used for qualified higher education expenses (may be subject to state taxes). They can be invested in a combination of stocks, bonds, or other underlying investment securities, can be invested in other states’ versions, and you can contribute to both a 529 plan and a Coverdell Savings account (the old education IRA) in the same year. Some states even offer a tax deduction for contributions.

The maximum contribution per year an adult can gift to another without reducing their estate tax credit at death is $11,000 per beneficiary. However, an adult can contrib- ute as much as $55,000 ($110,000 per married couple) in one year and remove that money from their future estate (if still alive after five years). Contribution limits are higher than for most other college savings plans (as much as $250,000 contribution per account is allowed in some states), and an adult can open an education account for themselves.

Anyone can fund the maximum contributions allowable by state law, no matter how much income they earn, even if they have no earned income at all. So far, no income limit restrictions have been placed on the tax-free withdrawal provision. The donor does not have to be related to a beneficiary to contribute on behalf of that minor’s account.

Investors in 529 plans have been allowed to adjust their asset allocations by shifting money into new investments when naming a new beneficiary for an account. But cur- rently they are also entitled to make two penalty-free changes per year without naming a new beneficiary, shifting assets within the current plan options and/or moving assets into another state’s plan. The move must be completed within 60 days of liquidating the funds or taxes will be charged on earnings plus a 10-percent penalty as well. (If the plan has performed poorly and there are no earnings, this is not a problem.) If you previously received a state tax deduction for your contributions, depending on the state, you may have to pay it back if you pull your money out.

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The funds are treated as the adult’s for financial aid purposes. The minor does not gain control of the money upon adulthood, and the account owner (adult) can transfer some or all of the funds to another beneficiary in the same family. Rollovers are permitted one time per year to another state’s 529 plan.

Many folks choose their own state’s plan because they can get some form of tax deduction or other tax relief. But if the plan is inferior, a tax refund is a hollow reward, considering the college funds might languish for years and lose more money than you gained from the legal tax dodge. Choose the best investment plan first, then consider any potential tax relief available.

Now for the rest of the story. Participants cannot direct their funds into any invest- ment of their choice. States direct the investment options, generally mutual fund look- alikes. If the funds are not used for qualified education expenses, withdrawals are taxed plus a 10-percent penalty. Withdrawals are also penalized if funds are not used for spe- cific higher-education purposes. Withdrawals void college tax credits on your return.

Owning a 529 account may eliminate dollar for dollar any financial aid package other- wise available. Qualified education expenses currently do not include cars, travel, or clothing.

If you invest in a 529 plan through a broker, be aware you may be subject to sales charges levied upon withdrawals in the first few years.

Portions of this program are set to self-destruct in the year 2010 along with the EGTRRA estate-tax elimination act. Then, earnings will be taxed at the child’s tax rate.

A government middle-class benefit of this magnitude makes one point perfectly clear:

Middle-income families had better use every opportunity to fund their future college educations, as entitlement social programs will be focused toward the poor. This is a golden handcuff funding strategy. If the tax rules change after your funds are invested, you could enjoy less flexibility for withdrawals or fewer tax benefits in the future.

Your government could plug up this tax loophole at any time. When the song comes for free, watch out for the accompaniment.

Coverdell Savings Accounts: Alias Education IRAs

Formerly known as education IRAs, there is no maximum limit on total contributions per child over the life of the account. But this plan limits annual payments to $2,000 per minor in 2004. Funds can be used both for elementary and secondary public or private school education. The account can pay for qualified educational expenses, and this pro- gram is not currently set to expire in the year 2010.

Annual contributions could be tax-deductible on your state tax return (depending on the state). You can also contribute to a 529 savings plan in the same year. Annual contri- butions can be made until April 15 of the following tax year (for a previous year), and qualified withdrawals are currently federally tax-free to pay eligible education expenses.

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Nonqualified withdrawals are taxed at the adult owner’s tax rate, and a 10-percent penalty is added unless withdrawals are made on account of death or disability of the beneficiary.

The value of the account is removed from the owner’s estate for estate tax purpose.

There are upper-income limits for eligibility to contribute to this program. No contribu- tions are allowed for singles earning more than $110,000 per year and couples earning more than $220,000 in annual income. State tax deductions are generally not available (unlike with the 529 savings plan). The owner makes all investment decisions and can use regular mutual funds, stocks, or bonds as investment vehicles.

The funds are considered the child’s assets for financial aid treatment, and this plan can eliminate other financial aid opportunities. Withdrawals are taxed and a penalty is added if funds are not used by age 30 or not transferred to another family child by that time. An amount of funds equal to the amount of any scholarship or other financial aid can be withdrawn without penalty. Contributions can be made up to the child’s 18th birthday.

Obvious disadvantages are the limited amount that can be contributed per year and the fragile future of this program due to the popularity of competing 529 plans sold heavily by brokers. This program could be phased out for lack of popularity. Its name and basic tenets have already been altered. It is doubtful that the government can maintain the tax- free future benefit promise, considering the high cost of future entitlements and the gen- eral political tendency for government to tax the middle class to pay for the poor.

College Bound With Series EE Bonds

Savings bond earnings are tax-free when used for certain college expenses (not room and board or athletic fees) if their owner has earned less than a certain amount of income in that year. The earnings on these bonds are tax-deferred until they are cashed in. If used for qualified college expenses, the earnings are income-tax free on the federal, state, and local levels. The bond must be Series EE issued after December 31, 1989, purchased in the parent’s or spouse’s name (no grandparents allowed). The purchaser must be age 24 or older before the bond was issued. Bonds issued in a child’s name do not qualify for the tax-free benefit.

A parent can purchase up to $15,000 per year or $30,000 per married couple. The interest is included as a parent asset for financial aid purposes. The principal is guaran- teed by the full faith and taxing power of the U.S. government, and interest is accrued over 30 years to final maturity of the bond. Series EE bonds can be redeemed six months after purchase, but, if redeemed within five years of their issue, there is a three-month interest penalty charged.

If your family income is above a certain amount in the year the bond is cashed in, the accrued interest is taxable, even though you bought the bond when you were under the income limit. This limit is raised over time to match inflation. This government program

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What About Prepaid Tuition Plans?

Wouldn’t it be great for someone to take the risk out of college funding? That’s what prepaid tuition plans promise. You lock in credits toward a four-year education ahead of time while the trust or investment company sweats over how to keep up with rising col- lege costs.

Under most prepaid tuition plans (either state or privately endowed), a parent or grandparent can contribute payments that will promise a certain amount of education plus room and board. The college fund (usually a trust) manages the assets until they are withdrawn and used at college time.

Many such plans are failing or already in default because they are trying to accom- plish the impossible: outpace rising college costs, pay management fees, and invest safely in bad markets. Promises aren’t guarantees. Though they are apart from the political landscape, their independent status and upbeat attitude is no guarantee that your student will receive what was promised.

There are restrictions on exiting the programs if you change your mind or they be- come insolvent. How will you redeem your funds if they become financially troubled?

How can someone manage your money safely and achieve an 8- to 10-percent return at the same time? Who will be willing to subsidize the promised education if they are long on promises and short on results?

If your child joins the military instead of enrolling in college, can you get an early refund? What accountants and regulators will be watching day and night to see that assets are properly managed to meet future costs?

What if your child is not admitted to a school in your state? Even if your state’s guarantee works, you have no price guarantee in any other state. If the trust funds become taxable in the future, you may be left with less money to pay the bills. During the invest- ment period, you have no control over the funds.

A better alternative might be a Uniform Gift to Minors or Uniform Transfer to Minors plan that invest in mutual funds that you can control.

Campus Crisis

A jointly owned money market mutual fund between parent and student, with one signature required for withdrawal, can produce instant cash during college years for tu- ition, books, and living expenses. The parent sends a deposit to the fund company. The child redeems what is needed by writing checks on the share balance. (Sounds just like home again, doesn’t it?)

Parents can maintain minimal control over the account by limiting the amount they deposit. Some funds offer overnight wire transfers. You can quickly wire money from your local bank or credit union for the occasional campus crisis.

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There Is Always Hope

If you have college-bound children or grandchildren and time is on your side, the Taxpayer Relief Act of 1997 makes paying for higher education easier.

As of 2003 the Hope Scholarship Credit was available for qualified tuition and re- lated costs paid to cover a student’s first two years of higher education at an eligible institution.

For each student, the tax credit covers the first $1,000 and 50 percent of the next

$1,000, for a maximum credit of $1,500 for educational expenses incurred in the first two years of college or other qualified post-secondary education.

The credit is phased out (reduced and then eliminated) for singles above certain in- come limits; those limits are raised (indexed) each year for inflation.

Parents putting more than one child through school can claim a Hope credit for each student who qualifies but only up to $2,000 a year in total lifetime credits per family.

To qualify, the student must be enrolled on at least half-time basis and attend an accredited college, university, or vocational school leading to a bachelor’s degree, an associate’s degree, or another recognized post-secondary credential.

Congress Cares Even More

The law also created a Lifetime Learning Credit for students taking courses to ac- quire or improve job skills. The 20-percent credit subtracted against $10,000 of tuition and fees can be used for any year of education after the first two years, up to a maximum of a $2,000 per year. The Lifetime Learning Credit limits who can take this tax credit through income limitations similar to the limits on the Hope Scholarship tax credit. You can use only one credit per student. Do the calculations to see whether the Hope or the Lifetime credit is best.

More Help From Washington

Never let it be said that procrastination pays off. The tax code offers a number of education-related breaks even for people who haven’t planned ahead. There are tax write- offs and tax credits that can whittle down a tax bill, easing the sting of tuition time. Up to

$3,000 for tax year 2003 interest was deductible on loans used for tuition and room and board. The tax law allows borrowers who pay for higher education either for themselves, spouses, or dependents to deduct interest paid during the life of the loan in which interest payments are paid. Loans from Grandma don’t count, however. You can’t double-dip and take a credit and a deduction for the same student. And unlike a tax credit, a deduction reduces only the income upon which the tax is figured, not the tax dollar for dollar itself.

Again, there are family income limitations on who can qualify for this tax break. (Interest on a home equity loan is generally also tax-deductible, no matter how the funds are used.)

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This deduction is phased out for higher-income taxpayers. See your tax advisor or IRS publications for current income limits.

Old IRAs Are Softies, Too

The 10-percent penalty that applies to most traditional IRA withdrawals before the owner reaches age 59 no longer applies to withdrawals taken for qualified higher educa- tion expenses for the taxpayer, his or her spouse, children, or grandchildren. This option is probably the least attractive as you are robbing your retirement fund for current needs.

Robbing Peter to pay Paul may solve today’s financial problem but creates a more serious retirement fund challenge in the future.

Roth and Roll for College

If you will have a child in college when you reach age 59 1/2 you may want to fund a Roth IRA for college savings. You can contribute up to $2,000 per year, and once the account has been open for at least five years and you are age 59 1/2 or older, you can withdraw as much as you want tax- and penalty-free.

This idea is especially appealing if you have other tax-sheltered retirement savings, such as a 401(k) plan or Keogh plan.

Roth IRA owners younger than age 59 1/2 can withdraw their original contributions (principal) tax- and penalty-free for college expenses (or for any other purpose). But if they dip into earnings for reasons other than education, that amount will be taxed. As long as the money is used for college bills, the 10-percent early withdrawal penalty does not apply.

There are short-term methods you can employ. Each strategy comes at a price:

1. Borrowing on the equity in your home is often recommended because the interest can be deducted from your tax return. This is dangerous. You are risking your home, perhaps putting it on the auction block.

Most equity lines of credit are adjustable demand loans written with an impaired risk clause (if your financial picture changes during the loan period, the institution can de- mand the money back pronto). If interest rates rise, in a few years your payments could be priced above your budget.

With home equity borrowing you are spreading out repayments over a longer time, creating a large debt to pay back. You are purchasing a long-term mortgage collateralized by your home.

2. Stafford subsidized or unsubsidized loans offer a limited amount of borrowing power and seem more viable because the student can ultimately take on the repayment responsibility.

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