Saving for College

August 28, 2008

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Saving for College

by Robert Needlman, M.D., F.A.A.P.
reviewed by Laura Jana, M.D., F.A.A.P.

It's true that the purpose of financial aid is to make college affordable to everyone. However, most financial aid--some 60 percent of it--comes in the form of loans, which means that many students finish college with not only a diploma, but also loads of debt. If this sounds less than ideal to you, it may be best to start saving for college now, before the bills begin to pile up.

Start early
The key to college savings is to start putting money away early on to take advantage of compounded interest. For example, if you began by saving $100 a month when your child turned six, at a 4 percent interest rate, you would have $18,500 by the time your child turned 18, of which more than $4,000 (roughly 28 percent) would have come from the interest. (See Finaid.com for several handy calculators, including the one used for this example.)

How savings affect financial aid
In assessing a student's financial need, the federal government calculates that approximately 5 percent of parents' savings should go toward college expenses each year; therefore, the estimated financial need--and thus the value of financial aid you receive--is reduced by that amount. The government does not count savings in the form of home equity or any savings at all if a family's income is less than $50,000 a year.

In one sense, if you qualify for financial aid, having money in the bank costs you, because the federal government counts it against your financial aid. On the other hand, if you don't save ahead of time, you may have to take out student loans. If you do, you--or your child--may end up paying more in interest than what it would have cost to save the money in the first place.

Savings in your child's name
Putting money away in your child's name may save money in taxes, because your child's tax rate is likely to be less than yours. However, money saved in your child's name reduces any financial aid award quite dramatically. This is because the federal government considers that 35 percent of a child's savings is available to pay for college in a given year. So, saving money in your child's name probably makes sense only if you are pretty sure that you earn too much to qualify for financial aid.

Tax breaks for college savings
In order to help make college more affordable, the federal and state governments have set up several different plans. Quick summaries follow below; for more details, see Think College Early (sponsored by the U.S. Department of Education) or other sites listed in our article "Online Resources for College Planning."

Education IRAs. You or a grandparent or friend can put up to $500 per year into one of these accounts (also called Coverdell Education Savings Accounts). The limit rises to $2,000 in 2002. The money accumulates tax free, and there are no federal taxes on withdrawal as long as the money goes toward college expenses. Families with combined incomes over $160,000 (or $110,000 for a single tax filer) are excluded.

State-sponsored savings plans (529 Plans). Named after section 529 of the tax code, these savings plans allow interest to accumulate tax free, with no federal tax on withdrawal starting in 2002. In many states, interest is also tax free; contributions may be tax deductible, too. To avoid penalties, the money has to be spent on college, but not necessarily in the same state as the account. There are no income limits.

These plans come in two varieties. One type guarantees that the account will grow at a rate equal to the average increase in college costs, a sort of college prepayment or "guaranteed tuition" plan. The other type is a form of mutual fund investment, which might grow faster than college tuition, but may also grow more slowly.

One word of caution: The federal government considers the money in these accounts to be your child's and reduces the estimated financial need--in essence, the amount of financial aid it awards--accordingly. So, there is a cost, especially if you plan to qualify for financial aid. Before you make any decisions, read more about 529 plans (including specifics about plans in each state) at www.collegesavings.org, the site of the College Savings Plans Network. Also, www.savingforcollege.com is a commercial site that provides a great deal of detailed information. You may want to consider talking to a financial planner or tax consultant.

HOPE Scholarships and Lifetime Learning tax credits. The HOPE Scholarship gives tax credits of up to $1,500 per student for the first two years of college. The Lifetime Learning tax credit has a maximum of $1,000 per taxpayer (family) and cannot be used in the same year for the same student as the HOPE Scholarship. Both tax credits have income limits, only available for adjusted gross incomes below $100,000 for joint filers, and $50,000 for single filers. For more details, see Think College Early and other online resources.


RELATED INFORMATION

			Online Resources for College Planning
			College Issues

Created September 05, 2001
Reviewed September 07, 2001

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