Saving for College

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	Saving for College Personal Finance Advisor by Deloitte & Touche OnLine Sept. 29, 1997

The new tax law creates new ways to save for college.

The average annual cost of attending a public college is now more than $10,000 -- $20,000 for a private institution. Unfortunately, increases in the cost of higher education have outpaced the inflation rate over the past 20 years, and this trend is expected to continue.

A number of states and the federal government recently adopted new education savings options. Because income and other limitations apply to many of the programs, it may be difficult to determine which option is best. The decision will depend on your time horizon, risk tolerance, income, and tax bracket.

Qualified State Tuition Programs: Fifteen states currently offer college savings plans, and another 15 are expected to launch such programs in the near future. There are two basic types of plans: Savings Plan Trusts are state-administered investment plans that can be used to fund education costs, and Prepaid Tuition Programs provide a hedge against inflation by locking in tuition costs for a selected state school at today’s prices. Plans vary, but most provide for deferral of federal and state income taxes on earnings generated in the plan. Funds must be used for "qualified expenses" (e.g., tuition, board, books), and taxes are levied on the portion of distributed funds attributable to earnings on contributions.

Participants in state plans are usually not required to attend home-state schools; however, penalties may apply if funds are used for an out-of-state school. States generally decide how funds are invested (the rate of return earned through state programs may be less than the return generated on other investment alternatives).

Distributions from state savings plans used for education expenses will qualify for the new Hope Scholarship and Lifetime Learning credits. The Hope Scholarship is a $1,500 federal tax credit for the first $1,000 and 50% of the second $1,000 spent on qualified education expenses; income limitations apply. For individuals who do not qualify for the Hope Scholarship credit, a Lifetime Learning credit equal to 20% of the first $5,000 of qualified education expenses (increasing to 20% of $10,000 after 2002) will be available.

Education IRAs: Next year parents can establish a custodial savings account for each child -- Education IRAs. An annual $500 nondeductible contribution is permitted for each child (such contributions are in addition to the $2,000 annual contribution allowed for IRAs). Funds in Education IRAs enjoy tax-deferred growth, and distributions for qualified education expenses are tax-free. Contributions to Education IRAs should not be made in the same years as contributions to state tuition programs, because penalties will apply. Other disadvantages: (1) distributions do not qualify for the Hope Scholarship or Lifetime Learning credit, and (2) income and 10% penalty taxes apply to nonqualified distributions. The following illustrates the growth of annual $500 contributions to an Education IRA, beginning at different age levels through age 18 (assuming 10% annual rate of return).

Contribution Age	Total Contributions	Value at age 18
Birth	$9,500	$28,137
5 years	$7,000	$15,386
10 years	$4,500	$7,468

Other IRAs: Beginning in 1998, penalty-free withdrawals from IRAs will be allowed for (1) qualified education expenses, and (2) first-time home purchases (up to a $10,000 lifetime cap).

The Taxpayer Relief Act of 1997 created a new category of nondeductible IRAs that can be used to accumulate funds for future education expenses -- the Roth IRA. (The old nondeductible IRAs are still available for individuals at all income levels.) Income earned in a Roth IRA is tax-free, and there are no required minimum distributions at age 70½. Qualified distributions -- defined as distributions occurring five years after the first contribution, and after age 59½, death, disability, or a first-time home purchase (up to $10,000) -- will not be subject to income tax. The Roth IRA allows individuals to withdraw contributions (not income) tax-free before age 59½.

Savings Bonds: Income taxes are not levied on the interest from U.S. Savings Bonds (Series EE) that are purchased and redeemed for qualified education expenses. These bonds have a relatively low rate of return; however, a consistent cash flow is provided and maturities can correspond to tuition payment timetables. The Hope Scholarship or Lifetime Learning credit will reduce the qualified education expenses that can be paid tax-free with Series EE bonds.

Following is a comparison of education savings options. Some are currently available and others will become available on Jan. 1, 1998.

Description	State College Savings Plans	Education IRA	Roth IRA	Nondeductible IRA	Regular IRA	U.S. Savings Bonds
Maximum contribution per year per person	Varies by State	$500	$2,000 (total of Roth, nondeductible, & deductible IRA contribution)	$2,000 (total of Roth, nondeductible, & deductible IRA contribution)	$2,000 (total of Roth, nondeductible, & deductible IRA contribution)	N/A
Beginning Adjusted Gross Income phase-out range	Varies by State	$95,000 single $150,000 joint	$95,000 single $150,000 joint	N/A	$25,000 Single $40,000 joint (Increased in 1998-2007)	$40,000 single $60,000 joint
Tax-deductible contribution	No	No	No	No	Yes	No
Tax-free growth	Yes	Yes	Yes	Yes	Yes	Yes
Income tax on distribution for qualified education expenses	Yes, income portion used for education costs taxed to beneficiary	No	Yes, if before age 59½ or less than 5 years from the first plan contribution	Yes, income portion at ordinary rates	Yes, at ordinary rates on entire distribution	No, unless redemption proceeds exceed education expenses minus Hope/Lifetime Learning credit
10% early withdrawal penalty before age 59½	No (state penalties may apply)	Yes, on early withdrawals not used for education costs, and at age 30	Yes, except for first time home buyers ($10,000 limit) and qualified education costs	Yes, except for first time home buyers ($10,000 limit) and qualified education costs	Yes, except for first time home buyers ($10,000 limit) and qualified education costs	N/A
50% excise tax (Age 70½ minimum distributions)	No	No	No	Yes	Yes	No

These are some thoughts to consider about saving for college expenses. Your financial and tax advisors can provide additional information and should be consulted before any action is taken.