Comparison of College Funding Strategies

529 Savings Plans are tax-favored college savings plans, usually administered by a state government, and typically invested in a combination of stocks and bonds. They offer an opportunity for tax-sheltered investing.

• Tax-sheltered growth, and under current law, no tax on withdrawals if funds are used for qualified educational expenses.
• Balances are transferable from one child to another.
• Some states allow a per-child state income tax deduction.
• You can shop for the best plan.
• The child does not control the account.
• High allowed contribution amounts

• The law sheltering 529 earnings sunsets in 2010.
• High and complicated fees.
• Hard to choose particular plans and hard to keep up with plan changes — lots of important fine print.
• Ordinary income taxes and a 10 percent penalty tax if you withdraw funds for anything other than qualified educational expenses.
• Can only make cash contributions — no stock.
• Little control over invesment strategy.
• Losses are itemized miscellaneous deductions, not matched against other gains.
• Could hurt financial aid eligibility.
• Investment risk associated with stocks.
• Unpredictable state income tax impact.

Prepaid Tuition (529) Plans are a second kind of tax-favored college savings plan that allows investors to buy tuition credits, which count as units of attendance. They therefore shift some of the risk of rising tuition costs from the family to the plan.

(The Independent 529 Plan is a particular prepaid tuition plan run by a consortium of schools instead of a particular state. It allows families to lock in tuition at current and slightly discounted prices by buying tuition certificates for participating schools.)

• Same as 529 plans.
• Shifts risk of tuition increase away from the family to the plan.
• The independent 529 plan has an increasing number of participating schools.

• Same as 529 plans.
• Purchased certificates cover only tuition and not other expenses.
• In the Independent 529 plan, funds not used for college expenses at an eligible school earn an investment return that is banded by plus or minus two percent a year.

U.S. Savings Bonds-Special Rules: EE Savings Bonds bought after 1989 by someone 24 years or older are exempt from federal income tax when used for qualified education expenses if the owner meets strict income and other eligibility requirements in the year the bonds are redeemed.

Modest potential tax break for lower to middle income parents.

Strict eligibility rules: In the year the bond is liquidated, the tax exemption is fully phased out once the owner's modified adjusted gross income exceeds $74,850 for single filers and $119,750 for joint filers. The exemption is also reduced by the use of scholarships, Hope/Lifetime Learning Credits, and 529 plan benefits. Savings bonds are counted as an asset of the owner in financial aid calculations.

An Educational IRA (Coverdell Education Savings Account) is a tax-sheltered account that accepts annual non-deductible contributions up to an annual IRS specified limit.

• Earnings are tax-free if used for qualified educational expenses.
• The money may be used for college and also pre-college education expenses, such as a home computer for a middle school child or nursery school tuition.
• Self-direction; control over investments.

• Income eligibility applies to contributors. (For single taxpayers, contribution eligibility phases out as adjusted gross income rises from $95,000 to $110,000, and at double these amounts for married couples.)
• Low contribution limit of $2,000/year.
• Tax breaks scheduled to sunset in 2010.
• Adverse effect on financial aid eligibility.
• Could reduce applicability of Hope and Lifetime Learning Credits.

A Custodial Account is a financial account established in the child's name with a parent or other adult listed as the custodian.

• Can lower the family's total taxable income: Once the child turns 14, the first $750 in earnings are tax-free and the next $750 in earnings are taxed at the child's rate (usually 10-15 percent for ordinary income and about 5 percent for capital gain income).
• Self-direction; control over investments.
• No contribution limits except gift rules.
• Facilitates gradual gifting to a minor.

• Contributions are an irrevocable gift to the child.
• The child gains access to the account at age of majority.
• Detrimental to financial aid eligibility.
• If balances are small, investment options can be limited and expensive.

An Inflation-Indexed Bond (I-Bond) is a government savings bond whose principal changes with inflation. It is redeemable after 12 months with a three-month interest penalty, and after five years with no penalty.

• Inflation protection.
• Taxes deferred until bond is redeemed.
• Exempt from state income tax.
• Good birth gifts for families not likely to be eligible for financial aid if titled in the child's name.

• Not perfectly liquid.
• Subject to federal income tax.
• Low expected returns relative to stocks.
• Cannot be consolidated into brokerage account.
• Annual purchases limited to $30,000 per person if purchased through a bank, plus an additional $30,000 per person if purchased online at www.treasurydirect.gov.

Hope Scholarship Tax Credit - A tax credit to 100% of the first $1,000 of qualified education expenses plus 50 percent of the next $1,000 per student per year.

Lifetime Learning Credit - a tax credit of 20 percent up to $10,000 of qualified expenses per taxpayer per year.

• Offers significant tax advantage if taxpayer meets strict income eligibility limits.
• Lifetime Learning Credit is available if student is enrolled in just one course at an eligible institution.

• Hope Credit is only available for full-time students in the first two years of post-secondary education, at an eligible institution, with no prior conviction for a felony drug offense for possession or distribution.
• Eligible expenses are first reduced by tax-free distributions from Coverdell Education Savings Accounts, plus other education assistance (other than gifts) that is excludable from gross income.
• Eligibility starts to diminish as adjusted gross income increases beyond $42,000 for single filers and $85,000 for joint filers.

A Federal Pell Grant is a federally funded grant available for eligible students.

Does not have to be repaid.

• $4,050 annual maximum award limit.
• Only for those with exceptional financial need.

A subsidized FFEL or direct Stafford loan is a student loan whose interest is paid by the U.S. Department of Education while a student is enrolled in school.

• Interest starts accruing after graduation
• Low interest rate.
• Also available to graduate students.
• Interest payments are deductible up to $2,500 per year, pending income and other limits.

• $2,625 to $8,500 annual limit depending on year in school.
• You must qualify for financial aid to get it.

An unsubsidized FFEL or direct Stafford loan is a student loan whose interest accrues while student is enrolled in school.

• Low interest rate.
• Also available to graduate students.
• Interest payments are deductible up to $2,500 per year, pending income and other limits.

• $2,625 to $8,500 annual limit (including any subsidized amounts awarded during same period) depending on year in school.
• Interest begins to accrue immediately.

A federal PLUS loan is a federally insured loan available to parents.

• Low interest rates.
• No annual maximum award limit.
• Interest payments are deductible up to $2,500 per year, pending income and other limits.

• Available only to parents of dependent undergraduate students.
• Interest begins to accrue immediately.