CEDAR POINT FEDERAL CREDIT UNION
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College Saving While Saving Taxes

Once you determine how much you need to save or can afford to save, you need to decide what types of college saving vehicles you want to use. In addition to mutual funds, regular brokerage accounts, and bank savings accounts, there are now a number of tax-advantaged alternatives available to help you save for college. Get the facts about each of the options, and decide which type might be right for you:

• 529 plans
• Prepaid tuition plans
• College savings plans
• Coverdell Education Savings Accounts
• Custodial Accounts
• Savings Bonds
   

The tax rules that apply to college savings options are complicated. Before investing, you may want to check with your tax adviser about the tax consequences of investing in any of these options.

529 Plans

Named after the section of the federal tax code that governs them, 529 plans are tax-advantaged programs that help families save for college. Selecting a plan requires homework. Every state offers at least one 529 plan and now a consortium of private colleges also offers a 529 plan. The tax advantages, investment options, restrictions, and fees can vary a great deal.

Two Types of 529 Plans

There are two types of 529 plans—prepaid tuition plans and college savings plans. Every state offers at least one of these types of plans. Some states offer both, and now a consortium of private colleges also offers a prepaid tuition plan.

Prepaid Tuition Plans

Prepaid tuition plans allow parents, grandparents, and others to lock in today's tuition rates at eligible public and private colleges or universities so that they don't have to worry about future tuition increases.

• Contribution Limits -You pay for amounts of tuition (years, credits, or units) in one lump sum or through installment payments. There are a number of options. Some prepaid tuition plans offer contracts for a two-year community college or a four-year undergraduate program, or a combination of the two, and can cover one to five years of tuition. Some plans even allow the contract to be applied to graduate school tuition.
• Covered Educational Expenses - With only a few exceptions, however, most prepaid tuition plans do not cover other expenses, such a room and board. So you may want to consider other college savings options to cover these costs.
• Residency Requirements and Other Limitations - Unlike college savings plans, most state prepaid tuition plans require either you or your child to be a resident of the state offering the plan when you apply. Some limit enrollment to a certain period each year. Many prepaid tuition plans also have age or grade limits for beneficiaries (i.e., future college students).
• Investment Options - Prepaid tuition plans have no investment options. Under prepaid plans, the price of the contract is determined prior to purchase and usually depends on the type of contract, the current grade of the beneficiary, the current and projected cost of tuition, and the projected rate of return. These programs then pool the money and make long-range investments so that the earnings meet or exceed college tuition increases. When a child is ready to go to college, the plan transfers funds to cover the tuition directly to the institution.
• Portability -If the child chooses not to attend a college covered by the prepaid tuition plan, all is not lost. Although you will not get the benefit of guaranteed tuition, all prepaid tuition plans allow you to use plan money to pay tuition at other colleges and universities. Many state prepaid tuition plans will pay out an amount equal to the weighted average tuition and mandatory fees at your state's public institutions, not to exceed the actual tuition and fees you incur. All prepaid plans also let you transfer the plan to a child's brother or sister (although age restrictions may prevent transfers to an older sibling). Unfortunately, if your child chooses not to go to college and a sibling doesn't use the plan, or you need to cancel the prepaid plan, most plans will only give you back what you originally contributed with a reduction or elimination of any interest earned. Some plans also charge a cancellation fee.

College Savings Plans

With college savings plans, students of all ages can save for all college costs, including tuition, fees, room, board, textbooks, and computers.

• Not Limited to In-State Public Colleges or State Resident - Withdrawals from college savings plans can be used at most colleges and universities throughout the country, including graduate schools. Some foreign education institutions also may be eligible. Many states now offer at least one college savings plan that has no residency restrictions. You can live in Ohio, contribute to a plan in Maine, and send your child to college in California. However, if your state offers state tax advantages to residents who participate in the local plan, you'll miss out if you opt for another state's 529 plan.
• Covered Education Expenses- College savings plans typically cover all "qualified education expenses" at eligible colleges, universities, and other post-secondary institutions including:
  • Tuition
  • Fees
  • Books and supplies
  • Equipment
  • Room and board
• Contribution Limits
  When you invest in a college savings plan, you pay money into an investment account on behalf of a designated beneficiary. Contributions can vary and are only limited by the maximum and minimum contributions limits set by most plans. Although the maximum amount of contributions differs from state to state, in the majority of states offering college savings plans, the maximum amount that you can contribute for one beneficiary exceeds $200,000.

To further increase the amount of contributions you can make, you can open a second college savings plan in another state. Currently, the IRS only requires that contributions for one child cannot be more than the amount necessary for the qualified higher education expenses of that child. So if you want your child to go to an expensive college and graduate school, one option you have is to open more than one college savings plan.

Most states also offer very flexible minimum contribution limits. Many require a $250 initial contribution with subsequent contributions of as little as $50. These minimum contribution amounts can be reduced even further in many states if you make contributions through payroll deductions or automatic transfers from a bank account.

• Investment Options -Typically, each plan gives you a number of investment options that allow you to invest in various portfolios of mutual funds. Some college savings plans offer age-based portfolios of mutual funds. When the child is younger, the portfolio typically invests mostly in stock funds, which carry a higher risk, but higher return potential. As your child grows older, the asset allocation becomes increasingly conservative as it gradually shifts to bond funds and other fixed-income funds. Many states also offer non-age-based investment options, allowing you to select portfolios with conservative, moderate, and aggressive asset allocations. Some states also offer investments options that allow you to invest in certificates of deposits whose interest rates are linked to an index that measures the average cost of college tuition.

Until recently, once you selected an investment option within a college savings plan, you could not change that option. Only new contributions could be invested in different investment options. Now, however, the IRS allows you to change your investment options once every calendar year in a college savings plan.

• Investment Risk -Investing in college savings plans does come with some risk. Unlike prepaid tuition plans, they don't lock in tuition prices. Nor does the state back or guarantee the investments. There also is the risk with most college savings plan investment options that you may lose money, or it may not grow enough to pay for college. For example, if you choose a plan option that invests in stock mutual funds, chances are that your invested funds' annual performance will mirror the trends of the stock market. Thus, you may lose money during a declining market.
• Fees, Charges, and Expenses- All 529 plans have fees and expenses. Not only do these charges vary among 529 plans, but also they can vary within a single 529 plan. Like mutual funds, a single college savings plan may offer more than one “class” of shares to investors. Often referred to as A, B, or C classes, units or fee structures, each class has different fees and expenses. You can look at the offering document to see if a particular college savings plan offers more than one class.

It is very important to take fees and expenses into account when selecting a college savings plan. Slightly larger fees and expenses can make a big difference in the value of your investment over time. Let's say you invest $10,000 in a college savings plan with a return of 8% before expenses. With a plan that had annual administration and operating expenses of 3.03%, after 18 years, you would end up with only $22,966.81. If the college savings plan had expenses of 0.65%, you would end up with $35,534—a 35% difference!

Here's a list of some of the most common fees, charges, and expenses found in college savings plans:

• Enrollment Fee. Several college savings plans charge a minimal enrollment fee. Currently, the highest enrollment fee is $90. Most enrollment fees are under $50.
• Annual Maintenance Fee. Most college savings plans charge annual maintenance fees. These fees usually range from $10 to $50. Many plans reduce or eliminate this fee for residents, if you make automatic contributions, or if you maintain a certain balance, typically $25,000.
• Sales Charge (Front-end Sales Load). Several college savings plans charge a sales charge when you buy certain investment options within a plan or purchase a plan through a broker or investment adviser instead of directly from the state. Generally, you can determine the sales load by looking at the fees and expenses section of the offering circular or prospectus. Not every plan has a sales load. In some plans, a sales charge may only be levied on certain share classes of the plan.

• Deferred Sales Charge. A deferred sales charge or contingent deferred sales charge (CDSC) is a charge you pay when you withdraw money from an investment option or college savings plan. It is sometimes referred to as the back-end load. The charge may start out at 2.5% for the first year, and get smaller each year after that until it reaches zero. Generally, you can determine the deferred sales charge by looking at the fees and expenses section of the offering circular or prospectus. Not every college savings plan has a deferred sales charge. In some plans, a deferred sales charge may only be levied on certain classes of the plan.
• Administration/Management Fee. This is the total annual college savings plan operating expenses expressed as a percentage of the plan's assets. For example, an expense ratio of 1% represents an annual charge to the plan's assets—including your proportional interest in those assets—of 1% per year.
• Underlying Fund Expenses. Because college savings plan portfolios typically invest in a number of mutual funds, they bear part of the fees and expenses of these underlying funds. This expense is expressed as a percentage of a mutual fund's assets. Because college savings plan investment portfolios sometimes invest in a number of mutual funds, the offering circular or prospectus may contain fund expenses percentages for each of these funds.

Comparison of 529 Plans

Common Features of Prepaid Tuition and College Savings Plans

Federal Tax Advantages - One of the biggest advantages of 529 plans over other college savings options are the tax advantages they offer. Earnings grow tax-free and withdrawals are tax-free when used for qualified education expenses.³

 
Also, anyone can contribute to a 529 plan. Unlike education savings accounts (ESAs) and saving bonds, which are discussed later, there are no income limitations. For most wealthy families, 529 plans are one of the few available tax-advantaged college savings options.

State Tax Advantages - State tax treatment of 529 plans varies from state to state. In over 20 states, contributions are tax deductible if you're a resident of the state sponsoring the 529 plan. For example, in Missouri, up to $8,000 in contributions to the state's 529 plan can be deducted from Missouri state taxable income per taxpayer per year. Many states also don't tax earnings or qualified withdrawals from 529 plans. To get this tax exemption, you may have to choose your state's 529 plan. These tax benefits may net you more investing in your state plan than if you invest in another state's plan that earns more.

Control - Unlike Custodial Accounts and ESAs, 529 plans allow the account owner to maintain control over the assets in a 529 plan for the life of the account. You also can change beneficiaries to another "family member" of the original beneficiary. Thus, if your child gets a scholarship or decides not to go to college, you can name another beneficiary, even yourself. Some 529 plans, especially prepaid tuition plans, may limit or restrict your ability to change beneficiaries, so check the plan offering document.

Transfers -The assets of one 529 plan can be transferred tax-free to another 529 plan of another beneficiary, as long as the new beneficiary is a "family member" of the beneficiary of the 529 plan from which the transfer was made. "Family members" include, among others, the beneficiary's spouse, son, daughter, grandchild, niece, nephew, and first cousin.

The assets of one 529 plan also can be transferred tax-free to another 529 plan for the same beneficiary. However, only one transfer of this type is allowed within any 12-month period. There also may be state tax implications when you transfer from one 529 plan to another. You may want to consult with your tax adviser before you make a transfer.

Withdrawals for Non-College Related Expenses - If your child decides not to go to college or you over-fund a 529 plan, you may pay a penalty in addition to any taxes you owe on any earnings. If you withdraw money from a 529 plan that is not used for qualified education expenses, you are generally required to pay income tax and an additional 10% penalty on earnings. There are a number of exceptions to this penalty. The penalty may be waived if your child gets a scholarship or is disabled. You also can avoid the taxes and penalties by transferring the 529 plan to another beneficiary that will use the funds for qualified education expenses. Coverdell Education Savings Accounts Those who want more investment choices may want to consider Coverdell Education Saving Accounts (ESAs). No Investment Restrictions- Formerly known as Education IRAs, ESAs are another tax-advantaged way to pay for college. Unlike 529 plans, your investment options are virtually limitless. Except for investing in life insurance contracts, you can buy and sell what you want whenever you want. Also, you can set them up at almost any brokerage firm, mutual-fund company, or other financial institution.

Federal Tax Advantages- Earnings in ESAs are tax-deferred, and withdrawals that are used for qualified education expenses are tax-free. Unlike 529 plans, there is no “sunset provision” in 2011 on the tax-free status of qualified plan withdrawals.

Education Expenses Covered - One advantage that ESAs have over other tax-advantaged saving options is that you can make tax-free withdrawals to pay for private elementary and high school expenses, as well as post-secondary school expenses. So if a private school is in the future, one option you might want to consider is saving for that expense in an ESA and using a 529 plan for college.

Contribution Limits - ESAs have two annual contribution limits for individuals:

1. You can give up to $2,000 to any one beneficiary assuming you meet the ESA income limits discussed below.
2. The total of all contributions to all ESAs set up for one beneficiary cannot exceed $2,000. If other family members set up ESAs for your child, you need to check with them to make sure this contribution limit is not exceeded.

If you exceed these contribution limits, there is a 6% excise tax on excess contributions unless the excess amount is withdrawn within six months of the contribution. Invest $2,000 a year at an annual yield of 6% from the time your child is born, and you will have a little over $61,000 in college savings when your child turns 18. Can't save that much or think you can get a higher return on your investment? Use our College Savings Calculator to estimate your savings.

Income Restrictions - A couple filing a joint return can contribute $2,000 if their modified adjusted gross income is less than $190,000 a year. The ability to contribute is phased out for couples filing jointly with modified adjusted gross incomes of between $190,000 and $220,000. Contributions are not allowed for couples filing jointly whose modified adjusted gross income is above $220,000.

Single taxpayers will be able to contribute $2,000 if their modified adjusted gross income is less than $95,000. Single taxpayers' ability to contribute is phased out if their modified adjusted gross income is between $95,000 and $110,000. No contributions are allowed if their modified adjusted gross income is above $110,000.

Fees, Charges, and Expenses - Fees, charges, and expenses will vary depending on the investments you choose and the institution where you open an ESA. Remember, however, that because of the fairly low contribution limits, even small annual fees or expenses could make a big difference in the value of your investment over time.

Custodial Accounts

Uniform Gift to Minors Act (UGMA) accounts or Uniform Transfer to Minors Act (UTMA) accounts—are another tax-advantaged way to save for college. A parent, grandparent, or other adult is custodian for the account and makes all the investment decisions until the child for whom the account was opened reaches the age of majority. UGMA accounts are limited to money and securities. UTMA accounts can hold other types of property. You can set up these accounts at almost any brokerage firm, mutual-fund company, or other financial institution.

Advantages - For children younger than 14, the first $750 in earnings in a custodial account is tax-free. The next $750 in earnings is taxed at the child's federal tax rate. Any earnings over $1500 are taxed at the custodian's federal tax rate. For children over 14, the first $750 in earnings is still tax-free, and all earnings after that are taxed at the child's tax rate. To learn more about the tax rules for children, you should read IRS Publication 929: Tax Rules for Children and Dependents.

As with ESAs, your investing options are virtually limitless. Nor are there any contribution or income limitations. In addition, withdrawals can be used for any purpose, not just qualified education expenses, without penalty.

Disadvantages - When your child reaches the age of majority—18 to 25 depending on the state you live in—he or she takes over control of the account and can use the money in the account for anything. Because you lose control over how the money may be spent, some parents and grandparents may not like this option. Another potential disadvantage is that because the account is considered the child's asset, you can't switch beneficiaries. So if your child decides not go to college or gets a scholarship, you can't switch the money to a brother, sister, or other family member.

Tax-Free Transfer to a 529 Plan - you now can transfer funds from a custodial account to a 529 plan if the plan accepts such transfer. However, you must liquidate any investments you have made in a custodial account because you can only transfer cash and pay taxes, if any, on any gains. Another problem with transferring custodial account funds is that the money is the child's asset, not yours, so you cannot transfer the 529 plan to another beneficiary. There also may be other restrictions and limitations.

Series EE & I Savings Bonds

U.S. Series EE savings bonds issued after 1989 or Series I saving bonds are another tax-advantaged way to save for college.

Advantages - Backed by the full faith and credit of the United States government, the interest from these bonds is tax free if used for qualified higher education expenses. Interest on Series EE and I savings bonds also is usually exempt from state and local taxes.

Disadvantages - The full interest exclusion is only available to married couples filing jointly with modified adjusted gross income of less than $83,650 and for single filers with modified adjusted gross income of less than $55,750 in 2001. The interest exclusion is phased out if your modified adjusted gross income is between $83,650 and $113,650 for joint filers and between $55,750 and $70,750 for single taxpayers. Regardless of your income, married couples filing separately cannot take advantage of this savings bond program. You can learn more about the Educational Savings Bond Program in IRS Publication 970: Tax Benefits for Education.

The rules for using savings bonds for education can be complicated. To learn more about using savings bonds for educational expenses, you should read the Bureau of Public Debt's frequently asked questions on education and savings bonds. The Bureau of Public Debt's Web site also provides information on the latest rates for Series EE and Series I savings bonds and how to buy saving bonds directly from the federal government.

Hope and Lifetime Learning Credits

The Hope Credit and Lifetime Learning Credit offer another way to reduce your taxes while paying for college. Available for only the first two years of college, the Hope Credit equals 100% of the first $1,000 paid for college tuition and fees and 50% of the second $1,000, for a maximum credit of $1,500 per student. To qualify for the Hope Credit, your child must be pursuing a degree, going to school at least half time, and not have a felony drug conviction.

With the Lifetime Learning Credit, you can claim up to 20% of the first $10,000 paid for college tuition and fees, for a maximum credit of $2,000 per tax return. Unlike the Hope Credit, there is no limit on the number of years you can claim the Lifetime Learning Credit. It may be used for undergraduate and graduate courses and even for tuition and fees when your child is attending school less than half time. But, you can only claim the credit once per tax return no matter how many children you have enrolled in college at the same time.

The full credits are available to you if your modified adjusted gross income is less than $40,000 if you are a single taxpayer and $80,000 if you are married filing jointly. The credits phase out if your modified adjusted gross income is between $40,000 and $50,000 if you're a single taxpayer and between $80,000 and $100,000 if you are married filing jointly. You can't get either of these credits if your modified adjusted gross income is above $50,000 if you are a single taxpayer, above $100,000 if you are married filing jointly or you are married filing separately.

If you qualify for a Hope Credit or Lifetime Learning Credit, you can still claim the credit even if you make a withdrawal from a 529 plan or ESA. You just can't use the credits to pay expenses paid with 529 or ESA money. Prior to 2002, you could not claim these credits if you made a withdrawal from a 529 or ESA.

Tips for Choosing College Savings Options

Understand the Tax Benefits  - A number of college savings options offer tax-advantaged ways to save. Taking advantage of these savings options may greatly affect how much you can accumulate for your child's college education. In addition to the federal tax benefits of many college savings options, there may also be state tax benefits. Savings bonds are usually exempt from state and local taxes. Many states allow you to deduct some or all of your contributions to a 529 plan if you're a resident of the state sponsoring the plan. In addition, states may offer other tax advantages for 529 plans. Because of these state tax benefits, you might want to check out your own state's 529 plan before considering other plans. Everyone's tax situation is different and state and federal tax law can be complex. You may want to consult with your tax adviser about which college savings options are best for you.

Examine Fees and Expenses - All of the college savings options discussed above involve various fees and expenses. A college saving option with higher costs must perform better than a low-cost option to generate the same returns for you. Even small differences in fees and expenses can translate into a large difference over time.

While we explain the various expenses involved with many 529 plans, that does not mean that other college savings options don't have fees and expenses. If you invest in mutual funds through an ESA or custodial account, you should check the fee table in the prospectus to see how the costs of a mutual fund add up over time. If you invest in stock, make sure you understand how much in commissions you must pay and factor this into any gain you may make.

Know the Risks As Well As the Rewards of Your College Savings Options - Compared to saving for retirement, your college saving timeline is relatively short. At most it may be 18 years. And for many people it's a lot less. This can impact your ability to weather a market decline and increases your risk.

Before investing in any college saving vehicle, carefully evaluate it and its investment options. Investment options with higher rates of return may take risks that are beyond your comfort level and are inconsistent with your goals. To learn more about the investment strategy of investment options you are considering and their risk, you should read the following materials:

• 529 Plans. Read the offering circular or prospectus. It usually contains the investment strategy and risks of a 529 plan and its investment portfolios. Most 529 plans provide this document on their Web sites.
• Mutual Funds. Read the prospectus and shareholder reports. Prospectus and shareholders reports are usually available from mutual fund companies or your financial professional.
• Stocks and other securities. Read a company's registration statement or annual (Form 10-K) and quarterly (Form 10-Q) reports.

Understand Your College Savings Plan's Limitations and Restrictions

What happens to your college savings if your child decides not to go to college, you have another child, or you lose your job? These events and many others could dramatically impact your college savings strategy. Unfortunately, most college savings options have various restrictions and limitations that may impact your ability to react to a changing situation. Carefully review any college saving options you're considering to make sure they have the flexibility and control you feel you need.

The following College Savings Plan Comparison Chart will help you understand and compare the various restrictions and limitations of each option.

College Savings Plan Comparison Chart

This page was updated:
August 15, 2007 11:04