Families with children know that paying for a college education is a major financial challenge. The cost of higher education continues to rise and most likely this is a trend that will continue. Even though the cost may seem insurmountable, it's still important to plan. Often times, families do not realize how much less an education can cost when they effectively implement a savings plan.
Financial aid is available to many students, however, most of the time the aid comes in the form of loans. Loans are the most expensive way to finance a college education. If a student borrows $35,000 at a 6.8% interest rate, it would take them 10 years of $400 monthly payments to pay off the loan. The $35,000 education actually cost $48,000 including interest.
Saving money for college actually reduces the cost of the education. If the goal was to receive the same $35,000 as above, you would need to save $200 monthly for 10 years at a 7% rate of return = $24,000 in total contributions.
So, as the example illustrates, the same education cost $24,000 by saving vs. $48,000 by borrowing…double the cost.
You've probably heard of "529 plans," which have become very popular in recent years. These types of plans allow for tax-free growth of investments, tax-free withdrawals as long as the funds are used for education expenses, and potentially state income tax deductions for the contributions to the account. 529 contributions are not deductible from federal income tax.
Moneys put in the account have to be considered off limits for anything but college education. Penalties and taxes are incurred if any moneys are withdrawn for purposes besides education.
There are limits on how much can be contributed to a 529 plan. First, gift tax limits apply – for 2013, a maximum of $14,000 ($28,000 for married couples) can be contributed per plan beneficiary. A special gifting provision allows a contributor to make five year's worth of annual exclusion gifts in one year on behalf of a 529 plan beneficiary without causing a taxable gift – for 2013, this amount is $70,000 ($140,000 for married couples). The contributor must elect this special gifting provision by filing a Form 709 – US Gift Tax Return.
States also set their own limits on how much can be contributed to the 529 plans they sponsor. The amounts vary by State, but most exceed $235,000 in accumulated contributions. Once the balance reaches that account limit, no further contributions can be made. Earnings are allowed to cause the account to exceed the limit.
529 plans do have an effect on financial aid eligibility. 529 plans owned by the parent are considered parental assets. These plans reduce need-based aid by a maximum of 5.64 percent of the value of the account. So, a parent with $10,000 in a 529 for their student would have their financial aid reduced by a maximum of $564.
The financial aid treatment of 529 plans owned by grandparents, aunts/uncles, and even non-custodial divorced parents is handled differently. The assets in these accounts are not reported as parental assets for financial aid purposes. However, once the grandparent starts taking distributions, it will cut the student's financial aid by 50% of the distribution. For example, a grandparent who draws $10,000 from a 529 they own for their grandchild's education, will result in the student's financial aid being reduced by $5,000. For this reason, it is usually advisable for non-parent account owners to transfer the accounts over to the parents before the student starts college. Some states have limitations on such transfers.
Establishing a plan for savings can be a very valuable tool in financing your child's education. If we can assist you in any way in this process, please let us know.