Talk about money: Families can combat college tuition costs in advance
by Mark Rosenberg
Jul 19, 2012 | 717 views | 0 0 comments | 5 5 recommendations | email to a friend | print

Measure K’s election win last month brings into sharp focus the issues of education and money.

The $48-a-year parcel tax will help maintainScottsValley’s record of sending 97 percent of its high school graduates to college. But, parents have to ask themselves, then what?

The cost of a college education is rising more than four times faster than the overall rate of inflation, according to InflationData.com. Some graduates leave college owing tens of thousands — or, for some advanced degrees, hundreds of thousands — of dollars.

The cost of attendingUniversityofCalifornia,Santa Cruz, next year is $33,291. Multiply that by four years for a bachelor’s degree and parents start getting the shakes.

Parents who want to be financially prepared should start planning early.  There are many ways to build a college nest egg. The money grows fastest if you avoid taxes, and the government offers several ways to do that.

Here’s a hypothetical example that assumes a 7 percent return on your money, which might or might not be achievable.

Let’s say you invest $2,000 on the day a child is born, then add $2,000 on every birthday till the child’s 18th — a total of 19 payments. When the child is 18, the account is worth about $80,000. But if the returns are taxed every year at a rate of 31 percent, the account is worth only $63,000. 

Clearly, tax free is best.

Here are summaries of two college savings methods:

529 plans

These allow you to invest large amounts of money, but most 529s limit the investments to a family of mutual funds. Growth is tax free. When the child starts college, the money can be withdrawn tax free as long as it is used for tuition, room and board, and other “qualifying” expenses. 

The donor names a child as beneficiary but can later change his mind and switch to a related beneficiary or reclaim the funds for himself.

Any nonqualified withdrawal — one that isn’t used for higher-education expenses — subjects the donor to income tax plus a 10 percent penalty on the earnings.

Coverdell Education Savings Accounts

While 529 plans are the collegiate equivalent of 401(k) retirement plans, Coverdell accounts act more like Roth IRAs.

The tax treatment of a Coverdell is much the same as a 529, but here are some differences.

  • Contributions are limited to $2,000 a year.
  • If a donor’s income is too high, she can’t contribute to a Coverdell.
  • Money can be invested in individual stocks or bonds, while most 529 plans restrict investment choices to a family of mutual funds.
  • Families can take money out of a Coverdell for any education expenses, including kindergarten through 12th grade schooling, while 529 assets must be used for college.
  • Coverdell donors can switch the beneficiary to an eligible family member, but unlike the 529, the donor can’t reclaim the money for himself.

One problem is that the rules for Coverdell accounts are tied to the Bush tax cuts that expire Dec. 31. If the government takes no action, the investment limit will drop from $2,000 to $500 a year, and using the money for precollege expenses won’t be allowed.

A top expert on these accounts is Joseph Hurley of Savingforcollege.com. He said, “I am not a huge fan of Coverdell accounts,” because unlike 529 plans, they don’t allow the donor to reclaim the money.

He also addressed the two other perceived advantages of Coverdell accounts. Though they offer more choices of what you can invest in, many financial institutions don’t offer them. And the option to withdraw money for primary and secondary schooling could soon disappear.

“The K-12 provision is slated to expire at the end of this year,” Hurley said, “so that particular benefit with Coverdells could very well go away.”

I will revisit this topic when we get more clarity on Coverdell rules.

Mark Rosenberg is an investment consultant for Financial West Group in Scotts Valley, a member of FINRA and SIPC. He can be reached at 439-9910 or mrosenberg@fwg.com.

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