How Do I Save?

To begin the savings process, you must define your goal -- the specific amount of money that you need to have available at a certain date for education costs. Once your goal is established, you must create a savings plan that will allow you to meet your goal. One of the primary factors in creating a savings plan is the amount of time you have to save.

Ideally, you would start saving as soon as possible -- for parents, at their child's birth. The earlier you start, the greater your options. In addition to allowing your investments to grow, an early start will reduce the necessary annual savings amount.

Getting Started

Once you have set money aside, you have to decide how to invest it. Depending upon your situation, you may choose from many types of investments. One approach is to purchase fixed income securities (like bonds, certificates of deposit or Treasury obligations) with maturity dates that match the time frame when you will need to pay education expenses.

You may decide to make equity investments rather than fixed-income investments. If so, consider using mutual funds to diversity your risk. You may also wish to consider using "index" funds which seek returns equal to the S&P 500 Index or other equity index. There are varying degrees of risk associated with different types of investments, so be sure to get professional guidance before making a decision.

Tax Pointers

Kiddie Tax

Certain savings methods offer tax advantages -- such deferring income taxes on investment earnings or shifting income to a lower tax bracket. An essential aspect of the income tax treatment of college savings is the "Kiddie Tax." The Kiddie tax rules of federal income tax laws require that the unearned income (e.g., interest and dividends) of a child under the age of 14 be taxed at his or her parent's marginal tax bracket once it exceeds $1,300. However, there are still some tax advantages for children under the age of 14 as summarized in the following table:     

To take advantage of these rules, you can transfer assets generating $1,300 (or less) of taxable income transferred to a child under the age of 14. Other tax-deferred or income-deferred investments, such as growth stocks and Series EE savings bonds, can be used to avoid the effects of the Kiddie tax, as long as they are not sold or redeemed until after the child is 14.

In the discussion of Series EE Bonds and Zero Coupon Bonds below, please note the opportunities for deferring income tax.

Investments

One way to save for education expenses is to segregate the savings in your own separate account. This method allows you to retain complete control over the funds, including the direction of investments and the ultimate use of the money. However, it does not take advantage of techniques to shift income to the lower tax brackets of children and/or trusts. If you are a parent saving for a child, you may want to consider saving in the child's name rather than your own. These techniques can be used effectively to minimize the taxes on education savings.

When investing for education, most investors look for low maintenance, low degree of risk, liquidity, and high after-tax yield. While all of the following investments have different characteristics, they are all popular for college savings plans.

Series EE Savings Bonds

As with all U.S. savings bonds, the interest income on Series EE Bonds is deferred and generally not taxed when the bond is cashed. In addition, the interest is exempt from state and local taxes. For all savings bonds, an election is available to report the accrued interest on an annual basis. This election is particularly useful for children under the age of 14 who have little unearned income because it allows a person to take advantage of the child's lower tax bracket and avoid the Kiddie tax.

Savings bonds are a low-risk, low-cost and liquid investment choice. Series EE Savings Bonds, unlike other savings bonds, offer an additional benefit -- the interest from the bonds that is used for college education may be excluded from income if certain requirements are met.

For the interest on Series EE Bonds to be excluded from income, the following requirements must be satisfied:

• The buyer must be at least 24 years old and must be the sole owner of the bonds (or joint owner with a spouse).
• The bonds must be redeemed during a year in which the buyer pays qualified educational expenses for himself, or herself, a spouse, or a dependent.  Qualified educational expenses are tuition and required fees at an educational institution.
• The redemption proceeds of the bonds (principal and interest) must not exceed the qualified educational expenses for the year; otherwise the amount of interest excluded from income is limited accordingly.
• If married, the buyer must file a joint income tax return in the year of redemption.

Caution: Even if the buyer meets all of the requirements, the exclusion of interest from income is phased out for higher income taxpayers. In the right situation, mainly for investors who prefer low risk and who are not subject to the phase-out of the exclusion, Series EE bonds provide a unique investment option. However, like many other fixed income investments, their rates of return may not keep pace with the rate of inflation on college costs.

Zero-Coupon Bonds

Zero-Coupon Bonds are similar to savings bonds -- they are issued at a discount and are redeemed at maturity for their face value. Unlike savings bond interest, the accrued interest for zero-coupon bonds, (represented by the discount amount) is included in the bondholder's income each year. There is no tax deferral. However, certain types of zero-coupon bonds may be tax exempt. For example, U.S. government bonds are exempt from state and local taxes. Similarly, municipal bonds are exempt from federal, state, and local taxes in the state or locality in which they are issued.

Zero-coupon bonds do have risks. Zero-coupon bonds tend to be more volatile than other types of bonds. In other words, the market value of a zero coupon bond tends to rise faster when interest rates fall, and fall faster when interest rates rise. To eliminate this risk, a zero-coupon bond must be held to maturity.

Mutual Funds

The advantage of a zero-coupon bond is that it offers a set rate of return and redemption at a specific date. For example, if education costs will begin in 5 years, a person can buy a zero-coupon bond that will mature at that time. If the bond is low risk (e.g., a U.S. government bond), the redemption amount is reasonably assured. The disadvantage is that the interest rate is locked in, and purchasing a long-term bond in periods of low interest rates might not be the best investment choice.

Mutual Funds are a popular choice for education funds. They offer immediate diversification of investment funds, professional management, generally low maintenance (especially no-load funds), and liquidity. In addition, there are a wide variety of investment choices, including money market funds, bond funds, municipal bond funds, equity funds, balanced funds, and international funds. The risks of the funds vary according to the types of investments held.

IRA Accounts and Deferred Accounts

IRA Accounts, Deferred Accounts and Deferred Annuities are other investment choices for education funds. Their primary advantage is that their earnings growth is tax deferred until amounts are withdrawn from the plans. For most people, however, the potential cost of withdrawals is too expensive -- IRA accounts and deferred annuities are subject to a 10 percent early distribution penalty if amounts are withdrawn before the owner reaches age 59 1/2. In addition, there may be withdrawal or surrender penalties associated with deferred annuities. These types of investments are primarily effective for people who will be over age 59 1/2 when education costs are incurred.

Transfer Methods

Other methods for saving for education costs involve setting up an education fund in the name of another taxpayer, normally a child or a trust for the benefit of a child. The benefits of these methods have been restricted by changes in the tax law, particularly for children under the age of 14 and for trusts. However, with proper planning, these methods can be very useful for minimizing taxes, and they remain powerful tools when a child is 14 years of age or older. The methods include: outright transfers, custodial accounts, minor trusts and crummey trusts.

Transfers (Outright).  An outright, or direct, transfer of property to a child is one method used to shift income to a child's lower tax bracket. These transfers qualify for the $10,000 annual exclusion from gift taxes discussed in the Gifts topic. However, the Kiddie tax severely limits the benefits of transfers of income-producing property to children under the age of 14.

For all direct transfers, the primary disadvantage is the loss of control by the donor over the assets transferred. In addition, once the child legally becomes an adult (between ages 18-21 in most states), the child has complete control over the use of the assets. There is no requirement that the assets be used for education costs. An additional disadvantage arises for a child who may need to apply for financial aid. The federal financial aid formula expects the child to apply a larger percentage of his or her assets toward education (35%) than it expects from the parents (5.6%). Therefore, assets owned directly by a child may reduce the amount of available financial aid.

Custodial Accounts (UGMA/UTMA).  Many people take advantage of custodial accounts to save for education costs. A custodian, usually the minor's parent or grandparent, receives assets for the minor and holds them in a separate account under the minor's name. The custodian has the power to invest the assets and use the property for the minor's benefit.

The availability and type of custodial account depends upon state law. In states that have adopted the Uniform Gift to Minors Act (UGMA), generally certain assets, primarily bank accounts, securities, life insurance and annuities, may be transferred to a custodial account. In these states, the property in the account belongs to the minor when he or she becomes an adult (18-21 years of age depending upon the state). Other states have adopted the Uniform Transfers to Minors Act (UTMA), which allows the transfer of any type of property to a custodial account. Custodial accounts terminate at age 21 regardless of the age of majority in the state.

As with outright transfers of property to a child, transfers to a custodial account qualify for the $10,000 annual gift tax exclusion discussed in the Gifts topic. Income earned on custodial property is taxable to the minor. If the minor is under the age of 14, the Kiddie tax applies. Finally, the assets are considered the property of the minor for purposes of calculating financial aid eligibility. Under the federal financial aid formula, the minor is expected to apply a larger percentage of his or her assets toward education (35%) than is expected from the parents (5.6%). Therefore, assets treated as the property of a minor may reduce the amount of available financial aid.

Warning: Parents may have to pay tax on the income from a custodial account to pay their support obligation. In some states, the payment of college education expenses is considered a legal obligation of the parents.

Minor's Trust.  A minor's trust, is a trust for the benefit of a person under age 21 at the time it is created. It is similar to a custodial account, but more rigid and potentially less accessible to the minor, and has the added benefit of an independent trustee. To qualify for the $10,000 annual gift tax exclusion, the trust must meet certain requirements: - 1) the trustee must have an unrestricted power to distribute the income and principal at any time, and 2) the minor must have the right to receive the trust assets at age 21.

A minor's trust may continue to exist after the beneficiary reaches age 21 if the beneficiary elects not to receive the trust assets. The trust is more complex than a custodial account and has additional administrative burdens (such as the filing of a tax return).

The tax benefits of a minor's trust were severely limited beginning in 1993 when the income tax brackets for trusts were compressed. Since the trust is a separate taxable entity, the income of a minor's trust is taxable at the trust's tax rates unless it is distributed to the beneficiary. Under the compressed brackets, only the first $1,500 of trust taxable income is taxed at a 15% rate. The next $2,100 is taxed at a 28% rate, and additional trust income is taxed at the standard 31%, 36% and 39.6% rates. Therefore, the accumulation of any significant amount of income in the trust has significant tax consequences.

To minimize the effect of the trust tax rates, a minor's trust may be combined with a custodial account. For children under the age of 14, income may be distributed from the trust to the child's custodial account to generate up to $1,300 of taxable income in the custodial account. This helps avoid the effects of the Kiddie tax. For children 14 years or older, the income of the trust may be distributed to the custodial account to take advantage of the child's lower 15% tax bracket. This combining these methods would make maximum use of both the child's and the trust's lower tax brackets.

Warning: Parents may have to pay tax on the income from a minor's trust if they use the income to pay their support obligation. In some states, the payment of college education expenses is considered a legal obligation of the parents.

Crummey Trust. A crummey trust is a very popular method of transferring all types of assets for the benefit of a child. Unlike under a minor's trust, the beneficiary does not have to receive the assets at age 21. The terms of the trust are virtually unrestricted and may include almost any terms that the donor desires. For donations to the trust to qualify for the $10,000 annual exclusion from gift tax, the beneficiary must have a right to withdraw any contributions to the trust up to the $10,000 amount. The beneficiary is normally given from 30-60 days to demand withdrawal of the contribution. If the right is exercised, the trustee must transfer the funds directly to the beneficiary. If the right is not exercised, the funds remain in the trust and are managed by the trustee. On the surface this right appears to give the beneficiary complete access to the contributions. Generally, however, the beneficiary recognizes that the donor may not make future contributions to the trust if a withdrawal is made.

Given the right to withdraw assets, the beneficiary is treated as the owner of the trust property and is taxed on the trust income. If the beneficiary is a child under the age of 14, the income will be subject to the Kiddie tax rules.

Special Methods

Some specialized methods of funding education costs have been developed or adapted from other areas and may be used in specific situations. These are:

• College Prepayment Plans
• Charitable Remainder Trusts
• Charitable Gift Annuities

Various state programs have been established to encourage parents to pre-fund the anticipated cost of educating their children.

In some states, zero coupon bonds are promoted by state agencies as a way of saving for college. The state agency might assist you by notifying you when these bonds become available. For more information, contact the state agency where you live to see if such a program is available.  (Click here to go to a list of state agencies.)

Many states also promote pre-funded or pre-paid tuition programs. These programs take a variety of forms, but typically involve the purchase of tuition "units" in discounted dollars today which can be applied to college expenses when the time comes. Many features of these plans have complex tax and other considerations which are beyond the scope of this program, but they are definitely worth a closer look. You can contact your state's education agency to find out more information.