Saving for College eBook

Saving for [email protected]

www.LifeFocus.com

LifeFocus.comT. Young

March 28, 2010

Table of ContentsEstimating College Costs ..................................................................................................................................12

What is the forecast for college cost increases? ......................................................................................12

Why can't colleges keep their prices down? ............................................................................................ 12

What expenses are included in the cost of college? ................................................................................12

Why you should start saving early ........................................................................................................... 12

How much do you need to save? .............................................................................................................13

College Saving Options .................................................................................................................................... 14

College costs ............................................................................................................................................14

College savings options ........................................................................................................................... 14

Factors that may affect college savings decisions ...................................................................................15

Discussing a college funding plan with your child ....................................................................................17

Dilemma of saving for college and retirement ..........................................................................................17

529 Plans (Qualified Tuition Programs) ........................................................................................................... 18

Introduction ............................................................................................................................................. 18

College savings plans ............................................................................................................................. 18

Prepaid tuition plans ................................................................................................................................18

Selecting a specific 529 plan ...................................................................................................................18

Managing your 529 account ....................................................................................................................18

Financial aid and 529 plans .................................................................................................................... 19

Questions & Answers ..............................................................................................................................19

Custodial Accounts (UTMA/UGMA) for Education Savings ..............................................................................21

What is it? ................................................................................................................................................ 21

When can it be used? .............................................................................................................................. 22

Strengths ..................................................................................................................................................22

Tradeoffs ..................................................................................................................................................23

How to do it .............................................................................................................................................. 23

Tax considerations ...................................................................................................................................23

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March 28, 2010See disclaimer on final page

Coverdell Education Savings Accounts ............................................................................................................ 25

What is it? ................................................................................................................................................ 25

Requirements ...........................................................................................................................................25

Strengths ..................................................................................................................................................26

Tradeoffs ..................................................................................................................................................27

How to do it .............................................................................................................................................. 27


Rollovers .................................................................................................................................................. 29

Transfers ..................................................................................................................................................29

Questions& Answers ................................................................................................................................29

Managing Expenses During the College Years ................................................................................................ 31

Introduction .............................................................................................................................................. 31

Savings .................................................................................................................................................... 31

Financial aid .............................................................................................................................................31

Education tax credits and deductions ...................................................................................................... 31

Out-of-pocket contributions ......................................................................................................................32

Other creative solutions ........................................................................................................................... 32

Applying for Financial Aid ..................................................................................................................................33

What is financial aid? ............................................................................................................................... 33

Who offers financial aid? ..........................................................................................................................33

Overview of the financial aid process .......................................................................................................33

The two formulas for calculating EFC ...................................................................................................... 34

How exactly is my EFC calculated under the federal methodology? ....................................................... 34

Steps to reduce your EFC under the federal methodology ......................................................................37

The institutional methodology vs. the federal methodology ..................................................................... 37

Steps in applying for financial aid .............................................................................................................38

Types of financial aid programs ............................................................................................................... 41

Do colleges award financial aid resources in a specific order? ................................................................42

Should you apply for financial aid even if you don't think your family will qualify? ...................................42



Positioning Your Income/Assets to Enhance Financial Aid Eligibility ................................................................43

What does it mean to enhance your financial aid eligibility? ....................................................................43

Strengths ..................................................................................................................................................43

Tradeoffs ..................................................................................................................................................43

Strategies to reduce available income ..................................................................................................... 44

Strategies to reduce available assets ...................................................................................................... 44

Saving for College and Retirement ................................................................................................................... 46

What is it? ................................................................................................................................................ 46

First, determine your monetary needs .................................................................................................... 46

You've come up short: what are your options? ........................................................................................ 46

How do you decide what strategy is best for you? ...................................................................................48

Can retirement accounts be used to save for college? ............................................................................49

Summary of Tax-Advantaged College Savings Options ...................................................................................50

College Savings Vehicles Compared ................................................................................................................52

529 Plans: Direct-Sold College Savings Plans ................................................................................................. 54

529 Plans: Advisor-Sold College Savings Plans ...............................................................................................61

529 Plans: Prepaid Tuition Plans ......................................................................................................................67

Advantages and Disadvantages of 529 Plans .................................................................................................. 70

Advantages and Disadvantages of U.S. Savings Bonds for College Savings .................................................. 72

Advantages and Disadvantages of Custodial Accounts for College Savings ................................................... 73

Advantages and Disadvantages of Coverdell Education Savings Accounts .....................................................74

529 Plans vs. Coverdell Education Savings Accounts ......................................................................................75

Investing for Major Financial Goals ...................................................................................................................77

How do you set goals? .............................................................................................................................77

Looking forward to retirement .................................................................................................................. 77

Facing the truth about college savings .....................................................................................................78

Investing for something big ...................................................................................................................... 78

The Best Ways to Save for College .................................................................................................................. 79

529 plans ................................................................................................................................................. 79



529 plans: college savings plans ............................................................................................................. 79

529 plans: prepaid tuition plans ............................................................................................................... 80

Coverdell education savings accounts .....................................................................................................80

Custodial accounts ...................................................................................................................................81

U.S. savings bonds .................................................................................................................................. 82

Financial aid impact ................................................................................................................................. 82

Saving for Retirement and a Child's Education at the Same Time ................................................................... 84

Know what your financial needs are ........................................................................................................ 84

Figure out what you can afford to put aside each month ......................................................................... 84

Retirement takes priority .......................................................................................................................... 84

If possible, save for your retirement and your child's college at the same time ....................................... 85

Help! I can't meet both goals ....................................................................................................................85

Can retirement accounts be used to save for college? ............................................................................86

Sticker Shock: Creative Ways to Lower the Cost of College ............................................................................ 87

Ask about tuition discounts and flexible repayment programs .................................................................87

Graduate in three years instead of four ....................................................................................................87

Earn college credit while still in high school .............................................................................................87

Think about cooperative education .......................................................................................................... 87

Enroll in a community college, then transfer to a four-year college ......................................................... 87

Defer enrollment for a year ...................................................................................................................... 88

Live at home ............................................................................................................................................ 88

Consider distance learning .......................................................................................................................88

Work part-time throughout the college years ........................................................................................... 88

Join the military ........................................................................................................................................ 88

Go to school in Canada ............................................................................................................................88

Check to see if your employer offers any educational assistance ........................................................... 88

Have grandparents pay tuition directly to the college .............................................................................. 89

ABCs of Financial Aid ....................................................................................................................................... 90

What is financial aid? ............................................................................................................................... 90



Need-based aid vs. merit aid ................................................................................................................... 90

Sources of merit aid ................................................................................................................................. 90

Sources of need-based aid ...................................................................................................................... 90

How is my child's financial need determined? ......................................................................................... 91

How does financial need relate to my child's financial aid award? .......................................................... 91

How much should our family rely on financial aid? .................................................................................. 92

The ABCs of 529 Plans .....................................................................................................................................93

The history of 529 plans ...........................................................................................................................93

What exactly is a 529 plan? ..................................................................................................................... 93

College savings plans .............................................................................................................................. 93

Prepaid tuition plans .................................................................................................................................94

What's so special about 529 plans? .........................................................................................................94

What are the drawbacks of 529 plans? ....................................................................................................95

Choosing a College Savings Plan .....................................................................................................................97

Compare the plans offered by different states ......................................................................................... 97

Consider the plan's account ownership and beneficiary designation rules ..............................................97


Number and type of investment vehicles offered .....................................................................................98

Contribution rules .....................................................................................................................................99

Costs and fees ......................................................................................................................................... 99

College Savings Plans vs. Prepaid Tuition Plans ............................................................................................. 100

How does each plan work? ......................................................................................................................100

Who can offer these plans? ..................................................................................................................... 100

How are your contributions invested with each type of plan? .................................................................. 100

Are there any restrictions on joining either type of plan or accessing the funds? .................................... 101

What education expenses are covered by each plan? ............................................................................ 101

What are the fees and expenses associated with each type of plan? ..................................................... 102

What is the income tax treatment of withdrawals from each plan? ..........................................................102

What impact does each type of plan have on financial aid? .................................................................... 103



Opening a 529 Account .................................................................................................................................... 104

Completing an account application .......................................................................................................... 104

Naming a beneficiary ............................................................................................................................... 104

Choosing an investment option ................................................................................................................104

Making an initial contribution ....................................................................................................................105

Managing the account ..............................................................................................................................105

529 Plans: The Ins and Outs of Contributions and Withdrawals .......................................................................106

How much can you contribute? ................................................................................................................106

How little can you start off with? ...............................................................................................................106

Know your other contribution rules ...........................................................................................................106

Maximizing your contributions ..................................................................................................................107

Lump-sum vs. periodic contributions ........................................................................................................107

Qualified withdrawals are tax free ............................................................................................................107

Beware of nonqualified withdrawals .........................................................................................................107

Is timing withdrawals important? ..............................................................................................................108

Making Changes to Your 529 Account ..............................................................................................................109

Changing the beneficiary ......................................................................................................................... 109

Changing the account owner ................................................................................................................... 109

Changing your investment options ...........................................................................................................109

Changing your monthly contributions .......................................................................................................110

Switching to a new 529 plan .................................................................................................................... 110

529 Plans and Financial Aid Eligibility ...............................................................................................................111

First, why should you be concerned? .......................................................................................................111

A general word about financial aid ...........................................................................................................111

How is your child's financial need determined? ....................................................................................... 111

The federal methodology and 529 plans ..................................................................................................112

The federal methodology and other college savings options ...................................................................112

The institutional methodology and 529 plans ...........................................................................................112

Income Tax Planning and 529 Plans ................................................................................................................ 114



Federal income tax treatment of qualified withdrawals ............................................................................ 114

State income tax treatment of qualified withdrawals ................................................................................114

Income tax treatment of nonqualified withdrawals (federal and state) .....................................................114

Deducting your contributions to a 529 plan ..............................................................................................114

Coordination with the Coverdell education savings account and education tax credits ...........................115

Estate Planning and 529 Plans .........................................................................................................................116

Overview of gift and estate tax rules ........................................................................................................116

Contributions to a 529 plan are treated as (federal) gifts to the beneficiary .............................................116

Special rule if you contribute over $13,000 in a year ............................................................................... 116

What about gifts from a grandparent? ......................................................................................................117

What if the owner of a 529 account dies? ................................................................................................117

What if the beneficiary of a 529 account dies? ........................................................................................ 117

529 Plans vs. Coverdell Education Savings Accounts ......................................................................................119

Definitions ................................................................................................................................................ 119

Contribution limits and restrictions ........................................................................................................... 119

Income tax treatment ............................................................................................................................... 119

Control of the account ..............................................................................................................................120

Gift tax ......................................................................................................................................................120

Federal financial aid .................................................................................................................................121

Can you have both? .................................................................................................................................121

Legislative impact .....................................................................................................................................121

529 Plans vs. Other College Savings Options .................................................................................................. 122

U.S. savings bonds .................................................................................................................................. 122

Mutual funds ............................................................................................................................................ 123

Custodial accounts ...................................................................................................................................123

Trusts ....................................................................................................................................................... 124

Legislative impact .....................................................................................................................................124

Are college savings plans a good way to save for college? ..............................................................................125

How can I save for my child's college education? .............................................................................................126



Can an UGMA/UTMA account reduce my child's financial aid for college? ......................................................127

Should I use my 401(k) to fund my child's college education? ......................................................................... 128

Should I open a Coverdell education savings account? ................................................................................... 129

Should I save for college in my name or my child's name? .............................................................................. 130

Do Series EE bonds offer any special advantages if used for college savings? ...............................................131

How can we possibly save for retirement and our child's college education at the same time? .......................132

Help! My child is only two years away from college and we haven't saved much. What should we do? ..........133

What is the CollegeSure CD? ........................................................................................................................... 134

Should I establish a trust for my child's college education fund? ......................................................................135

What is the college inflation rate? ..................................................................................................................... 136

What expenses are included in the annual cost of college? ............................................................................. 137

Are there any ways to lower the cost of college? ..............................................................................................138

How long have 529 plans been around? .......................................................................................................... 139

Why are these plans referred to as "529" plans? ..............................................................................................140

Do 529 plans include both college savings plans and prepaid tuition plans? ................................................... 141

What's the difference between college savings plans and prepaid tuition plans? ............................................ 142

How many states currently have 529 plans? .................................................................................................... 143

Who can legally offer 529 plans? ......................................................................................................................144

How do I know whether to choose a college savings plan or a prepaid tuition plan? ....................................... 145

Can I invest in any state's 529 plan, or am I limited to my own state's plan? ................................................... 146

I've decided on a college savings plan, but how do I go about choosing one? .................................................147

Can my spouse and I open a joint 529 account for our child? .......................................................................... 148

If I open a 529 account, will my child's choice of college be restricted? ........................................................... 149

Can I open a 529 account for a nonrelative? .................................................................................................... 150

Is there an income limit on who can open an account? .................................................................................... 151

Can more than one account be opened for the same child? ............................................................................ 152

How do I enroll in a state's 529 plan? ............................................................................................................... 153

Can I open a 529 account in anticipation of my future grandchild? .................................................................. 154

Can I open a 529 plan with a lump sum? ..........................................................................................................155



What happens if I open a 529 plan in one state and then move to another state? ...........................................156

Are there rules on who can open a 529 account? .............................................................................................157

Can a non-U.S. citizen open a 529 account? ....................................................................................................158

Does it make sense to open a 529 account if my child is only two years away from college? ......................... 159

I have two children. Should I open one account for both children or one account for each child? ................... 160

What expenses and fees are generally associated with 529 plans? .................................................................161

Do 529 plan expenses vary among states? ......................................................................................................162

Who can be a beneficiary of a 529 plan? ..........................................................................................................163

Is there an age limit on who can be a beneficiary of a 529 plan? ..................................................................... 164

Can a 529 account have more than one beneficiary? .......................................................................................165

Can I open a 529 account and name myself as beneficiary? ........................................................................... 166

Can I change the beneficiary of a 529 account? ...............................................................................................167

Under what circumstances can the account owner of a 529 plan be changed? ...............................................168

Can I roll over my existing 529 account to another state's 529 plan without penalty? ......................................169

Can I move funds from my Coverdell education savings account to a 529 plan? .............................................170

Does it make sense to cash in my prepaid tuition plan and contribute to a college savings plan? ...................171

Is my rate of return guaranteed under a 529 plan? ...........................................................................................172

What's the difference between how a college savings plan and a prepaid tuition plan invests? ...................... 173

Does a college savings plan allow me to choose my own investments? ..........................................................174

What recourse do I have if I'm unhappy with my college savings plan's investment performance? ................. 175

How often can I make contributions to my child's 529 account? .......................................................................176

Can I contribute my own stocks and bonds to the 529 account I've set up for my child? ................................. 177

How much can I invest in a 529 plan? .............................................................................................................. 178

Can contributions to a 529 plan be directly debited from my checking account? ............................................. 179

What's the difference between how a college savings plan and a prepaid tuition plan invests? ...................... 180

I'm contributing to a 529 plan for my grandchild. What about Medicaid spend-down requirements? ............... 181

Can I contribute to a 529 account and a Coverdell ESA in the same year for the same beneficiary?• •• ......... 182

Can I deduct my contributions to my 529 account? .......................................................................................... 183

Will I pay income tax when the money in my 529 plan is withdrawn to pay for college expenses? ..................184



Will I be penalized if the money in my 529 plan isn't used for college expenses? ............................................185

I'd like to make a lump-sum contribution to my grandchild's 529 account. Will I owe gift tax? ......................... 186

I opened a college savings plan from a different state. Will I get that state's tax benefits? .............................. 187

The Economic Growth and Tax Relief Reconciliation Act contains sunset provisions. Should I worry? ...........188

I opened a 529 plan with my child as beneficiary. If my mother contributes, is that a gift to me? .....................189



Estimating College Costs

What is the forecast for college cost increases?

You've seen the charts--a college education is expensive. All those benefits of personal growth, expanded horizons, and increased lifetime earning power come at a price, a price that increases every year. For the 2009/2010 academic year, the average cost of attendance at a four-year public college for in-state students is $19,388, the average cost of attendance at a four-year public college for out-of-state students is $30,916, and the average cost of attendance at a four-year private college is $39,028. (Source: The College Board's 2009 Trends in College Pricing Report.) The trend of annual college costs outpacing inflation is expected to continue.

Why can't colleges keep their prices down?

There are many reasons why colleges have a hard time holding down their price increases to the rate of inflation. For one thing, higher education is labor intensive. For another, there are a variety of extra costs that colleges must absorb, like recruiting, technology (all those computers and networks), and building maintenance costs. Couple this with the reality that parents increasingly expect more bang for the buck, everything from modernized career centers to state-of-the-art recreational facilities and medical centers.

What expenses are included in the cost of college?

In the academic world, the cost of college is generally referred to as the cost of attendance (COA). Each college has its own COA. The COA consists of five items:

• Tuition and fees: These expenses are generally the same for all students.

• Books and supplies: These expenses can vary depending on the courses selected.

• Room and board: These expenses can vary depending on where the student lives (e.g., dorm, off-campus apartment, at home) and the meal plan chosen.

• Transportation: This expense can vary depending on how far the student lives from the college. It can involve daily commuting expenses, three round-trip flights home a year, or anything in between.

• Personal expenses: This category varies greatly among students. It can include telephone bills, health insurance, late-night pizzas, personal spending money, or even day-care bills.

Twice per year, the federal government recalculates the COA for each college and then adjusts the figures for inflation. The government then uses the COA figures to determine your child's particular financial need come financial aid time.

Why you should start saving early

Next to buying a home, a college education is the largest expenditure most parents will ever make (and perhaps the biggest expenditure when more than one child is in the family picture). Faced with such a daunting task, you might be inclined to ignore the problem and wait until you are more financially settled before you start saving. But that would be a mistake.

The key to sanity in the area of education planning is advance planning. The earlier in the process you become informed about the potential costs and your saving options, the greater chance you will start saving. And the more money you save now, the less money you or your child will need to borrow later.

It is important to begin saving as early as possible so you can earn interest, dividends, and/or capital gains on as



much money as possible. With a long-term savings strategy, you can hopefully keep ahead of college inflation.

Regular investments add up over time. By investing even a small amount of money on a regular basis, you have the potential to accumulate a significant amount in your child's college fund. The following table illustrates how your monthly investment can grow over time (assuming an approximate 6 percent after-tax return rate):

Monthly investment 5 years 10 years 15 years

$100 $6, 977 $16,388 $29,082

$300 $20,931 $49,164 $87,246

$500 $34,885 $81,940 $145,409

Note: The above example is for illustrative purposes only and does not represent the return of any investment. There is no guarantee that your investment will realize a return and there is a risk that you will lose your investment entirely.

How much do you need to save?

How much you need to save obviously depends on the estimated cost of college at the time your child is ready to attend. Often, these numbers are staggering. For many parents, the question of how much they should save becomes how much they can afford to save.

To determine how much you can afford to save for your child's college each month, you will need to prepare a budget and examine your monthly income and expenses. Don't be discouraged if you can save only a minimal amount at first. The key is to start saving early and consistently, and to add to it whenever you can from raises, bonuses, or unexpected gifts.

After you determine how much you can save each month, you will need to choose one or more college saving options. There are many possibilities for college savings--529 plans, Coverdell education savings accounts, custodial accounts, bank accounts, and mutual funds. To help make your nest egg grow, you will want to maximize the after-tax return on your savings while minimizing risk.

Finally, keep in mind that most parents are not able to save 100 percent of their child's college education (after all, do you know anybody who purchased a home entirely with his or her own savings?). Instead, parents generally supplement their savings at college time with a combination of personal loans, financial aid (student loans, grants, scholarships, and work-study), and tax credits to cover college costs.



College Saving Options

College costs

For the 2009/2010 college year, the average annual cost of attendance (known as the COA) at a four-year public college for in-state students is $19,388, the average cost at a four-year public college for out-of-state students is $30,916, and the average cost at a four-year private college is $39,028. The COA figure includes tuition and fees, room and board, books and supplies, transportation, and personal expenses. (Source: The College Board's 2009 Trends in College Pricing Report.)

College savings options

It is important for parents to start putting money aside for college as early as possible. But where should you put your money? There are many possibilities, each with varied features. For example, some options offer tax advantages, some are more costly to establish, some charge management fees, some require parental income to be below a certain level, and some impose penalties if the money is not used for college.

Following is a list of options:

• 529 college savings plans

• 529 prepaid tuition plans

• Coverdell education savings accounts

• Custodial accounts (UTMA/UGMA)

• Gifting

• Series EE bonds

• Traditional IRAs and Roth IRAs

• Employer-sponsored retirement plans

• Employee stock purchase plans

• Cash value life insurance

• 2503 (c) trusts

• Crummey trusts

• Tax-deferred annuities

• Other tax-advantaged strategies

• Prepay mortgage

• CollegeSure CD

• Options unique to business owners



Factors that may affect college savings decisions

When investing for college, there are several factors to consider.

Tax advantages

Money saved for college goes a lot further when it's allowed to accumulate tax free or tax deferred. To come out ahead in the college savings game, it's wise to consider tax-advantaged strategies.

Example(s): Assume that every year you put money away in a non tax-advantaged investment that earns 9 percent. If your earnings are subject to a 33 percent tax rate (federal and state), your after-tax return is 6 percent.

Example(s): Now assume you put the same amount of money every year into a tax-advantaged vehicle, such as a 529 plan that earns 9 percent per year. If you later withdraw the money to pay qualified education expenses, you have no tax liability. So, your after-tax return is 9 percent.

Example(s): The result is that in some cases your return can be 50 percent greater with a tax-advantaged strategy like a Coverdell ESA than with an investment that offers no special tax advantages (although there is no guarantee that an investment will generate any earnings).

Tip: Due to provisions in the Jobs and Growth Tax Relief Reconciliation Act of 2003 that reduced the tax rates on dividends and long-term capital gains, the comparative advantage of tax-advantaged strategies over non tax-advantaged strategies is somewhat lessened. (However, the reduced tax rates for dividends and long-term capital gains are scheduled to sunset, or expire, beginning in 2011.)

Kiddie tax

Many parents believe they can shift assets to their child in order to avoid high income taxes. This strategy works best if the child is generally age 24 or older. If the child is under age 24, the kiddie tax rules apply.

The basic tax rules are as follows:

• For children age 18 or under age 24 if a full-time student, the first $950 of annual unearned income (e.g., interest, dividends, capital gains) is tax free, the second $950 is taxed at the child's rate, and any unearned income over $1,900 is taxed at the parents' rate. This latter tax is referred to as the kiddie tax. So, after the first $1,900 of investment income, a child under age 24 will end up paying the same tax as if the parents had retained the asset.

• For children age 24 or older, the first $950 of annual unearned income is tax free, and all earnings over $950 are taxed at the child's rate. if the child is in a lower percent tax bracket, the child will pay less tax than his or her parents would pay on the same income.

Tip: One way parents may avoid the kiddie tax is to put their child's savings in tax-free or tax-deferred investments so that any taxable income is postponed until after the child reaches age 24 (when the child is taxed at his or her own rate). Such investments can include Series EE bonds (may also be called Patriot bonds) or tax-free municipal bonds. Alternatively, parents can try to hold just enough assets in their child's name so that the investment income remains under $1,900.

Financial aid

Whether or not a child will qualify for financial aid (e.g., loan, grant, scholarship, or work-study) may affect parental savings decisions. The majority of financial aid is need-based, meaning that it's based on a family's ability to pay.

Predicting whether a child will qualify for financial aid many years down the road is an inexact science. Some



families with incomes of $100,000 or more may qualify for aid, while those with lesser incomes may not. Income is only one of the factors used to determine financial aid eligibility. Other factors include amount of assets, family size, number of household members in college at the same time, and the existence of any special personal or financial circumstances.

If a child is expected to qualify for financial aid (and most do), parents should be aware of the formula the federal government uses to calculate aid--called the federal methodology--because there can be a financial aid impact on long-term savings decisions. The more money a family is expected to contribute to college costs, the less financial aid a child will be eligible for.

Briefly, under the federal methodology, parents are expected to contribute 5.6 percent of their assets to college costs each year, and students are expected to contribute 20 percent of their assets each year.

Example(s): For example, $20,000 in your child's savings account would translate into a $4,000 expected contribution ($20,000 x.20), but the same money in your account would result in a $1,120 expected contribution ($20,000 x.056).

Also, the federal methodology excludes some parental assets from consideration in determining a family's total assets:

• Retirement accounts (e.g., IRA, 401(k) plan, 403(b) plan, Keogh plan)

• Home equity in a primary residence or family farm


• Annuities

Thus, all options being equal, parents may choose to put their money into one or more of these nonassessable assets.

Caution: Although the federal government excludes these assets, individual colleges have discretion whether to consider them in determining a family's ability to pay college costs.

Time frame

Time frame is a very important consideration. Is the child in preschool or a freshman in high school? Obviously, most college savings strategies work best when the child is many years away from college. With a longer time horizon, parents can be more aggressive in their investments and have more years to take advantage of compounding.

When the child is a baby up until about middle school, most professional financial planners recommend putting more money into equity investments because historically, over the long term, equities have provided higher returns than other types of investments (though past performance is no guarantee of future results). Then, as the child moves from middle school to high school, it's usually wise for parents to start shifting a portion of their equities toward shorter-term, fixed income investments.

If the time frame is only a few years, parents will be limited in their choice of appropriate strategies. For example, if the child were in high school, equities normally would not be a preferred strategy due to the short-term volatility of these investments. Similarly, parents would not have enough time to build up cash value in a life insurance policy.

Amount of money available to invest

The amount of money parents have to invest at a particular time might affect their savings strategies. For example, if parents have only a small amount of money to invest, trusts probably aren't the best option because they are typically more costly to establish and maintain than other college saving options. In this case, a 529 plan may be more appropriate.



Control issues

Generally, when parents give money or property to their child, they lose control of those assets. Such a loss of parental ownership can take place immediately, as in the case of an outright gift of stock certificates, or it may be delayed, as in the case of a custodial account or trust. In any event, parents must assess their personal feelings about relinquishing control of assets to their child. Some children may not be mature enough to handle such assets, whereas others can be counted on to use them for college costs.

Discussing a college funding plan with your child

As college expenses continue to rise relative to the means of the average family to pay such costs in full, parents may find it helpful to sit down with their older children and discuss ways to pay for college. For example, parents may want to discuss:

• Whether they intend to fund 100 percent of college costs or whether they expect their child to contribute and, if so, in what amount. For example, parents might convey their expectation that their child contribute a certain percentage of all earnings from a part-time job or a portion of all gifts.

• Whether the child will play a role in the savings strategy. For example, parents who want to gift appreciated stock to their child should convey their expectation that the child will apply all of the gains to college costs.

• Whether any money will need to be borrowed, and if so, how much and in whose name the loan(s) will be obtained. The amount that needs to be borrowed may affect the type of college the child applies to (e.g., public or private, top tier or middle tier).

• Whether there will need to be shared financial responsibility during the college years. For example, the child may need to participate in a work-study program or obtain outside work during the college years.

Communicating these expectations ahead of time can prevent unpleasant surprises and help parents and their children better plan for the expenses that lie ahead. Also, an open discussion can give children an increased awareness of the financial burden their parents may be undertaking on their behalf.

Dilemma of saving for college and retirement

For many parents, especially those who started families in their 30s and 40s, the problem of saving for college and retirement at the same time is a nagging reality. Most financial planning professionals recommend saving for both at the same time. The reason is that parents typically can't afford to delay saving for their retirement until the college years are over, because doing so would mean missing out on years of tax-deferred growth and, possibly, employer-matching 401(k) plan contributions.

The key to saving for both is for parents to tailor their monthly investment to the particular investment goal--college or retirement. Parents will then need to determine their time frames and liquidity needs for each goal, which may require the assistance of a financial planning professional.



529 Plans (Qualified Tuition Programs)

Introduction

Since their introduction nearly a decade ago, Section 529 plans have revolutionized the way parents, grandparents, and others save for college. Americans have poured billions of dollars into 529 plans, and contributions are expected to keep flowing in the years ahead. What makes these plans so special? The primary advantage of 529 plans is that funds in the plan are free from income tax at the federal level when used to pay the beneficiary's qualified education expenses. Plus, anyone can open a 529 account, regardless of income level or state of residence.

There are two types of 529 plans--college savings plans and prepaid tuition plans. Each works differently, and it's important to understand these differences before you open an account in a 529 plan.

Tip: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about specific 529 plans is available in each issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.

Caution: Fees and expenses are typically associated with opening and/or maintaining a 529 account (e.g., annual maintenance and administration fees, and investment expenses based on a percentage of your total account value)

College savings plans

A college savings plan lets you save money for college in an income tax-deferred investment account. The account is managed by an experienced financial institution designated by the state. When you open an account, you name your child (or grandchild or other friend or relative, as the case may be) as beneficiary. You also choose or are assigned an investment portfolio for the investment of your contributions. You then contribute as much or as little money as you like, subject to the plan's limits.

Prepaid tuition plans

A prepaid tuition plan lets you prepay tuition expenses at participating colleges for use in the future, allowing you to lock in current tuition costs and gain some peace of mind over spiraling college costs. There are two types of prepaid tuition plans--those that are offered by the states, and those that are offered by colleges. Generally, state prepaid tuition plans are open only to state residents, while college prepaid tuition plans are open to everyone. Note: Unless specifically noted, all references are to state prepaid tuition plans.

Selecting a specific 529 plan

There are many factors you should consider when deciding between a college savings plan and a prepaid tuition plan. In the case of college savings plans (which generally allow nonresidents to join), you should compare several characteristics that can make these plans differ from state to state. For example, investment options and flexibility, fees, state tax treatment, and contribution rules can vary widely.

Managing your 529 account

Once you select a particular 529 plan and open an account, you'll need to understand your plan's rules about plan contributions and, later, plan withdrawals. Though most plans operate under the same federal guidelines, there is room for innovation within individual plans. You may also want to understand if it's better to make



lump-sum or periodic contributions, and learn about ways to maximize your contributions.

Financial aid and 529 plans

At college time, a 529 plan may impact how much financial aid a student receives. Specifically, parent-owned 529 plans are factored into the aid determination.

Questions & Answers

Why are these plans referred to as "529" plans?

College savings plans and prepaid tuition plans are often referred to as 529 plans because they are governed by Section 529 of the Internal Revenue Code. Section 529 officially refers to these plans as "qualified tuition programs," or QTPs.

Tip: In many instances, the term "529 plan" is used interchangeably with "college savings plan," but this use is not completely accurate. A college savings plan is only one type of 529 plan; a qualifying prepaid tuition plan is the other.

How long have 529 plans been around?

Section 529 plans, officially called qualified tuition programs, or QTPs, were created by the federal government with passage of the Small Business Job Protection Act of 1996, a piece of legislation that actually had little to do with college savings. These plans were later modified by the Taxpayer Relief Act of 1997, the Economic Growth and Tax Relief Reconciliation Act of 2001, and the Pension Protection Act of 2006.

Who offers 529 plans?

It depends on the type of 529 plan. There are two types of 529 plans--college savings plans and prepaid tuition plans. With college savings plans, only states are allowed to operate them. With prepaid tuition plans, both states and colleges are allowed to operate them.

Tip: As a practical matter, states designate an agent (usually a financial institution or other professional money manager) to manage and administer their particular college savings plan or prepaid tuition plan.

Is the rate of return guaranteed under a 529 plan?

That depends on the type of 529 plan--a college savings plan or a prepaid tuition plan. College savings plans don't guarantee your return. Your contributions go into individual investment portfolios that you choose, and the value of your account could rise or fall (similar to a 401(k) plan). Although you could potentially earn a higher rate of return with a college savings plan, you could lose money.

Prepaid tuition plans, however, generally guarantee you a minimum rate of return to ensure that you keep pace with college inflation. In effect, you prepay tuition in today's dollars for use in the future, enabling you to "lock in" future tuition at today's prices. However, prepaid tuition plans generally limit you to the rate of return promised by the plan--you won't be entitled to any excess investment gains.

Is income tax due when money in a 529 plan is withdrawn to pay for college expenses?

No federal income tax is due on distributions from a 529 plan (college savings plan or prepaid tuition plan) that are used to pay qualified education expenses. (Distributions include both your original contributions plus any earnings.) Qualified education expenses may include tuition, fees, books, and room and board for college and graduate school.

However, state income tax treatment may differ; check the laws of your state.



Is there a penalty if money in a 529 plan isn't used for college expenses?

Yes. If you use the money for any other purpose, the earnings portion of your distribution will be taxable on your federal (and possibly state) income tax return in the year of the distribution. Also, you must pay a 10 percent federal penalty on the earnings portion of your distribution (there are a couple of exceptions--the penalty is not charged if you terminate the account because the beneficiary has died or become disabled, or if you withdraw funds equal to the amount of a scholarship that the beneficiary has received).

The "distributee" is the one subject to tax (this is the person who actually receives the money from the 529 plan). In most situations, this will be the account owner. However, some plans specify who the distributee is, while others allow the account owner to determine the recipient of a nonqualified withdrawal.



Custodial Accounts (UTMA/UGMA) for Education Savings

What is it?

A custodial account is an account established at a financial institution for the benefit of a minor child and managed by the parent or another designated custodian. A custodial account is established under a particular state's Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA).

Any money placed in a custodial account is gifted irrevocably to your child. While the child is a minor under the age of 18 or 21 (depending on the state), the money is controlled by the custodian and can be used only for the benefit of the child. Any income earned by the account is taxed to the child (though certain children are subject to the kiddie tax). When the child reaches the relevant age, the custodianship ends and the child assumes sole control of the money.

No separate legal forms or trust documents are required to establish the custodial account.

The custodian must comply with the particular state's UTMA/UGMA statute. Generally, the custodian has broad powers regarding investments and is not accountable to a court (unlike a guardian).

Tip: Once the custodial account is established, there is no limit on who can contribute to it. So, in addition to parents, generous grandparents have a place to transfer money for the college education of their grandchildren.

Caution: The Small Business and Work Opportunity Tax Act of 2007 expanded the kiddie tax rules beginning in 2008. The expanded application of the kiddie tax rules may make custodial accounts less effective as a college savings strategy.

Differences between an UTMA account and an UGMA account

There are two differences between an UTMA custodial account and an UGMA custodial account. First, there are differences in what type of property each account may hold. The UGMA authorizes cash, bank accounts, stocks, bonds, mutual funds, and so on. The UTMA broadens these holdings to include real estate and other property, including limited partnership interests.

Second, UGMA accounts generally terminate at age 18, whereas UTMA accounts generally end at age 21, and in some states, age 25.

Most states have enacted UTMA to supersede UGMA.

Tip: It is recommended you do not commingle an UTMA account with an UGMA account, because the earlier termination date (age 18) of the UGMA account may then apply to the UTMA account.

Tip: The longer duration of UTMA accounts (up to age 25 in some states) makes them more attractive to parents than UGMA accounts, because most parents are reluctant to hand over the account assets to their 18-year-old child, who, in most cases, is just starting college. Once the child receives the money, there is no requirement it be used for college expenses, and that cross-country trip can look mighty tempting.

The kiddie tax

The kiddie tax rules apply to children who are (1) under age 18, or (2) under age 19 or a full-time student under age 24, provided the child doesn't earn more than one-half of his or her financial support. Children in these categories are taxed at their parents' rate on all unearned income over $1,900. The first $950 of unearned income is tax free and the next $950 is taxed at the child's rate.



Child's Age Investment Income Federal Tax Rate

Under 24 $0-$950 tax exempt

$951-$1,900 child's rate

over $1,900 parents' rate

24 and older $0-$950 tax exempt

over $950 child's rate

Tip: To minimize the impact of the kiddie tax, parents might consider investing their child's savings in tax-free or tax-deferred investments, so that any taxable income is postponed until after the child reaches age 24 (when the child is taxed at his or her own rate). Such investments can include U.S. savings bonds, tax-free municipal bonds, or growth stocks (which provide little, if any, current income). Alternatively, parents can try to hold just enough assets in their child's name so that the investment income remains under $1,900.

Caution: State law may limit the types of assets that can be contributed to the custodial account.

When can it be used?

You want to accumulate money for college in your child's name to take advantage of the potential tax savings

Any income earned by a custodial account is taxed to the child, not the parents. Because children are generally in a lower tax bracket than their parents, this will often result in tax savings. However, the expansion of the kiddie tax in recent years negates this advantage unless the child's annual unearned income is below a certain amount, as discussed above.

Strengths

Custodial accounts are relatively simple to establish and maintain

You can open a custodial account at your local financial institution, then simply contribute money whenever you want. Unlike a trust, there are no annual tax returns to prepare for the custodial account itself. You may need to file a tax return for the child if reportable income is high enough.

Custodial accounts exist with relatively low cost

You don't have to pay a trustee or pay an accountant to file annual tax returns. You can even save money on the custodian fee by acting as custodian yourself.

Custodial accounts provide an opportunity for tax savings

A custodial account held in a child's name creates the opportunity for tax savings, particularly for children age 24 and older because children this age are taxed at their own (presumably lower) rate on any unearned income over $950. In addition, children under age 24 can reap tax savings up to the first $1,900 of unearned income (any income over this amount is taxed at the parents' rate).

Caution: For sales and exchanges prior to May 6, 2003, individuals in marginal income tax brackets greater than 15 percent were subject to tax on most long-term capital gains at a rate of 20 percent, while individuals in the 10 or 15 percent brackets were subject to tax at a rate of 10 percent. In addition, special rules applied to property with a holding period of more than five years. Dividends were taxed at ordinary income tax rates. Absent further legislative action, these rates will again be effective beginning January 1, 2011.



Tradeoffs

Custodianship ends and child gains control of the funds at age 18 or 21 (depending on the state)

When the child reaches age 18 or 21, the custodianship ends. This means that the child assumes sole control of the funds.

There is no requirement that your child use the money for college expenses

When your child receives the money at the age of majority, there is no requirement that the money be used for college expenses. This may pose a serious problem, especially in states where children gain control of the money at age 18, when college is just beginning. By contrast, if the child receives the money at age 21, hopefully most of the money in the custodial account has already been applied to the college bills.

Loss of parental control over assets unless parent is custodian

If you choose a third party custodian, you lose the opportunity to manage and invest the account assets.

Kiddie tax rules diminish opportunity for tax savings

The kiddie tax rules apply to children who are (1) under age 18, or (2) under age 19 or a full-time student under age 24, provided the child doesn't earn more than one-half of his or her financial support. Children in these categories are taxed at their parents' rate on all unearned income over $1,900. The expansion of the kiddie tax rules in recent years may make custodial accounts less effective as a college savings strategy.

Inflexibility of UTMA/UGMA statute

A custodial account is strictly governed by the particular state's UTMA/UGMA statute, and the custodian is bound to act accordingly. There is no opportunity to customize your account (as you can with a trust).

Negative impact on your child's eligibility for financial aid

A custodial account is in your child's name and thus included in your child's assets come financial aid time. Under the federal financial aid methodology, a child is expected to contribute 20 percent of his or her assets toward college costs, while parents are expected to contribute only 5.6 percent of their assets. The more a child is expected to contribute with the funds he or she already has, the less financial aid the child will be eligible for.

How to do it

Open an account at your local financial institution

A custodial account can be opened quite easily at your local financial institution. You will need your child's Social Security number.

Contribute money to the custodial account

Once you set up the account, you control when and how money is contributed to the account.

Tax considerations

Income tax consequences for child

Any income earned in a custodial account is taxed to the child, regardless of whether it is distributed. The reason is that a custodianship is not a separate legal entity or taxpayer (unlike a trust).



Under the kiddie tax rules, children who are (1) under age 18, or (2) under age 19 or a full-time student under age 24, provided the child doesn't earn more than one-half of his or her financial support, are taxed at their parents' rate on all unearned income over $1,900. The first $950 of unearned income is tax free and the next $950 is taxed at the child's rate.

For children age 24 or older, the first $950 of unearned income is tax exempt, and any additional amounts are taxed at the child's rate.

Tip: If your child is age 24 or older and in the 10 percent or 15 percent tax bracket, the capital gains tax rate is generally 5 percent. (For tax years 2008 through 2010, individuals in the 10 percent or 15 percent tax bracket will pay no tax on most long-term capital gains and qualifying dividends.)

Caution: When the parent who establishes the custodial account has a legal obligation to support his or her child, and this obligation is satisfied from the income earned by custodial account, the income is not taxed to the child. In this situation, the parent must recognize the income under the grantor trust rules of the Internal Revenue Code. In the context of education planning, this is important in those states where a college education is considered an item of support. However, most states do not consider a college education an item of support.

Transfers to a custodial account qualify for the annual gift tax exclusion

For gift tax purposes, transfers to a custodial account qualify for the $13,000 federal annual gift tax exclusion, even though the child's possession of the account assets is delayed until the child reaches the age of majority. If you transfer more than the annual gift tax exclusion amount to a custodial account in a given year, you may owe gift tax.

Potential inclusion of custodial account in parent's estate

Property in a custodial account is included in a parent's gross estate if the parent who established the account dies while serving as custodian. This risk can be avoided if the parent who establishes the account (donor) names someone else as custodian. Because most families want to retain managerial control over the account, the donor/parent can name another close family member, such as the donor's sibling, as custodian. This way, control stays in the family without triggering the potential for inclusion of the account in the gross estate. If a non-donor spouse is chosen as custodian, it is possible for the IRS to assert estate tax inclusion for custodial funds held by the non-donor parent.



Coverdell Education Savings Accounts

What is it?

A Coverdell education savings account is a tax-advantaged educational savings account that you can establish for a child under the age of 18 (this limit does not apply to beneficiaries with special needs). The child does not need to be your dependent. Contributions to a Coverdell ESA can total up to $2,000 each year. While contributions are made with after-tax dollars, distributions used to pay qualifying education expenses are not included in income.

Caution: The following discussion refers to the provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 ("2001 Tax Act") relating to Coverdell ESA contribution rules and limits. Unless extended, these provisions will expire at the end of 2010. For tax years beginning after December 31, 2010, the contribution rules and limits that existed prior to the 2001 Tax Act would apply.

The basics

• If you meet specified income limits, you can contribute up to $2,000 per child per year to a Coverdell ESA

• Contributions must be in cash

• Contributions can be made by April 15 of the year following the tax year for which the contribution is being made

• The beneficiary must be under age 18 at the time you open the Coverdell ESA, unless the beneficiary is an individual with special needs

• You don't get a deduction for contributions that you make to a Coverdell ESA; the dollars that you contribute are after-tax dollars

• Earnings in the Coverdell ESA grow tax deferred, and the earnings portion of any distributions are income tax free as long as they are used to pay qualifying education expenses (the contribution portion is also tax free because they are made with after-tax dollars)

Qualifying education expenses

For purposes of a Coverdell ESA, qualifying education expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an accredited post-secondary school (college) that is eligible to participate in the federal student aid program. For students enrolled at least half time, qualifying education expenses also include room and board.

Qualifying education expenses also include elementary and secondary education expenses. In addition to tuition, fees, books, supplies, equipment, and room and board, qualifying elementary and secondary education expenses may include tutoring, computer equipment, Internet access, and software that is primarily educational in nature.

Tip: For purposes of taking distributions from a Coverdell ESA, qualified education expenses must be reduced by any scholarships or other financial aid received.

Requirements



You must meet income limits

If your modified adjusted gross income (MAGI) is $95,000 or less for single filers or $190,000 or less for joint filers, you can make a full $2,000 contribution to a Coverdell ESA. A partial contribution is allowed for single filers with a MAGI between $95,000 and $110,000 and joint filers with a MAGI between $190,000 and $220,000.

Contributions in the maximum amount have not already been made this year to a Coverdell ESA with the same beneficiary

You can establish and contribute to more than one Coverdell ESA (assuming you meet the income limits), but no more than $2,000 can be contributed in any calendar year on behalf of any one beneficiary.

Example(s): You set up a Coverdell ESA for your five-year-old son. You also set up a Coverdell ESA for your three-year-old daughter. You can contribute the maximum amount to your daughter's Coverdell ESA each year and the same amount to your son's Coverdell ESA each year.

Example(s): You establish a Coverdell ESA for your nephew Joe. Joe's father also establishes a Coverdell ESA for Joe. Joe's father contributes $1,900 to the Coverdell ESA that he established. You can contribute only $100 for that year to the Coverdell ESA that you established.

Tip: Individuals who receive a military death gratuity or a service member group life insurance (SGLI) program payment may contribute the funds to one or more Coverdell ESAs, and such contributions will be treated as rollover contributions and won't be subject to the normal Coverdell ESA income or contribution limits. This provision is generally effective with respect to payments made for deaths occurring on or after June 17, 2008. Also, the contribution of a military death gratuity or SGLI payment to one or more Coverdell ESAs is allowed for deaths occurring on or after October 7, 2001 but before June 17, 2008, provided the individual makes the contribution to the account no later than one year after June 17, 2009.

Beneficiary of Coverdell ESA has not yet reached age 18

When the beneficiary of a Coverdell ESA reaches age 18, no further contributions can be made. The exception is if the beneficiary is an individual with special needs, in which case there is no age limit.

Strengths

Distributions used for the beneficiary's qualified education expenses are income tax free

For distributions (withdrawals) used to pay qualified education expenses, the earnings portion of the distribution is tax exempt (contributions are also tax exempt because they're made with after-tax dollars).

Funds can be rolled over to another Coverdell ESA for a family member of the current beneficiary

A Coverdell ESA can be rolled over without tax or penalty consequences to another Coverdell ESA established for the same beneficiary, or for a family member of the original beneficiary.

Contributions are discretionary

You do not have to make a contribution to a Coverdell ESA in any given year or years. Except for limits on the maximum amount that you can contribute in a year, you can exercise complete discretion in determining how much and when to contribute.

You have control over investments

With a Coverdell ESA, you can control the underlying investments. This is usually not the case with a 529 college savings plan or prepaid tuition plan.



Distributions from a Coverdell ESA can be tax exempt in same year an education tax credit is taken

A beneficiary can take a tax-free distribution from a Coverdell ESA in the same year that he or she takes the Hope credit (renamed the American Opportunity tax credit for 2009 and 2010) or Lifetime Learning credit. (The result is the same if the beneficiary's parent takes the credit.) However, the catch is that the same qualified education expenses can't be used to qualify for the tax-free distribution and the credit.

Coverdell ESA considered parental asset for federal financial aid purposes

The federal financial aid formula counts a Coverdell ESA as a parent's asset. This means that 5.6 percent of the funds must be applied to college costs each year before a student is eligible for federal financial aid. Also, distributions that are used to pay qualified education expenses aren't counted as either parent or student income for federal financial aid purposes.

Tradeoffs

After-tax dollars are contributed

You receive no deduction for amounts contributed to a Coverdell ESA. Your contribution comes from after-tax dollars.

Ability to contribute depends on income

If your MAGI is $110,000 or more for single filers or $220,000 or more for joint filers, you can't contribute to a Coverdell ESA. A partial contribution is allowed for single filers with a MAGI between $95,000 and $110,000 and joint filers with a MAGI between $190,000 and $220,000. Otherwise, if your MAGI is $95,000 or less for single filers or $190,000 or less for joint filers, you can make a full $2,000 contribution to a Coverdell ESA.

Distributions not used to pay qualified education expenses partly subject to tax and penalty

Distributions that are not used to pay qualifying education expenses are included in the beneficiary's income to the degree that the distribution consists of earnings. All distributions are considered made partly from contributions and partly from earnings. Also, any portion of a distribution that is included in a beneficiary's income is subject to an additional 10 percent penalty tax.

Tip: The amount of any nonqualified distribution attributable to the contribution of a military death gratuity or SGLI payment is not taxable.

Any remaining funds in a Coverdell ESA must be distributed when the beneficiary reaches age 30

Any funds remaining in a Coverdell ESA when the beneficiary reaches age 30 must be distributed (except for beneficiaries with special needs). Funds distributed from a Coverdell ESA at such time are considered taxable income to the beneficiary to the extent of earnings.

Fees and expenses

There are commission costs and other fees generally associated with opening a Coverdell ESA account.

How to do it

Establish Coverdell ESA at a bank or other financial institution

Coverdell ESAs can be established at a bank or other financial institution approved by the IRS.



Make contributions

Contributions to a Coverdell ESA must be made by April 15 of the year following the year for which the contribution is made.

Tax considerations

Contributions to a Coverdell ESA are made with after-tax dollars

You receive no deduction for amounts contributed to a Coverdell ESA. Your contribution comes from after-tax dollars.

Qualifying distributions are tax free

If distributions are used to pay qualifying education expenses, the earnings portion of the distribution is tax exempt (the contribution portion is also tax free because they are made with after-tax dollars).

Portion of nonqualifying distribution is included in income and subject to 10 percent penalty tax

When a beneficiary takes a distribution from a Coverdell ESA but does not have qualifying education expenses in that tax year, the portion of the distribution that represents earnings is included in the beneficiary's income. This portion of the distribution is generally also subject to an additional 10 percent penalty tax. However, this 10 percent penalty tax will not apply if the distribution is:

• Made after the death of the beneficiary to his or her beneficiary or estate

• Attributable to the beneficiary's disability, or

• Made on account of a scholarship, an educational assistance allowance, or a payment of the designated beneficiary's educational expenses that is excludable from gross income

Coverdell ESA may result in taxable income upon death of beneficiary

If a Coverdell ESA is transferred upon the death of the beneficiary to anyone other than a surviving spouse or family member, the Coverdell ESA ceases to be a Coverdell ESA, and whatever portion of the account represents earnings is income to the recipient.

A contribution to a Coverdell ESA is considered a completed gift

Contributions that you make to a Coverdell ESA are considered completed gifts. However, unless your Coverdell ESA contribution and other gifts you make to the same beneficiary (in the same year) total more than the annual gift tax exclusion (currently $13,000), there is no federal gift tax liability. And, gift tax due on gifts in excess of the annual gift tax exclusion may be offset by your $1 million gift tax applicable exclusion amount.

Caution: There may be state gift tax consequences as well.

Coverdell ESA is not included in calculating estate tax

Because money contributed to a Coverdell ESA is considered a completed gift to the beneficiary at the time of the contribution, such money is no longer part of the contributor's assets once it has been contributed to the Coverdell ESA. Therefore, the money contributed would not be included in the contributor's estate upon his or her death. However, if the beneficiary dies before using up all of his or her Coverdell ESA money, the remaining balance in the Coverdell ESA may be included in the beneficiary's estate for estate tax purposes, depending on the value of the estate at the time of death and the year in which he or she dies.



Rollovers

A Coverdell ESA can be rolled over without tax or penalty consequences to another Coverdell ESA established for the same beneficiary, or for a family member of the original beneficiary. This can be done once every 12 months. Like IRAs, there is a 60-day window in which funds may be rolled over.

Transfers

If the beneficiary dies while there is money in a Coverdell ESA, and the Coverdell ESA is transferred to a surviving spouse or other family member, there is no taxable transaction. Similarly, if a Coverdell ESA is transferred to a spouse or former spouse as the result of a divorce decree, there is no tax consequence. However, if upon the beneficiary's death, the Coverdell ESA is transferred to anyone other than a surviving spouse or other family member, the Coverdell ESA stops being a Coverdell ESA, and the portion of the account that represents earnings is considered income to the person who receives the funds.

Questions& Answers

How much can you contribute if your income falls in the phaseout range?

The most you can ever contribute to a Coverdell ESA for a single beneficiary in a year is $2,000. If your MAGI is between $95,000 and $110,000 for single filers or $190,000 and $220,000 for joint filers, your ability to contribute to a Coverdell ESA is limited. This limitation is calculated as follows:

MAGI between $95,000 and $110,000:

1. Subtract $95,000 from your MAGI (if your MAGI is less than $95,000, you can contribute the maximum). If the result is $15,000 or more, stop--you cannot contribute to a Coverdell ESA.

2. Divide the result from line 1 by $15,000.

3. Multiply the result from line 2 by $2,000.

4. Subtract the result from $2,000.

This is the maximum amount you can contribute to a Coverdell ESA.

MAGI between $190,000 and $220,000:

1. Subtract $190,000 from your MAGI (if your MAGI is less than $190,000, you can contribute up to $2,000). If the result is $30,000 or more, stop--you cannot contribute to a Coverdell ESA.

2. Divide the result from line 1 by $30,000.

3. Multiply the result from line 2 by $2,000.

4. Subtract the result from $2,000.

This is the maximum amount you can contribute to a Coverdell ESA.

Are there restrictions on taking distributions from a Coverdell ESA?

Yes and no. Generally, contributions that you make to a Coverdell ESA are considered gifts. Once you contribute to a Coverdell ESA, distributions from the Coverdell ESA can only be made to the beneficiary (except for withdrawals of excess contributions). Distributions can be made from Coverdell ESAs at any time, but only qualifying distributions qualify for tax-free status.



Qualifying distributions are tax exempt if they are used for qualifying education expenses and if they do not exceed the expenses incurred by the beneficiary during the year.

Nonqualifying distributions are distributions made for noneducation expenses, and they are partially included in the beneficiary's income and may be subject to a 10 percent penalty. Distributions are considered to consist partly of original contributions and partly of earnings. Only the portion of a distribution that represents earnings is included in the income of the beneficiary.

The part of the distribution that represents contributions (and is therefore not included in income) is calculated by multiplying the amount of the distribution by the ratio of contributions in the Coverdell ESA (prior to the distribution) to the total balance in the Coverdell ESA prior to the distribution. The remainder of the distribution represents earnings.

Example(s): A Coverdell ESA has a total balance of $5,000. The $5,000 consists of $4,000 in contributions and $1,000 in earnings. A $1,000 distribution is made to the Coverdell ESA beneficiary, but none of the $1,000 is used for qualified education expenses. Because 80 percent of the entire value of the account at the time of the distribution consists of contributions, 80 percent of the distribution ($800) is considered to represent original contributions, and only 20 percent ($200) is considered to be earnings includable in income.

A special calculation is required when you have qualifying education expenses but the distribution exceeds these expenses.

What happens when a beneficiary has $5,000 in qualifying education expenses but receives $6,000 as a Coverdell ESA distribution?

Any time that a distribution from a Coverdell ESA totals more than the qualifying education expenses, a beneficiary must make a special calculation to determine how much of the distribution must be included in income:

1. Enter total qualifying higher education expenses.

2. Enter total amount of distribution.

3. Enter portion of distribution that represents earnings.

4. Divide line 1 by line 2.

5. Multiply line 4 by line 3. This amount must be excluded from income.

What happens if you contribute too much money to a Coverdell ESA in a given year?

If you contribute more to a Coverdell ESA than you are allowed in one year, you have until May 31 of the following tax year to withdraw the funds, along with any earnings attributable to the funds. Any overcontributions remaining after this date are subject to a 6 percent excise tax.

Caution: The 6 percent excise tax is also assessed if total contributions to all Coverdell ESAs for any one beneficiary exceed the maximum $2,000 amount.



Managing Expenses During the College Years

Introduction

For most parents, paying for a child's college or graduate school education is a major event. For some parents, it rivals only the purchase of a home in number of dollars spent. As the cost of college continues to rise, it's little wonder that parents view their ability to pay college costs with some apprehension. Yet, in all but the most affluent families, paying for college does not involve a 100 percent out-of-pocket contribution from parents. Rather, the average family uses a combination of strategies to pay higher education costs--savings, financial aid, education tax credits, out-of-pocket contributions, and other creative solutions.

Savings

Hopefully, you're one of the parents who have been saving money for their child's college education on a regular basis. If so, now's the time to use those funds. But in many cases, this won't be enough to cover all the bills.

Financial aid

The majority of college-bound students qualify for some type of need-based financial aid (as opposed to merit-based financial aid like athletic scholarships), and this can supplement your savings. The largest provider of need-based financial aid is the federal government, followed by colleges.

Need-based financial aid consists of loans, grants, scholarships, and work-study jobs. Loans eventually need to be repaid by you or your child, while scholarships and grants do not. Work-study jobs are paid jobs performed by students and are subsidized by the federal government or the individual college.

Every college that accepts a student will try to create a financial aid package for that student. Typically, loans make up the biggest portion of any financial aid package (approximately 60 percent), though the exact percentage will vary by student. Most students take out at least some student loans, which lessen the financial burden on their parents.,

All students should apply for federal financial aid, even if they're not sure they'll qualify, because eligibility criteria may change slightly from year to year and filing the federal government's aid application (called the FAFSA) is often a prerequisite for obtaining other types of aid, such as college aid.

After you become savvy about the financial aid process, you can learn about legitimate steps to take to position your income and assets to enhance your child's financial aid eligibility. Though it's best to become familiar with these steps while your child is still in high school (allowing time to implement them), you can also take advantage of these suggestions while your child is in college because financial aid must be reapplied for every year.

One final note: graduate students may not have the same breadth of financial aid programs available to them, or, conversely, they may have certain programs available to them that are not available to undergraduates. For example, the federal government's grant programs are limited to undergraduates, but universities may offer special grant programs to graduate students that are not available to undergraduates.

Education tax credits and deductions

There are several education tax credits and deductions that can help families weather college costs--the Hope credit (renamed the American Opportunity tax credit for 2009 and 2010), the Lifetime Learning credit, the deduction for qualified higher education costs, and later, the student loan interest deduction. As a general rule, a tax credit is more favorable than a deduction because it results in a dollar-for-dollar reduction of taxes owed.

The American Opportunity credit is worth up to $2,500 per student per year for the first four years of a child's



undergraduate college education. The Lifetime Learning credit is worth up to $2,000 per tax return (regardless of the number of family members who qualify) per year for undergraduate or graduate courses taken throughout a student's lifetime. The catch is that the credits are mutually exclusive; that is, they cannot both be taken in the same year for the same individual.

The maximum American Opportunity tax credit is available to single filers with a modified adjusted gross income (MAGI) below $80,000 and joint filers with a MAGI below $160,000. A partial credit is available to single filers with a MAGI between $80,000 and $90,000 and joint filers with a MAGI between $160,000 and $180,000. The maximum Lifetime Learning credit is available to single filers with a MAGI below $50,000 and joint filers with a MAGI below $100,000. A partial credit is available to single filers with a MAGI between $50,000 and $60,000 and joint filers with a MAGI between $100,000 and $120,000.

In addition, a deduction for higher education costs is available to qualifying individuals in 2009. Individuals with an adjusted gross income (AGI) of $65,000 or less, or married couples filing jointly with an AGI of $130,000 or less, can take a deduction up to $4,000. A deduction of $2,000 is available for single filers with an AGI between $65,000 and $80,000, and for married couples filing jointly with an AGI between $130,000 and $160,000. Unfortunately, the deduction for qualified higher education expenses cannot be claimed in the same year that the Hope credit or the Lifetime Learning credit is taken for the same student. Also, the deduction cannot be taken for the same education expenses that were paid with a tax-free distribution from a Coverdell education savings account or a 529 plan. This deduction is not available for 2010.

Finally, when it's time for your child to repay student loans, he or she may be eligible for the student loan interest deduction, which allows an individual to deduct from gross income a portion of the interest paid on a student loan during the year. The maximum deduction is $2,500.

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Out-of-pocket contributions

Your child is eligible for financial aid, she has chosen an accelerated program that allows her to graduate in three years, and you will qualify for the Hope credit during her freshman year. But even with these cost-cutting measures, many parents will need to pay a portion of the college or graduate school bill (sometimes a substantial portion) from their own pocket.

The way you pay the bill from your own pocket can range from the simple to the complex. It may mean tapping funds from any number of sources--your current weekly paycheck, your savings and investments, your IRA or employer retirement plan, your home equity, other loan sources such as banks or brokerage houses, or other assets such as cash value life insurance. The commonality is that the money comes from you and is a drain on your financial net worth.

An important reminder: Paying for college out of pocket can conflict with other important financial goals, most notably saving for your retirement. It can be hard to manage both goals, but it is possible to save for college and retirement.

Other creative solutions

Finally, there are other creative ways for parents to lower their college costs by lowering the actual cost of school. For example, a student could choose an accelerated program and graduate in three years instead of four; a cooperative education where education is interspersed with paid internships; or a live-at-home arrangement where money is saved on room-and-board costs.



Applying for Financial Aid

What is financial aid?

Financial aid is money given by colleges and federal and state governments to help students pay for college or graduate school. This money is in the form of loans, grants, scholarships, and work-study. Loans and work-study must be repaid either through financial obligation (loans) or service to the college (work-study). By contrast, grants and scholarships do not have to be repaid.

There are two types of financial aid: need-based, which is based on your family's ability to pay, and merit-based, which is based on a student's academic, athletic, or special talent. Most financial aid is need-based, and the discussion here focuses on need-based aid.

Who offers financial aid?

There are many players in the financial aid arena. Along with you (and your own savings and loans), think of these financial aid providers as pieces of a puzzle that must fit together to create a fully-funded college education.

Federal government

The federal government is the largest dispenser of need-based financial aid for higher education. The federal government funnels money to colleges and banks, and directly to students for loans, grants, scholarships, and work-study programs.

Colleges

Colleges constitute the second largest provider of financial aid. The money can come from the college's own reserves (private colleges generally have greater endowment funds than public colleges), or from federal and state government agencies. Colleges may also direct students to a particular bank that coordinates loans with that school. Colleges that accept a student who is eligible for financial aid will create a financial aid package for that student.

State governments

Most states offer financial education assistance to state residents, to students attending in-state public schools, and to colleges and banks located within their borders.

Other players

A vast number of corporations, foundations, and associations of all kinds offer merit financial aid. Most organizations seek students with specific qualifications, backgrounds, and future plans--for example, a Nebraska high school graduate who plans to major in pre-med. In recent years, the Internet has become a valuable tool to search for grants and scholarships.

Overview of the financial aid process

To understand how the financial aid process works, it's important to understand how your child's financial need is determined. This process is called needs analysis.

Under needs analysis, household and financial information submitted on your child's financial aid application is used to calculate your family's expected contribution to college costs. Two primary formulas are used to calculate the expected family contribution (EFC): the federal methodology and the institutional methodology (these formulas will be discussed later in greater detail). The EFC is the minimum amount that a family is expected to contribute toward their child's college costs. The difference between the cost of attendance at your child's college



(a variable) and your EFC (a constant) equals your child's financial need.

Example(s): If the cost of attendance at State University is $20,000 per year and your family's EFC is $8,000, then your child's financial need would be $12,000.

Colleges aren't obligated to meet 100 percent of your child's need. If a college meets only part of your child's financial need (as is the practice at many colleges), then you have been "gapped" by the college. The remaining portion is called unmet need, and you are responsible for meeting it.

Example(s): Assume that your child's financial need is $12,000. State University offers your child $10,000 of financial aid. The result is an unmet need of $2,000. So, your family would be responsible for both the EFC of $8,000 and the unmet need of $2,000.

The two formulas for calculating EFC

The two primary formulas for calculating a family's EFC are the federal methodology and the institutional methodology.

Federal methodology

The federal methodology is used by the federal government to calculate your EFC to determine eligibility for federal financial aid programs. The federal methodology is also used by colleges when federal funds are being distributed. It is codified in the federal government's aid application, called the Free Application for Federal Student Aid, or FAFSA. Congress may modify the federal methodology slightly from year to year.

Institutional methodology

The institutional methodology is an alternative to the federal methodology. It is administered by the College Scholarship Service, a private company that provides educational services to colleges and the public. The institutional methodology is used by some 3,000 colleges to calculate your EFC when the college's own private funds are being distributed. So, a college may use the institutional methodology to distribute its own funds and the federal methodology to distribute any federal financial aid funds at its disposal. You submit your information for the institutional methodology on the PROFILE form application rather than on the FAFSA.

In some instances, a college will not use the institutional methodology when distributing its funds, but will use its own individual formula. In this case, you will need to obtain the college's particular financial aid application form.

There are differences in the way the EFC is calculated under the federal methodology vs. the institutional methodology (discussed in greater detail below). As a general rule, the institutional methodology digs deeper into a child's financial background than the federal methodology because colleges want to make sure that their own funds go to the neediest students.

How exactly is my EFC calculated under the federal methodology?

The federal methodology examines your family's income, assets, and household information to calculate the EFC. Since most students are dependent, the discussion here focuses on dependent students and their parents, except where noted. To determine your dependency status, see the section below entitled What are the Steps in Applying for Financial Aid?

Income

The income component of the federal methodology consists of the adjusted gross income (AGI) of both parents and student from the previous tax year, plus any untaxed income and benefits, minus any applicable deductions. For independent students, only the student's AGI and untaxed income and benefits are counted, along with those of a spouse, if any. The previous tax year is known as the base year. For example, the base year for the 2009/2010 academic year is 2008.



The AGI figure is simply taken from a line on your federal tax return. The untaxed income and benefits portion is a bit trickier. The major untaxed income and benefits that must be added back to your income for financial aid purposes include (see the FAFSA for others) deductible retirement plan contributions made in the base year, tax-exempt interest income (e.g., municipal bond interest), untaxed Social Security benefits, child support received, earned income credit, workers' compensation, and disability payments.

After a total income figure is determined, certain deductions can be taken. One example of a deduction is any federal and state taxes you paid in the previous year, including Social Security taxes (see the FAFSA for more deductions).

Perhaps the two most important deductions, however, are the income protection allowance and the employment expense allowance. The income protection allowance is an allowance for shelter, food, clothing, car maintenance, insurance, and basic medical care. For parents, the allowance depends on the total number of household members and the number of children in college.

The employment expense allowance is an allowance for parents only for employment expenses.

In addition, the FAFSA will ask you for the amount of any education tax credits ( Hope credit, renamed the American Opportunity tax credit for 2009 and 2010, and Lifetime Learning credit) you took in the base year in order to provide offsets for them.

A family's total financial aid income (AGI plus untaxed income/benefits minus deductions) is assessed at a 50 percent flat rate under the federal methodology.

Example(s): The Walker's total financial aid income is $40,000. They will be expected to contribute $20,000 to college costs.

Assets

The federal methodology counts some assets and excludes others in arriving at your EFC (these assets are called assessable or non-assessable assets). Your assets for financial aid purposes are those you own at the time you sign the FAFSA. The more assessable assets your family has, the more money your family will be expected to contribute toward college costs.

The following assets are not included in the federal methodology:

• Retirement accounts (e.g., 401(k)s, IRAs)

• Annuities


• Personal items (e.g., car, clothes, furniture, household items)

• Home equity in primary residence

• Family farm

Assessable assets are all other assets of the parents and student. These include items such as checking and savings accounts, money market accounts, certificates of deposit, stocks, bonds, mutual funds, U.S. savings bonds, tax-exempt bonds, custodial accounts, trusts, limited partnerships, vacation homes, investment properties, and business and farm assets. After total assets are determined, you can then offset these assets with any investment or real estate debt (e.g., a mortgage on an investment property or a margin account loan with your broker).

Example(s): Assume the Noodle Family has IRAs worth $50,000, an annuity worth $250,000, $60,000 in home equity, and a checking account worth $1,000. Their total assets under the federal methodology are $1,000.



An important note to keep in mind is that the federal government does not care about any consumer debt you may have. In other words, your assessable assets are not reduced by the amount of your outstanding consumer debt.

Example(s): The Bensons have $100,000 in stocks, an IRA worth $50,000, and $75,000 in long-term debt. Their total assets are $100,000 under the federal methodology.

Example(s): The Carlins have $20,000 in U.S. savings bonds, an IRA worth $40,000, a $300,000 cash value life insurance policy, and no consumer debt. Their total assets are $20,000 under the federal methodology.

Technical Note: Regarding trust funds and custodial accounts, the income is valued as of the base year (the year before the FAFSA is submitted) and the assets (corpus) are valued as of the date the FAFSA is signed. If a trust has more than one beneficiary, only that portion attributable to the student or parent is reportable. You may need to consult a financial professional to determine income and asset values for trust funds and custodial accounts.

When a family's total assessable assets are determined, the federal methodology gives parents an asset protection allowance that allows them to exclude a certain portion of their assets from consideration (students don't get an asset protection allowance). The asset protection allowance varies depending on the age of the older parent at the time the student applies for aid (the older the parent, the greater the allowance).

When a final asset figure is reached for parents and student, parents must contribute a maximum of 5.6 percent of their assets toward college costs and the student must contribute 20 percent of his or her assets toward college costs.

Example(s): The sum of $50,000 in your child's bank account equals a $10,000 expected contribution to college costs ($50,000 x 20 percent), whereas the same $50,000 in the parents' account equals a $2,800 contribution ($50,000 x 5.6 percent).

Tip: There is one situation in which the federal methodology does not factor in any assets of parent or student. This is when the parents' AGI (or an independent student's AGI) is below $50,000 and the parents are eligible to file a 1040EZ or 1040A. In this case, the EFC is calculated using only income under the Simplified Needs Test. The result is generally a lower EFC and thus more financial aid.

Caution: Although you qualify for the Simplified Needs Test under the federal methodology, colleges and your state may still require you to list your assets in order for you to be eligible for college or state funds.

Household information

If the parents are both living and married to each other, the income and asset information for both parents is listed on the FAFSA. If the parents are living together but not formally married, they should file the application as if they are separated (see below), unless their state recognizes common law marriage.

If the parents are separated (living apart for an indefinite period) or divorced, then only the income and assets of the parent with whom the child lived the majority of time during the past 12 months is listed on the application. If the parent has remarried, then the stepparent's income and assets are listed on the application as though this person were the natural parent; the noncustodial parent's income and assets are not listed.

Tip: Under the federal methodology, the federal government does not recognize legal agreements that absolve a stepparent from contributing to college costs or that make the noncustodial parent responsible for college costs. Under the institutional methodology, however, colleges may inquire about the resources of the noncustodial divorced parent or ignore the resources of the stepparent.

On a related note, legal guardians are no longer included on the FAFSA, which means their income and assets are not automatically included. A student whose parents are deceased will be considered an independent student, regardless of any legal guardianship. By contrast, a student whose parents are living will file as a



dependent student, but the FAFSA will reflect the financial information of the appropriate parent(s) rather than the legal guardian, unless the financial aid officer exercises "professional judgment."

The federal methodology also requires you to list the number of people in the household whom the parents will support between July 1 and June 30 of the upcoming college year. This includes the student, parents, siblings, an unborn child, and others who get more than half their support from the parents and who will continue to get this support in the upcoming college year. From this number, students must also report the total number of household members enrolled in college in the same year. The student is always counted. In addition, parents and other siblings are counted if they are enrolled at least half time in a program leading to a degree or certificate.

Tip: If additional household members are in college, the EFC is greatly reduced. Specifically, the parents' total EFC is divided by the number enrolled in college.

Example(s): The Smart Family's EFC is $12,000. They will have two children enrolled in college in the same year, a freshman and a sophomore. As a result, their EFC for each child is $6,000.

Steps to reduce your EFC under the federal methodology

There are legitimate steps you can take to position your income and assets to enhance your child's financial aid eligibility under the federal methodology. The idea is to lower your EFC, which, in turn, raises your child's aid eligibility. Examples of these strategies include deferring income and bonuses, avoiding the sale of investments that will result in capital gains in the base year, and paying down consumer debt. It should be noted that these suggestions are legal and are not meant to subvert the financial aid system in any way. To implement these suggestions, you should become familiar with them at least a couple of years before the year you complete the FAFSA.

The institutional methodology vs. the federal methodology

There are several differences in the way the EFC is calculated under the federal methodology (FM) vs. the institutional methodology (IM).

Regarding the institutional methodology, some of the negatives are:

• The IM formula does not recognize a simplified needs test for parents whose incomes are below $50,000.

• The IM formula requires a minimum student contribution from the student's income and does not give students an income protection allowance.

• The IM formula includes home equity and family farm assets in its calculations (and may require parents to borrow against it before aid is distributed).

• The IM formula requires parents to report any savings accounts in the names of the student's siblings (to discourage the shifting of assets among siblings) and requires students to list any retirement accounts they have.

• The IM formula requires parents to report how much they contribute to flexible spending accounts for child care and medical care.

• The IM formula requires parents to report how much money they expect to earn in the coming year. Similarly, students must report any outside scholarships they expect to receive and any relative's contributions.

• The IM formula (at a college's discretion) may only allow dependent children (not parents) to be counted as members of the household enrolled in college.

• The IM formula (at a college's discretion) may not allow losses from tax return Schedules C, D, E, or F



that lower AGI and may not allow certain depreciation expenses.

• The IM formula (at a college's discretion) may require business or farm balance sheets for the prior two years, and detailed projections of future income.

On the positive side:

• The IM formula includes an allowance against income for any unreimbursed medical expenses that exceed 4 percent of the parents' financial aid income.

• The IM formula (at a college's discretion) may have an allowance against income for the private school tuition of other household members and for a parent's own student loans.

• The IM formula (at a college's discretion) may consider a noncustodial parent's assets and income.

Steps in applying for financial aid

There are several steps in the financial aid application process:

Step 1: The first step is for your child to apply to and be accepted by (hopefully) a number of colleges. This allows your student to compare and negotiate financial aid awards from several colleges. Keep in mind that the financial aid timeline and the admissions timeline are different.

Caution: From a financial aid perspective, it is often recommended that students not apply to college on an early-decision basis. The reason is that if a college knows the student is committed to the college, it may be less inclined to award a favorable financial aid package. In addition, the student will have to examine and respond to the financial aid award before receiving awards from other schools.

Step 2: The next step is to file the appropriate financial aid applications by the stated deadlines. Unfortunately, you must apply for financial aid at each school before you learn whether you have been accepted for admission at that school. Note that students must reapply for financial aid each year.

The two basic financial aid applications are the (1) FAFSA and (2) the PROFILE. The FAFSA is used by the federal government and colleges when federal financial aid funds are being distributed; it calculates your EFC under the federal methodology. The PROFILE is used by most colleges (approximately 3,000) when their own funds are being distributed; it calculates your EFC under the institutional methodology. In addition, some colleges use their own institutional aid forms in place of the PROFILE. If so, you will need to obtain a copy of that application from the financial aid officer at that particular college.

There are actually three different types of FAFSAs: (1) for dependent students, (2) for independent students without dependents (a spouse is not considered a dependent), and (3) for independent students with dependents. The federal methodology will vary slightly depending on what form is used. The main difference is that the dependent student FAFSA uses both parent and student financial data to arrive at the EFC, and the two independent student FAFSAs do not use parental data to arrive at the EFC.

To fill out the correct FAFSA, you must first determine your child's dependency status. A dependent student is one who is at least partially dependent on his or her parents for support. If your child is just graduating from high school or less than 24 years of age, most likely he or she will be classified as a dependent. By contrast, an independent student is not dependent on parental support. The federal government considers you independent if you meet any one of the following conditions:

• You are 24 years of age by December 31 of the award year

• You are an orphan or a ward of the court, or were a ward of the court until age 18

• You are married or have legal dependents other than a spouse



• You are a graduate or professional student

• You are a veteran of the U.S. Armed Services

• You are an active member of the armed forces

• You are deemed independent in the professional judgment of the financial aid administrator (FAA) based upon documented unusual circumstances

Tip: Most states and colleges go beyond this federal test when determining whether you are truly independent. For example, they may ask for written proof that your parents are unable to provide you with any financial support whatsoever. Once you have determined your dependency status, you can then obtain the correct FAFSA. The FAFSA is available at high school guidance offices or college financial aid offices. The earliest date it can be filed is January 1 in the year your child will be attending college. This is because the application relies on your previous year's tax return. The federal deadline for filing the FAFSA is June 30, but many colleges have an earlier deadline. There is no fee for submitting the FAFSA.

Tip: Parents should submit the FAFSA as close to January 1 as possible because many financial aid programs operate on a first-come, first-served basis. Because most parents have not yet completed their federal income tax returns by early January, it is recommended that parents hire a professional tax preparer to complete an estimated income tax return, a practice the federal government considers acceptable. However, parents will still need to complete their final income tax return as soon as possible because the college will likely require a copy at the time it prepares the student's financial aid package.

When it's complete, a FAFSA can be filed in four ways: (1) manually completing the form and mailing it to the regional processor listed on the form, (2) filing electronically through the college (not all colleges have this capability), (3) filing electronically using the U.S. Department of Education's FAFSA Express software (this software can be downloaded from the Internet at www.ed.gov, and (4) filing on the Internet by contacting www.fafsa.ed.gov.

Paper FAFSAs take approximately four to six weeks to process; electronic FAFSAs take only one week. However, if you file an electronic FAFSA, you still need to print out the certification page, sign it, and mail it to the designated processor within 21 days of transmitting your data (or the processing of your application will be delayed).

The PROFILE is available at high school guidance offices, college financial aid offices, or on the Internet at www.finaid.org. Like the FAFSA, there are three different PROFILE applications that depend on whether you are a (1) dependent student, (2) independent student without dependents, or (3) independent student with dependents. You determine your dependency status the same way as for the FAFSA. Also like the FAFSA, each college may have its own deadline for filing the form.

Unlike the FAFSA, there is a processing fee for filing the PROFILE application. In addition to the FAFSA and PROFILE forms, you will also need to submit any other financial aid applications (college or state) to the appropriate institutions at this time.

Step 3: Four to six weeks after the FAFSA is filed (one week if you filed your FAFSA on-line), your family should receive a Student Aid Report or SAR (or Acknowledgment Report when the PROFILE is filed). This form indicates your EFC in the upper right-hand corner of page one of the report. For example, "EFC6000" means that your expected family contribution to college costs is $6,000. The SAR will also be sent to each college you listed on the FAFSA.

You should review the SAR to make sure the EFC was calculated using accurate information. Any corrections should be made immediately and sent back for reprocessing (e.g., updating estimated tax information, arithmetic errors, or clerical errors).

Tip: If there is an asterisk (*) next to the EFC reported on the SAR, your family has been chosen for verification. Verification can range from providing tax returns and household information to



providing appraisals for certain assets listed on the FAFSA. Don't take it personally if you are chosen--nearly 30 percent of all FAFSAs are verified.

Step 4: After you (and the colleges) receive the SAR, the college's financial aid administrator (FAA) goes to work. The administrator subtracts your EFC from the cost of attendance at that particular college to arrive at your child's financial need. The FAA then attempts to create a financial aid package to meet that need. The package will include various combinations of loans, grants, scholarships, and work-study programs (the type and order of financial aid resources typically used to fulfill a student's financial need is discussed in greater detail below).

Tip: Your goal is to have your child's financial need met with the highest amount of gift aid (scholarships and grants) and the least amount of self-help aid (loans and work-study). Private colleges tend to provide more gift aid than public colleges so they can better compete with their less expensive counterparts. As a guide, the average financial aid package consists of 60 percent loans that must be paid back. Unfortunately, as college becomes more and more expensive, the trend is to meet a student's financial need with a higher percentage of loans than gift aid.

Caution: As mentioned previously, colleges are not obligated to meet all of your child's financial need. Colleges have limited financial aid budgets and tend to offer the most aid to those students who meet their specific enrollment goals (e.g., improve the women's hockey program or the debating team). If the college does not meet all of your child's needs, then you have been "gapped" and you are responsible for the shortfall.

Step 5: Sometime in March or April, the FAA notifies the student of the financial aid package in an award letter (the student must first be accepted to the college). The award letter states the specific amount and type of financial aid being offered, and a date by which the letter must be returned.

You may accept, decline, or attempt to renegotiate any part of the financial aid award. It is important to reply by the required date because otherwise your child's award will be cancelled and the money freed up for some other student. Note that accepting the award does not commit your child to attending that school; it just safeguards the award.

Ideally, students will want to have all of their award letters from various colleges on hand before making a decision. This is sometimes easier said than done, however. The financial aid process and the admissions process operate on different schedules, and occasionally students must make a decision to enroll at a particular college before they know the contents of their award letter. Similarly, a student may not have received all of his or her outstanding award letters before being called on to make an acceptance decision at a college from which an award letter was received. In either case, the student or parent should contact the appropriate FAA to see if you can expedite the consideration of the aid package.

Step 6: If you want to appeal all or part of your child's financial aid award, follow the instructions in the award letter. This usually involves a polite business letter to the FAA and a follow-up telephone call or meeting.

The process of renegotiating your child's financial aid package has been much publicized as of late, with descriptions ranging from haggling to dialing for dollars. Rare a decade ago, negotiating is now so much part of the picture that some colleges have set aside funds specifically for maneuvering at season's end. Some educational professionals have criticized this process on the grounds that those parents that yell the loudest reap the biggest rewards. This is not necessarily true. In fact, you'll do much better if you approach the FAA without carrying a big stick.

Your chances of successfully renegotiating your child's aid package are best if you can document a special circumstance that affects your ability to pay the EFC (rather than a simple plea of inability to pay). Such special circumstances may include the recent death or disability of a parent, divorce, prolonged unemployment, unusually high medical expenses, or a natural disaster than destroyed certain assets. In addition, more obscure circumstances may be the reason for negotiation. For example, your income on last year's tax return may have been higher than usual because you converted a traditional IRA to a Roth IRA or because you received a one-time windfall, such as a special bonus, insurance settlement, or inheritance. Make sure to document any change with the appropriate paperwork.



In addition to a special family circumstance, many parents and students attempt to play one college's aid package against another college's aid package. This strategy has the best chance of success if College A and College B are direct competitors and you have the qualities that College A is looking for. If College A is an Ivy League school and College B is a small state university, chances are that one will not be persuaded by the aid package of the other. As a matter of fact, public institutions rarely haggle, so your best chances for a deal will be at one of the approximately 1,600 private colleges.

Keep in mind that the college market, like the housing market, can be a seller's market or a buyer's market, and that this can affect the negotiation process. Currently, there are more students than college spaces as the children of the baby boomers reach college age.

Types of financial aid programs

There are several types of financial aid programs. The most common financial aid programs are those offered by the federal government. The main federal programs are as follows:

Pell Grant and Supplemental Educational Opportunity Grant (SEOG)

The Pell Grant is available to undergraduate students. It is an entitlement program, which means the grant is available to all students who qualify.

The SEOG is reserved for undergraduate students with the most financial need (Pell Grant recipients are given priority). The SEOG is a campus-based program, which means that each college receives a limited amount of money for this program and the FAA at each college decides which students will receive this grant. Once the funds are awarded, there are no more until the following year. This is an example of a first-come, first-served program.

Also, there are two relatively new federal grant programs available to full-time undergraduate students who qualify for a Pell Grant and meet other requirements. Grants available to first- and second-year students are called Academic Competitiveness Grants, and grants available to third- and fourth-year students are called National Science and Mathematics Access to Retain Talent (SMART) Grants and are available only to those students majoring in certain subject areas. Both grant programs are scheduled to sunset at the end of fiscal year 2010.

Stafford Loan, Perkins Loan, and PLUS Loan

The federal Stafford Loan is a low-interest loan made to both undergraduate and graduate students. Your lender can be either the federal government or a private financial institution, depending on which lending program a particular college participates in. The interest rate is set each June.

A Stafford Loan may be subsidized or unsubsidized, depending on whether you have a financial need. With a subsidized federal Stafford Loan, the federal government pays the interest on the loan while you are in school, during deferment periods, and for six months after you leave school. Like the Pell Grant, the subsidized Stafford Loan is an entitlement program and is thus available to all students who qualify. With an unsubsidized federal Stafford Loan, you (not the federal government) are responsible for paying the interest during the school year and deferment periods. Regardless of whether the loan is subsidized or unsubsidized, there are limits on the amount of money that can be borrowed each year, as well as limits on the total debt that may be incurred.

A Perkins Loan is a low-interest loan available to both undergraduate and graduate students with the lowest EFCs. Like the SEOG, the Perkins Loan program is campus-based, which means each college receives a certain amount of money for this program, and you borrow the money directly from the college. When the funds run out, there are no more until the following year. This loan is subsidized; that is, the federal government pays the interest while you are in school, during deferment periods, and for nine months after you graduate.

The PLUS Loan is a non-need-based program; that is, you can qualify without financial need. The loan is for parents with good credit histories who want to help pay for their child's education and for graduate and professional students. Borrowers are eligible to borrow up to the full cost of their education, minus the EFC and any other financial aid received. This loan is obtained through financial institutions.



Work-study

The federal work-study program is a need-based program that subsidizes jobs for both undergraduate and graduate students. Like the SEOG and Perkins Loan, the federal work-study program is campus-based. The funds are distributed on a first-come, first-served basis. Often, these jobs involve community service work and can be related to your course of study.

Do colleges award financial aid resources in a specific order?

Generally, yes. Colleges usually fulfill a student's financial need by awarding financial aid resources in the following order:

• Federal Pell Grant (for those students who qualify)

• State grant

• Federal Stafford Loan (subsidized)

• Company and organization scholarships and grants, military financial aid programs, or any other outside financial aid resources

• Perkins Loan, SEOG, or federal work-study (funds for these programs are allocated to colleges by the federal government for allocation to students; whether a student receives any of these funds depends on timing of application, financial need, and availability of funds)

• College grant or tuition discount (at the college's discretion)

Although this is the typical order, it may vary according to the availability of funds at a particular college and/or the particular student's merit. The more merit a student has, the better types of financial aid he or she will likely receive (e.g., less loans, more grants).

Should you apply for financial aid even if you don't think your family will qualify?

Generally, yes. No matter how high your income or asset base is, your family should apply for financial aid. At the very least this means filing the FAFSA. In addition, you may choose to file the PROFILE or other individual college application. There are a few reasons for this suggestion.

First, it can be difficult to predict whether your child will qualify for financial aid without actually filing the FAFSA because the federal government's eligibility criteria for certain aid programs may change unexpectedly from year to year. Second, some financial aid programs are not based on need--such as the federal government's PLUS Loan and certain state programs--yet you must still file a FAFSA to be eligible to borrow funds. Third, you really lose nothing (except a few hours of your time) for filing the FAFSA because it is a free form that costs nothing to process.

Although the PROFILE application does have a processing fee, it is a small investment to make for the opportunity to learn whether your child qualifies for a college's own aid programs. The worst that can happen is that you discover you don't qualify for any financial aid. In that case, you won't be left wondering whether you should have applied. Considering that your child may be awarded gift aid that you won't have to repay, the investment of your time may well be worth it.



Positioning Your Income/Assets to Enhance Financial Aid Eligibility

What does it mean to enhance your financial aid eligibility?

If you qualify for federal financial aid, there are a number of strategies you can try to implement to enhance the amount of aid your child will receive when you apply for financial aid. The idea is to lower your expected family contribution (EFC), which in turn raises your child's aid eligibility. Although some of these strategies can be employed as late as the base year--the year prior to the year you fill out the Free Application for Federal Student Aid form (FAFSA)--others can be implemented years before your child will be starting college.

It is important to note that these strategies are perfectly legal and are not in any way meant to undermine the federal financial aid process. These strategies simply examine the federal methodology and take advantage of its rules regarding which family assets and income are included in determining a student's financial aid eligibility.

Strengths

You increase your child's eligibility for federal financial aid

By implementing strategies that lower your assessable income and assets under the federal formula for financial aid, you decrease the amount of money your family is expected to contribute to college costs. A decrease in your EFC, in turn, means your child will be eligible for more financial aid. This translates into less current out-of-pocket costs for you.

You may reap incidental financial benefits that are important to you

By implementing certain strategies tailored to the federal methodology for financial aid, you not only increase your child's aid eligibility but also may place yourself in a better financial position. For instance, by paying down your mortgage, you not only increase your child's federal aid eligibility because home equity is not counted as an asset under the federal formula, but you also benefit by saving on mortgage interest and owning your home sooner.

Tradeoffs

Colleges don't use the same formula as the federal government in determining aid eligibility

The primary drawback of implementing specific strategies to take full advantage of federal financial aid is that you increase your chances for aid under the federal system only. Colleges have their own formula for determining which students are most deserving of campus-based aid, and this formula may not recognize a strategy that is successful under the federal methodology. For instance, under the federal methodology, the federal government does not consider your home equity in calculating your total assets. However, most colleges do consider home equity in determining a family's ability to contribute to college costs, and some may even expect parents to borrow against it.

The increased financial aid may consist entirely of loans

If you are successful at reducing your total income and assets under the federal methodology and thus increasing your child's financial aid package, there is no guarantee that a portion of the increased aid package will consist of grants or scholarships (which do not have to be paid back). Instead, your child's additional aid package could consist entirely of loans that will need to be paid back by you or your child.



You may not want to disrupt an otherwise sound investment program

It is generally not a good idea to drastically change your overall financial planning scheme for financial aid reasons only. Ideally, any changes you make should be in line with your overall financial planning picture.

Strategies to reduce available income

There are a number of steps you can take to reduce your adjusted gross income (AGI) under the federal methodology for determining financial aid. The lower your AGI, the less money you will be expected to contribute toward college costs and the higher your child's aid eligibility.

Tip: Remember, you apply for financial aid each year. Thus you should consider the following strategies for each of the years you will be applying for aid, not just for the initial application.

Time the receipt of discretionary income to avoid the base year

Your income in the base year will directly affect your child's financial aid eligibility in the following year. Although it is highly unlikely you will be able to defer your weekly (or monthly) paycheck, it may be possible to defer other types of discretionary income beyond the base year. For example, if possible, you should try to:

• Defer receiving employment bonuses until after December 31 of the base year.

• Avoid selling investments that will have taxable capital gains or interest, such as mutual funds, stocks, or savings bonds, until after December 31 of the base year. To avoid taking an untimely distribution from an investment that is earning a favorable rate of return, use the investment as collateral for a low-interest loan instead.

• Sell investments that can be taken at a loss during the base year, as long as the investments are not expected to recover.

• Avoid pension and IRA distributions in the base year.

• If you are on an expense account, ask your employer to reimburse you directly so that any reimbursement amounts do not artificially inflate your income.

Pay all federal and state income taxes due during the base year

This strategy is advantageous for two reasons: It reduces the amount of available cash on hand, and you can deduct the total amount of federal and state taxes you pay during the base year on the FAFSA.

Leverage student income limit

For the academic year 2009/2010, the first $3,750 of income a student earns is not considered in determining a child's total income. This is known as the student's income protection allowance. However, everything a student earns beyond the allowance is first taxed and then assessed at 50 percent for financial aid purposes. In other words, the federal government expects your child to contribute 50 percent of all income earned over the allowance (after taxes).

To avoid this result, parents may want to consider having their children perform volunteer work once their kids reach the allowance limit. However, some children may balk at this suggestion because they want a job to earn extra spending money.

Strategies to reduce available assets

There are a number of steps you can take to reduce the amount of assets that will be included under the federal methodology. Under this formula, the federal government includes some assets and excludes others in arriving at



your family's total assets. The lower your assessable assets, the less money you will be expected to contribute toward college costs and the higher your child's aid eligibility.

It is important to remember that the relevant date for determining whether you own a particular asset is the date that you submit the FAFSA. Consequently, the following strategies can be implemented up to the time you complete the FAFSA.

Use cash to pay down consumer debt

The federal methodology does not care about the amount of consumer debt you may have. So if you have $10,000 in assets and $10,000 worth of consumer debts, the federal government still lists your total assets as $10,000. When you use available cash to pay down consumer debt, you reduce the amount of your cash on hand.

Tip: It is usually a good idea to retain three to six months worth of liquid assets for emergencies.

Use cash to make large purchases

Another strategy to reduce cash on hand (an assessable asset) is to make large planned purchases the year before your child begins college. Such items may include a car, furniture, or the like for parents and a car (second-hand, of course), computer, or the like for students. Remember, the idea is not to go out and spend the money on anything; the purchase should have been previously planned.

Increase home equity

The federal methodology does not count home equity as an asset in determining your child's financial aid eligibility. So using assessable assets to pay down the mortgage on your home is one way to reduce these assets and benefit yourself at the same time.

Caution: Although the federal government does not include home equity in determining a family's total assets, most private colleges do include home equity in deciding which students are most deserving of campus-based aid. In addition, some colleges may expect parents to borrow against the equity in their homes to help finance their child's college education.

Leverage parents' asset protection allowance

Once the parents' assessable assets are totaled, the federal methodology grants parents an asset protection allowance, which enables them to exclude a certain portion of their assets from consideration. The amount of the asset protection allowance varies depending on the age of the older parent at the time the child applies for aid (the idea being the closer the parents are to retirement age, the larger the asset protection allowance).

Once parents determine what their asset protection allowance will be, one strategy is to consider saving an equal amount of money in assets that are counted under the federal methodology. Then, any savings above this amount can be shifted to assets that are excluded by the federal methodology, such as home equity, retirement plans, cash value life insurance, and annuities.

Use student's assets for the first year

Under the federal methodology for financial aid, the federal government expects a child to contribute 20 percent of his or her assets each year to college costs, whereas parents are expected to contribute a maximum of 5.6 percent of their assets. If assets have been accumulated in a child's name, parents may want to consider using these assets to pay for the first year of college. By reducing the child's assets in the first year, the family will likely increase its chances to qualify for more financial aid in subsequent years.



Saving for College and Retirement

What is it?

These days it's not uncommon for parents to postpone starting a family until both spouses are settled in their marriage and careers, often well into their 30s and 40s. Though this financial security can be an advantage, it can also present a dilemma--the need to save for college and retirement at the same time.

The prevailing wisdom has parents saving for both goals at the same time. The reason is that older parents can't afford to put off saving for retirement until the college years are over, because to do so means missing out on years of tax-deferred growth. Moreover, because generous corporate pensions (and lifetime job security) are now the exception rather than the rule, employees must take greater responsibility for funding their own retirements.

First, determine your monetary needs

The first step is to determine your projected monetary needs, both for retirement and college. This analysis will reveal whether you are on a savings course to meet both goals, or whether some modifications will be necessary.

For information on figuring your income needs in retirement, see Determining Your Retirement Income Needs: Pre-Retirement.

For information on estimating college expenses, see Estimating College Costs.

You've come up short: what are your options?

You've run the numbers on both your anticipated retirement and college expenses, and you've come up short. The numbers say you won't be able to afford to educate your children and retire with the lifestyle you expected based on your current earnings. Now what? It's time to sit down and make some tough decisions about your expectations and, ultimately, how to compromise.

The following options can help you in that effort. Some parents may need to combine more than one strategy to meet their goals.

Defer retirement

Staying in the workforce longer is one way of meeting your retirement and education goals. The longer you wait to dip into your retirement funds, the longer the money will last. For more information, see Delayed Retirement Considerations.

Reduce standard of living now or in retirement

You may be able to adjust your spending habits now in order to have more money later. Consider making a written budget to track your monthly income and expenses (see Budgeting for more information). If your monetary needs have fallen far short of the mark, you will need to make a bigger spending adjustment than you would with a lesser shortfall. The following are some suggested changes:

• Move to a less-expensive home or apartment

• Sell your second car and carpool whenever possible

• Reduce your entertainment budget (e.g., bring your lunch to work, eat out once a month instead of every week, rent movies instead of going to the cinema)



• Get books and magazines from the library instead of the bookstore

• Cancel any club memberships (e.g., golf club, health club)

• Set a limit on birthday and holiday gifts for family members

• Forgo expensive vacations

• Shop for clothes in the off-season, when they're likely to be on sale

• Buy used furniture and used big-ticket items

• Limit your child's extracurricular activities, like music lessons or hockey camp

If you're unable or unwilling to lower your standard of living now, perhaps you can lower it in retirement. This may mean revising your expectations about a luxurious, vacation-filled retirement. The key is to recognize the difference between the things you want and the things you need. The following are a few suggestions to help reduce your standard of living in retirement:

• Reduce your housing expectations

• Cut back on travel plans

• Own a less-expensive automobile

• Lower household expenses

Note: There's a difference between reducing your standard of living in retirement and drastically reducing your standard of living in retirement. Most professionals discourage the use of retirement funds for your child's education if paying college bills will leave you high and dry in your retirement years.

Work part-time during retirement

About 25 percent of retirees work part-time. You may find that the extra income enables you to enjoy the kind of retirement you had anticipated.

Increase earnings (i.e., spouse returns to work)

Increasing earnings may be another way to meet both your education and retirement goals. The usual scenario is that a stay-at-home spouse returns to the workforce. This has the benefit of increasing the family's earnings so there's more money available to save for education and/or retirement. However, there are drawbacks. The additional income may push the family into a higher tax bracket (see Second-Income Analysis), and incidental expenses like day care and commuting costs may eat into your overall take-home pay. For more information on the pros and cons of a spouse returning to work, see Spouse Returns to or Increases Hours at Work.

In addition to a spouse returning to work, one spouse may decide to increase his or her hours at work, take another job with better compensation, or moonlight at a second job. Factors to consider here include the expectation of increased job pressure, less availability for child rearing and household management, the amount of extra income, the opportunity for advancement, and job security. Another way to create extra income is for a spouse to turn a hobby into a business.

Be more aggressive in investments

Your analysis has shown that your current savings (and the accompanying investment vehicles) will leave you short of your education and retirement goals. One option is to try to earn a greater rate of return on your savings. This may mean choosing more aggressive investments (e.g., growth stocks) over more conservative investments (e.g., bonds, certificates of deposit, savings accounts). This strategy works best the more years you have until retirement.



Caution: The more aggressive the investment, the greater the risk of loss of your principal. This strategy isn't for people who shudder at the slightest downturn in the stock market. If you'll have trouble sleeping at night, you probably shouldn't take on greater risk in your investment portfolio.

Reduce education goal

One of the realities parents may have to face is that they can't afford to fund 100 percent (or 75 percent, or 50 percent, as the case may be) of their child's college education. This is often an emotional issue. Parents naturally want the best for their children. For many parents, this translates into sending them to (and paying for) college (especially in cases where one or both parents didn't have such an opportunity).

You may have dreamed that your child would go to a prestigious Ivy League school. Well, with a year's cost at such a school hovering at the $40,000 mark, maybe you need to lower your expectations. That small liberal arts college or the big state school may challenge your child just as much and at a far lower cost. Remember, there are loans available for college, but none for retirement.

Children pay more and/or assume more responsibility for loans

With college costs continuing to increase at a rate faster than most family incomes (see Estimating College Costs), and with perhaps more than one child in the family picture, chances are that more responsibility will fall on your child to help fund college costs. This money can come from part-time jobs or gifts, though the majority of your child's contribution is likely to come from student loans. For more information on student loans, see Financial Aid: Loans.

Though student loans can be a financial burden in the early years, when graduates are just starting out in their careers, many loan providers offer flexible repayment options in anticipation of this common situation (see Repaying Student Loans). In addition, if your child meets certain income limits, he or she can deduct the interest paid on qualified student loans (see Student Loan Interest Deduction for more information).

When children take out student loans, parents can always decide to help financially rather than mortgaging their house before college. Students who take out student loans to pay for college may have a more vested interest in their education than students who receive help from their parents.

Other ways to lower cost of college

In addition to reducing your education goal and having your child pay a portion of college costs, there are other ways to lower the cost of college. For example, your child can choose a college with an accelerated program that allows students to graduate in three years instead of four. Likewise, your child may choose to attend a community college for two years and then transfer to a four-year private institution. The diploma will reflect the four-year college, but your pocketbook won't. For more ideas on ways to lower the cost of college, see Implementing Other Creative Solutions to Cover Higher Education Costs.

How do you decide what strategy is best for you?

This decision must be made on a case-by-case basis. What works for one family may not work for another family. In some cases, more than one strategy will be necessary to deal with the demands of educating children and retiring successfully. Factors influencing your decision may include the following:

• The amount of your financial need

• Your current income and assets and any expectation of significant future income (e.g., a bonus at work, exercise of stock options, an inheritance)

• The number of years you have until retirement

• Your willingness to reduce your standard of living (now or in the future) for the sake of your children

• The number of children in your family who plan on attending college



• The academic, athletic, or other notable skills of your child that may raise the possibility of a college scholarship

Can retirement accounts be used to save for college?

Yes. But should you? Probably not. Many financial advisors recommend against dipping into your retirement account to pay college expenses as a preferred strategy. But if you must, there are some tax breaks available.

It's now possible to withdraw money from either a traditional IRA or Roth IRA before age 59½ to pay college expenses without incurring the 10 percent early withdrawal penalty that normally applies to such withdrawals. However, any distributions of earnings and deductible contributions from a traditional IRA and any nonqualified distributions of earnings from a Roth IRA may be included in your income for the year, which may push you into a higher tax bracket. For more information, see Traditional IRAs and Roth IRAs.

Tip: This college exception to the 10 percent early withdrawal penalty is a good reason to funnel your child's income from a part-time job into an IRA.

Unfortunately, there's no similar college exception for employer-sponsored retirement plans, such as a 401(k) plan. So, if you're under age 59½, you'll pay a 10 percent early withdrawal penalty on any withdrawals. As with an IRA, any withdrawals are added into your income for the year, which may push you into a higher tax bracket. Nevertheless, saving in a 401(k) plan can be an attractive option for some parents because the company may match employee contributions and because most employer plans allow you to borrow against your contributions (and possibly earnings) before age 59½ without penalty. For more information, see Employer-Sponsored Retirement Plans for Education Savings.

Tip: Some parents who have built a college fund within their 401(k) accounts, but who are not yet 59½ when the kids are in college, take out what's called a bridge loan (such as a home equity loan) to pay their child's college bills. A bridge loan is a source of funds that tides you over until it's more economical to tap your retirement account. Although you pay interest on a bridge loan, it may still cost less than what your 401(k) funds can earn. Then, when you turn 59½, you can start tapping your 401(k) plan to pay off the bridge loan with no early withdrawal penalty.

A benefit of using retirement accounts to save for college is that the federal government doesn't consider the value of your retirement accounts in awarding financial aid (the federal formula also excludes annuities, cash value life insurance, and home equity from consideration). However, most private colleges do consider the value of your retirement accounts in deciding which students are the most deserving of campus-based aid. See Applying for Financial Aid for more information.



Summary of Tax-Advantaged College Savings Options

Federal tax-deferred-growth and tax-free earnings when withdrawals are used for qualified education expenses:

529 Plans

• 529 college savings plan:You open an individual investment account and direct your contributions to one or more pre-established investment portfolios offered by the plan. Typically, there are fees and expenses associated with opening and/or maintaining a college savings plan account (e.g., annual maintenance fee, administrative fees, and investment expenses based on a percentage of total account value).• 529 prepaid tuition plan:You prepay college tuition now at a participating college for use by your child in the future. Your contributions are pooled into the plan's general investment fund, and you are generally guaranteed a certain rate of return (or a certain amount of tuition). Typically, there are enrollment and administrative fees associated with opening and/or maintaining a prepaid tuition plan account.

State tax benefits may also apply for those who invest in the state plan where they reside.

Coverdell Education Savings Account (ESA)*

Allows saving for elementary and secondary school (K-12), as well as college. You establish an individual investment account and select the underlying investments for your contributions (i.e., stocks, mutual funds). Depending on the financial institution, there may be fees associated with opening and/or maintaining a Coverdell ESA. Income limits restrict who can open an account, and the maximum contribution allowed per year is $2,000.

State tax benefits may also apply.

U.S. Savings Bonds (Series EE and Series I)

For the bond's earnings to be exempt from federal income tax, you must meet income limits in the year you redeem the bond (the proceeds are added to your income for this determination). The earnings on federal savings bonds are always exempt from state income tax. Typically, there are no fees and expenses, except for the possibility of brokerage fees if the bonds are purchased through a broker.

Earnings taxed at the child's tax rate, but no special treatment for withdrawals to pay education expenses:

Custodial Accounts

Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) custodial accounts are established for the benefit of a minor child and managed by you or another custodian you designate. The exact type of property that can be held in the account, although generally quite broad, depends on whether your state has enacted UGMA or UTMA. Depending on the financial institution, there may be fees associated with opening and/or maintaining a custodial account. Assets transferred to the account are irrevocable gifts to the child, and withdrawals can be used only for the child's benefit. When the child reaches age 18 or 21 (depending on state law), the custodianship ends and the child receives full control of the remaining assets.

Earnings are taxed each year at the child's tax rate, but children under 19 years old and full-time students under age 24 (who do not earn more than one-half of their support) are taxed at their parents' tax rate on any earnings over a certain amount according to the kiddie tax rules.

*The provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 that raised the annual contribution limit for Coverdell ESAs to $2,000 will expire on December 31, 2010. Unless Congress extends the law, after December 31, 2010 the annual contribution limit for Coverdell ESAs will revert to $500, the limit in effect prior to January 1, 2002.

Investors should consider the investment objectives, risks, charges and expenses associated with 529 plans carefully before investing. More information about 529 plans is available in the issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.



The availability of the tax or other benefits mentioned above may be conditioned on meeting certain requirements.



College Savings Vehicles Compared

529 plans Coverdell ESA U.S. savings bonds

Custodial account

Participation restrictions

No(though state-run prepaid tuition plans are generally limited to state residents)

Yes, income limit for contributions and $2,000 maximum annual contribution per child*

No, but ability to exclude bond proceeds from federal income tax depends on income

No

Investment control

(of the underlying investments)

No Yes Yes Yes

Federal tax-exempt withdrawals

(if funds are used for qualified education expenses)

Yes (withdrawals may also be exempt from state income tax, depending on state law)

Yes (withdrawals may also be exempt from state income tax, depending on state law)

Yes, but income limits and other requirements must be met (bond proceeds are generally exempt from state income tax)

No

Penalties

(if funds aren't used for qualified education expenses)

Yes, a 10 percent federal penalty applies to the earnings portion of all nonqualified withdrawals (a state penalty may also apply)

Same as 529 plans

No, but the bond proceeds won't be exempt from federal income tax

No, but withdrawals from the account can only be made for the child's benefit

Federal financial aid treatment

(student assets are weighed more heavily than parent assets)

Parent asset (if parent is account owner)

Parent asset (if parent is account owner)

Parent asset (if parent is owner of bonds)

Student asset



Fees and expenses

College savings plan: typically an annual maintenance fee, administration fees, and investment expenses based on a percentage of total account value Prepaid tuition plan: typically an enrollment fee and various administrative fees

There may be fees associated with opening and/or maintaining an account, depending on financial institution

No fees or expenses, except for the possibility of brokerage fees if bonds are purchased through a broker

There may be fees associated with opening and/or maintaining an account, depending on financial institution

*The provision of the Economic Growth and Tax Relief Reconciliation Act of 2001 that increased the annual contribution limit for Coverdell ESAs to $2,000 is set to expire on December 31, 2010. Unless Congress acts, after that date, the annual contribution limit for Coverdell ESAs will revert to $500, the limit that was in effect prior to January 1, 2002.

U.S. Savings Bonds are guaranteed as to the payment of principal and interest. The remaining types of college savings vehicles are not guaranteed (except for 529 prepaid tuition plans) and are more risky.

Investors should consider the investment objectives, risks, charges and expenses associated with 529 plans before investing. More information about 529 plans is available in the issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.




529 Plans: Direct-Sold College Savings Plans

Current as of October 30, 2009

This table provides direct-sold 529 plan information for participating states and the District of Columbia.

Note:Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in each issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.

State Name of plan, manager, contact information

Residency restrictions Contribution limit State tax benefits

AL Higher Education 529 FundVan Kampen Asset Management, Inc. alabama529.com (866) 529-2228

Account owner or beneficiary must be an Alabama resident

$300,000 Qualified withdrawals from Alabama 529 plans (but not other states' 529 plans) are tax free and contributions to in-state plan are deductible, up to a cap

AK University of Alaska College Savings Plan T. Rowe Price Associates, Inc. uacollegesavings.com (866) 277-1005

Open to all $320,000 Alaska has no state income tax

T. Rowe Price College Savings Plan T. Rowe Price Associates, Inc. price529.com (800) 369-3641

Open to all $320,000

AZ Arizona Family College Savings Program--CollegeSure® 529 Plan College Savings Bank arizona.collegesavings.com (800) 888-2723

Open to all $335,000 Qualified withdrawals are tax free and contributions to any state's 529 plan are deductible, up to a cap

Fidelity Arizona College Savings PlanFidelity Investments fidelity.com/arizona (800) 544-1262


AR GIFT College Investing PlanUpromise Investments, Inc. thegiftplan.com (800) 587-7301

Open to all $366,000 Qualified withdrawals are tax free, and contributions to in-state plan are deductible, up to a cap



CA The ScholarShare College Savings Plan Fidelity Investments scholarshare.com (800) 544-5248

Open to all $320,000 Qualified withdrawals are tax free

CO Direct Portfolio College Savings Plan Upromise Investments, Inc. and The Vanguard Group collegeinvest.org (800) 997-4295

Open to all $280,000 Qualified withdrawals are tax free, and all contributions to in-state plan are deductible

Stable Value Plus College Savings Program MetLife Insurance Company collegeinvest.org (800) 448-2424


CT Connecticut Higher Education Trust (CHET) TIAA-CREF aboutchet.com (888) 799-2438

Open to all $300,000 Qualified withdrawals are tax free, and contributions to in-state plan are deductible, up to a cap, with a five-year carryover of excess contributions

DE Delaware College Investment Plan Fidelity Investments fidelity.com/delaware (800) 544-1655


DC DC 529 College Savings Program Calvert Asset Management Company, Inc. dccollegesavings.com (800) 368-2745

Account owner must be a DC resident or work for a firm with over 300 employees that has payroll deduction for this plan

$260,000 Qualified withdrawals are tax free, and contributions to in-state plan are deductible, up to a cap, with a five-year carryover of excess contributions

FL Florida College Investment Plan Florida Prepaid College Board myfloridaprepaid.com (800) 552-4723

Open to all $341,000 Florida has no state income tax

GA Path2College 529 Plan TIAA-CREF path2college529.com (877) 424-4377


HI Hawaii's College Savings Program Upromise Investments, Inc. hi529.s.upromise.com (866) 529-3343




ID Idaho College Savings Program (IDeal) Upromise Investments, Inc. idsaves.s.upromise.com (866) 433-2533


IL Bright Start College Savings Program OFI Private Investments, Inc. brightstartsavings.com (877) 432-7444


IN CollegeChoice 529 Direct Savings Plan Upromise Investments, Inc. collegechoicedirect.s.upromise.com (866) 485-9415

Open to all $298,770 Qualified withdrawals are tax free, and a credit may be claimed for a portion of contributions made to in-state plan

IA College Savings Iowa State Treasurer of Iowa, Upromise Investments, Inc, and The Vanguard Group collegesavingsiowa.s.upromise.com (888) 672-9116


KS Learning Quest 529 Education Savings Program American Century Investment Management, Inc. learningquestsavings.com (800) 579-2203

Open to all $300,000 Qualified withdrawals are tax free, and contributions to any state's 529 plan are deductible, up to a cap

KY Kentucky Education Savings Plan Trust TIAA-CREF kysaves.com (877) 598-7878


LA START Saving Program Louisiana State Treasurer startsaving.la.gov (800) 259-5626

Account owner or beneficiary must be a Louisiana resident

$259,720 Qualified withdrawals are tax free, and contributions to in-state plan are deductible, up to a cap, with an unlimited carryover of excess contributions

ME NextGen College Investing Plan - Client Direct Series Merrill Lynch nextgenplan.com (877) 463-9843

Open to all $340,000 Qualified withdrawals are tax free, and contributions to any state's 529 plan are deductible, up to a cap, if specific income limits are met



MD College Savings Plans of Maryland - College Investment Plan T. Rowe Price Associates, Inc. collegesavingsmd.org (888) 463-4723

Open to all $320,000 Quallified withdrawals are tax free, and contributions to in-state plan are deductible, up to a cap, with a ten-year carryover of excess contributions

MA U.Fund College Investing Plan Fidelity Investments fidelity.com/ufund (800) 544-2776

Open to all $300,000 Quallified withdrawals are tax free

MI Michigan Education Savings Program TIAA-CREF misaves.com (877) 861-6377


MN Minnesota College Savings Plan TIAA-CREF mnsaves.org (877) 338-4646


MS Mississippi Affordable College Savings (MACS) Program TIAA-CREF collegesavingsms.com (800) 486-3670


MO MOST--Missouri's 529 College Savings Plan Upromise Investments, Inc. missourimost.s.upromise.com (888) 414-6678


MT Montana Family Education Savings Program--CollegeSure® 529 Plan College Savings Bank montana.collegesavings.com (800) 888-2723


Pacific Life Funds 529 College Savings Plan (MT) Pacific Life Funds collegesavings.pacificlife.com (800) 722-2333

Account owner must be a Montana resident

$335,000

NE College Savings Plan of Nebraska Union Bank & Trust Company planforcollegenow.com (888) 993-3746




NV The Upromise College Fund Upromise Investments, Inc. upromisecollegefund.com (800) 587-7305

Open to all $310,000 Nevada has no state income tax

The Vanguard 529 Savings Plan Upromise Investments, Inc. vanguard.com (866) 734-4530


USAA College Savings Plan Upromise Investments, Inc. usaa.com (800) 292-8825


NH UNIQUE College Investing Plan Fidelity Investments fidelity.com/unique (800) 544-1914

Open to all $330,000 New Hampshire has no state income tax

NJ NJBEST 529 College Savings Plan Franklin Templeton Distributors, Inc. njbest.com (877) 465-2378

Account owner or beneficiary must be a New Jersey resident

$305,000 Qualified withdrawals are tax free

NM The Education Plan's College Savings Program OFI Private Investments, Inc. theeducationplan.com (877) 337-5268


NY New York's 529 College Savings Program Upromise Investments, Inc. and The Vanguard Group uii.nysaves.s.upromise.com (877) 697-2837


NC National College Savings Program College Foundation, Inc. cfnc.org/nc529 (800) 600-3453


ND College SAVE Upromise Investments, Inc. collegesave4u.s.upromise.com (866) 728-3529




OH Ohio CollegeAdvantage 529 Savings PlanOhio Tuition Trust Authority collegeadvantage.com (800) 233-6734

Open to all $331,000 Qualified withdrawals are tax free, and contributions to in-state plan are deductible, up to a cap, with an unlimited carryover of excess contributions

OK Oklahoma College Savings Plan TIAA-CREF ok4saving.org (877) 654-7284


OR Oregon College Savings PlanOFI Private Investments, Inc. oregoncollegesavings.com (866) 772-8464

Open to all $310,000 Qualified withdrawals are tax free, and contributions to in-state plan are deductible, up to a cap, with a four-year carryover of excess contributions

PA Pennsylvania 529 Investment Plan Upromise Investments, Inc. and the Vanguard Group makecollegepossible.com (800) 294-6195


RI CollegeBoundfund AllianceBerstein LP alliancebernstein.com/ri (888) 324-5057

Account owner or beneficiary must be a Rhode Island resident, or the account owner must work in Rhode Island

$365,000 Qualified withdrawals are tax free, and contributions to in-state plan are deductible, up to a cap, with an unlimited carryover of excess contributions

SC Future Scholar 529 College Savings Plan Columbia Management Distributors, Inc. futurescholar.com (888) 244-5674

Account owner or beneficiary must be a South Carolina resident or an employee of the State of South Carolina or Bank of America

$318,000 Qualified withdrawals are tax free, and all contributions to in-state plan are deductible

SD CollegeAccess 529 Allianz Global Investors Distributors, LLC collegeaccess529.com (866) 529-7462

Account owner or beneficiary must be a South Dakota resident

$350,000 South Dakota has no state income tax

TX Texas College Savings Plan OFI Private Investments, Inc.texascollegesavings.com (800) 445-4723

Open to all $320,000 Texas has no state income tax



UT Utah Educational Savings Plan (UESP) Trust Utah Higher Education Assistance Authority uesp.org (800) 418-2551


VT Vermont Higher Education Investment Plan TIAA-CREF vheip.com (800) 637-5860


VA Virginia Education Savings Trust (VEST) Virginia College Savings Plan Board virginia529.com (888) 567-0540


CollegeWealth Virginia College Savings Plan Board virginia529.com (888) 567-0540


WV SMART529 WV Direct College Savings Plan Hartford Life Insurance Company smart529.com (866) 574-3542

Account owner or beneficiary must have a West Virginia mailing address or be a West Virginia resident on active duty in the U.S. Armed Forces

$265,620 Qualified withdrawals are tax free, and all contributions to in-state plan are deductible

SMART529 Select Hartford Life Insurance Company smart529select.com (866) 574-3542


WI EdVest Wells Fargo Funds Management, LLCwellsfargoadvantagefunds.com (888) 338-3789




529 Plans: Advisor-Sold College Savings Plans


This table provides advisor-sold 529 plan information for participating states and the District of Columbia.



Residency restrictions

Contribution limit State tax benefits

AL Higher Education 529 FundVan Kampen Asset Management, Inc. vankampen.com (866) 529-2228

Open to all $300,000 Qualified withdrawals from Alabama 529 plans (but not other states' 529 plans) are tax free and contributions to in-state plan are deductible, up to a cap

AK John Hancock Freedom 529T. Rowe Price Associates, Inc. johnhancockfreedom529.com (866) 222-7498

Open to all $320,000 Alaska has no state income tax

AZ InvestEd PlanWaddell & Reed invested529.com (888) 923-3355

Open to all $335,000 Qualified withdrawals are tax free and contributions to any state's 529 plan are deductible, up to a cap

AR iShares 529 Plan Upromise Investments, Inc. ishares529.s.upromise.com (888) 529-9552

Open to all $366,000 Qualified withdrawals are tax free and contributions to in-state plan are deductible, up to a cap

CA ScholarShare Advisor College Savings Plan Fidelity Investments scholarshare.com (800)522-7297


CO Scholars Choice College Savings Program ClearBridge Advisors, LLC scholars-choice.com (888) 572-4652




DC DC 529 College Savings Program Calvert Asset Management Co., Inc.dccollegesavings.com (800) 368-2745

Open to all $260,000 Qualified withdrawals are tax free, and contributions to any DC plan are deductible, up to a cap, with a five-year carryover of excess contributions

IL Bright Start College Savings Program OFI Private Investments, Inc. brightstartadvisor.com (877) 432-7444


Bright Directions College Savings Program Union Bank & Trust Company brightdirections.com (866) 722-7283


IN CollegeChoice Advisor 529 Savings Plan Upromise Investments, Inc. collegechoiceadvisor529.s.upromise.com (866) 485-9413


IA Iowa Advisor 529 Plan Upromise Investments, Inc. iowaadvisor529.s.upromise.com (800) 774-5127


KS Learning Quest Advisor American Century Investment Management, Inc. learningquestsavings.com (877) 882-6236


Schwab 529 College Savings Plan American Century Investment Management, Inc. schwab.com/529 (866) 663-5247




ME NextGen College Investing Plan - Client Select Series Merrill Lynch nextgenplan.com (877) 463-9843

Open to all $340,000 Qualified withdrawals are tax free, and contributions to any state's 529 plan are deductible, up to a cap, if specific income limits are met

MS MACS 529 Advisor Program TIAA-CREF 529advisorprograms.com (877) 238-7529


MO MOST--Missouri's 529 Advisor Plan Upromise Investments, Inc. most529advisor.s.upromise.com (888) 411-0117


MT Pacific Life Funds 529 College Savings Plan Pacific Life Funds collegesavings.pacificlife.com (800) 722-2333


NE College Savings Plan of Nebraska Union Bank & Trust Company planforcollegenow.com (888) 993-3746


TD Ameritrade 529 College Savings Plan Union Bank & Trust Company collegesavings.tdameritrade.com (877) 408-4644


State Farm College Savings Plan Union Bank & Trust Company statefarm.com/mutual/acct_types/529.asp (800) 321-7520


NV Columbia 529 PlanUpromise Investments, Inc. columbia529.com (877) 994-2529

Open to all $310,000 Nevada has no state income tax



NH Fidelity Advisor 529 PlanFidelity Investments advisor.fidelity.com (800) 522-7297

Open to all $330,000 New Hampshire has no state income tax

NJ Franklin Templeton 529 College Savings PlanFranklin Templeton Distributors, Inc.franklintempleton.com (866) 362-1597


NM Scholar'sEdgeOFI Private Investments, Inc.scholarsedge529.com (866) 529-7283


NY New York's 529 College Savings Program Upromise Investments, Inc. and Columbia Management Group ny529advisor.com (800) 774-2108


OH Putnam CollegeAdvantage Putnam Investments putnam.com (800) 225-1581


BlackRock CollegeAdvantage 529 Plan BlackRock Advisors blackrock.com/collegeadvantage (866) 529-8582


OK OklahomaDream 529 Plan TIAA-CREF okdream529.com (877) 529-9299


OR OppenheimerFunds 529 Plan OFI Private Investments, Inc. opp529.com (866) 772-8464

Open to all $310,000 Qualified withdrawals are tax free, and contributions to in-state plan are deductible, up to a cap, with a four-year carryover of excess contributions



MFS 529 Savings Plan MFS Investment Management mfs.com (866) 637-7526


RI CollegeBoundfund AllianceBernstein LP alliancebernstein.com (888) 324-5057


SC Future Scholar 529 College Savings Plan Columbia Management Distributors, Inc. futurescholar.com (888) 244-5674


SD CollegeAccess 529 Allianz Global Investors Distributors LLC collegeaccess529.com (866) 529-7462

Open to all $350,000 South Dakota has no state income tax

TX Lonestar 529 Plan OFI Private Investments, Inc. lonestar529.com (800) 445-4723

Open to all $320,000 Texas has no state income tax

VA CollegeAmericaAmerican Funds americanfunds.com (800) 421-0180


WV The Hartford Smart529 Hartford Life Insurance Companysmart529.com (866) 574-3542


WI EdVest Wells Fargo Funds Management, LLC edvest.com (888) 338-3789




tomorrow's scholarWells Fargo Funds Management, LLC tomorrowsscholar.com (866) 677-6933




529 Plans: Prepaid Tuition Plans


This table provides information on 529 prepaid tuition plans that are currently accepting new enrollments. The first section covers state-sponsored plans; the second covers college-sponsored plans.


State-Sponsored Prepaid Tuition Plans


Residency restrictions

Contribution limit State tax benefits

FL Florida Prepaid College Plan Florida Prepaid College Board my floridaprepaid.com (800) 552-4723

Beneficiary or parent/guardian must be a Florida resident for at least 12 months prior to enrollment

$45,875 for a four-year contract purchased in lump sum for 8th grader

Florida has no state income tax

IL College Illinois! 529 Prepaid Tuition ProgramIllinois Student Assistance Commission collegeillinois.com (877) 877-3724

Account owner or beneficiary must be an Illinois resident for at least 12 months prior to enrollment

$70,126 for a nine-semester contract purchased in lump sum for 9th grader or older

Qualified withdrawals are tax free, and contributions to in-state plan are deductible, up to a cap

MD College Savings Plans of Maryland - Prepaid College Trust College Savings Plans of Maryland collegesavingsmd.org (888) 463-4723

Account owner or beneficiary must be a Maryland or District of Columbia resident

$48,295 for a five-year contract purchased in lump sum for 9th grader

Qualified withdrawals are tax free, and contributions to in-state plan are deductible, up to a cap, with an unlimited carryover of excess contributions

MA U.PlanMassachusetts Educational Financing Authority mefa.org (800) 449-6332 Note: This plan does not meet the requirements of Section 529 of the Internal Revenue Code

Open to all Cost of tuition and fees for four years at the highest-cost participating institution

The U. Plan issues Massachusetts general obligation bonds that are exempt from federal and state income tax



MI Michigan Education TrustMET Board of Directors and Treasury Department met4kid.com (800) 638-4543

Beneficiary must be a Michigan resident

$48,432 for a four-year contract purchased in lump sum after 10th grade

Qualified withdrawals are tax free, and all contributions to in-state plan are deductible

MS Mississippi Prepaid Affordable College Tuition (MPACT) Program Mississippi Treasury Department treasury.state.ms.us (800) 987-4450

Account owner or beneficiary must be a Mississippi resident

$25,895 for a five-year contract purchased in lump sum for 12th grader

Qualified withdrawals are tax free, and all contributions to in-state plan are deductible

NV Nevada Prepaid Tuition Program State Treasurer nevadatreasurer.gov/PrepaidTuition (888) 477-2667

Account owner or beneficiary must be a Nevada resident, or account owner must be an alumnus of a Nevada college

$19,050 for a four-year contract purchased in lump sum for 9th grader

Nevada has no state income tax

PA Pennsylvania 529 Guaranteed Savings Plan State Treasury makecollegepossible.com (800) 440-4000

Account owner or beneficiary must be a Pennsylvania resident

$368,600 Qualified withdrawals are tax free, and contributions to any state's 529 plan are deductible, up to a cap

TN Tennessee's BEST Prepaid College Tuition Plan State Treasurer treasury.tn.gov/best (888) 486-2378

Account owner or beneficiary must be a Tennessee resident

$235,000 Tennessee has no state income tax

TX Texas Tuition Promise Fund OFI Private Investments, Inc. texastuitionpromisefund..com (800) 455-4723

Beneficiary must be a Texas resident or have a parent who is a Texas resident and the account owner

$59,100 for lump sum contract

Texas has no state income tax

VA Virginia Prepaid Education Program (VPEP) Virginia College Savings Plan virginia529.com (888) 567-0540

Account owner, beneficiary, or parent of a nonresident beneficiary must be a Virginia resident or member of U.S. military who is stationed in Virginia

$56,925 for a five-year contract purchased in lump sum for a newborn

Qualified withdrawals are tax free, and contributions to in-state plan are deductible, up to a cap, with an unlimited carryover of excess contributions

WA Guaranteed Education Tuition (GET)Washington State Higher Education Coordinating Board get.wa.gov (800) 955-2318

Account owner or beneficiary must be a Washington resident

$50,500 for 500 units Washington has no state income tax



Private College-Sponsored Prepaid Tuition Plans

Independent 529 PlanTuition Plan Consortium, LLC independent529plan.org (888) 718-7878

Open to all Cost of five years full-time undergraduate tuition and mandatory fees at the highest-cost participating institution

Varies from state to state; contact a tax professional



Advantages and Disadvantages of 529 Plans

Advantages

• People of all income levels are eligible to contribute to a 529 plan• 529 plans have high contribution limits (many plans have contribution limits of $300,000 and up)• College savings plans are open to residents of any state• Plan contributions grow income tax deferred• Withdrawals that are used to pay the beneficiary's qualified education expenses are completely income tax free at the federal level• States may offer their own income tax incentives for residents of their state, such as a tax deduction for contributions or a tax exemption for withdrawals used to pay the beneficiary's qualified education expenses. Before investing in a 529 plan outside your state of residency, find out what state tax benefits, if any, you might lose if you do so.• Plan contributions qualify for the $13,000 ($26,000 for joint gifts) annual gift tax exclusion, and a special election lets you contribute up to $65,000 ($130,000 for joint gifts) in a single year and avoid gift tax by treating the amount as a gift in equal installments over five years (no additional gifts can be made to the beneficiary during the five-year period without incurring a gift tax)• Plan contributions generally aren't considered part of your estate for federal tax purposes, yet you still retain control of the account during your lifetime as the account owner• You can change the beneficiary without penalty if certain conditions are met• You can contribute to a 529 plan and a Coverdell education savings account (ESA) in the same year for the same beneficiary without triggering a penalty• Once every 12 months you can roll over the beneficiary's 529 account to a different 529 plan for the same beneficiary without tax or penalty implications• Some 529 college savings plans let you change your investment portfolio once each calendar year and/or anytime you change the beneficiary• A 529 account is treated as a parental asset for federal financial aid purposes (if parent is the account owner) and assessed at a rate of 5.6% (distributions aren't counted as parent or student income)• A 529 account owned by someone other than the parent (like a grandparent) is not considered an asset for financial aid purposes

Disadvantages

• 529 plans charge various fees and expenses to cover investment expenses and the administration of your account• Withdrawals from a 529 plan that are not used for the beneficiary's qualified education expenses are taxed and penalized (the earnings portion of the withdrawal is subject to a 10 percent federal penalty and is taxed at the income tax rate of the person who receives the withdrawal)• For college savings plans, your investment choices are limited to the pre-established investment portfolios offered by the plan; prepaid tuition plans give you no opportunity to choose your investments• You are generally limited to the prepaid tuition plan offered by your state of residence• Prepaid tuition plans are generally designed to pay the undergraduate tuition (but not room and board) costs at in-state public colleges, so the beneficiary won't get the maximum benefits under the plan if he or she attends a private or out-of-state college• Prepaid tuition plans generally require that all tuition credits be used before the beneficiary reaches age 30, and all withdrawals completed within 10 years of the time the beneficiary starts college• College savings plans don't guarantee your return and are subject to risk--you could lose some or all of the money you've contributed• College savings plans aren't legally required to let you change the investment option on your existing contributions once per calendar year or allow you to choose a new investment option for any future contributions (though most plans do give you this flexibility)



Advantages and Disadvantages of U.S. Savings Bonds for College Savings

Series EE bonds (may also be called Patriot bonds) issued January 1990 and laterSeries I bonds

Advantages

• Interest earned is generally exempt from state income tax• Interest earned may be exempt from federal income tax if bond proceeds are used to pay the beneficiary's qualified education expenses, provided certain other conditions are met*• Bonds are backed by the federal government, so they offer a virtually guaranteed rate of return• You retain control of the bonds as long as they are owned in your name• Series EE bonds are purchased at half their face value, so you can begin investing with smaller amounts• Bonds earn interest for up to 30 years• Bonds are treated as a parental asset for federal financial aid purposes and assessed at a rate of 5.6 percent

Disadvantages

• Bond proceeds that are not used for the beneficiary's qualified higher education expenses will be taxed to the owner• Qualified education expenses for purposes of U.S. savings bonds generally include tuition and fees only, not room and board• The maximum annual purchase allowed is $15,000 per individual for EE bonds ($30,000 face value) and $30,000 for I bonds (EE bonds may be purchased at half their face value; I bonds are purchased at full face value)• Your income must be below a certain level at the time you redeem (cash in) the bonds for you to be eligible to exclude the interest earned from federal income tax (yet you must add the bond proceeds into your total income for the year when determining whether you meet this income threshold)*

*For the interest to be excluded from federal income tax, the following conditions must be met: (1) the owner must be at least 24 years old when the bonds are purchased (2) the beneficiary must be the owner, the owner's spouse, or the owner's dependent and (3) in 2010, the owner's modified adjusted gross income (MAGI) at the time the bonds are redeemed (cashed in) must be less than $70,100 for a full exemption for single filers (a partial exemption is allowed for MAGI between $70,100 and $85,100) and less than $105,100 for joint filers (a partial exemption is allowed for MAGI between $105,100 and $135,100).



Advantages and Disadvantages of Custodial Accounts for College Savings

Uniform Gifts to Minors Act (UGMA)Uniform Transfers to Minors Act (UTMA)

Advantages

• People of all income levels are eligible to open an UGMA/UTMA account• You can invest as much as you want in an UGMA/UTMA account--there are no contribution limits• Both types of accounts offer a wide variety of investment choices (though an UTMA account generally gives you more options than an UGMA account)

Disadvantages

• Investment earnings are generally subject to federal and state income tax every year, and the sale of assets may trigger capital gains tax • Earnings are taxed to the child (beneficiary) every year, and special rules commonly referred to as the "kiddie tax" rules apply when a child has unearned income• Children subject to the kiddie tax are generally taxed at their parents' tax rate on any unearned income over a certain amount ($1,900 in 2010)• Gifts made to an UGMA/UTMA account are irrevocable gifts to your child and withdrawals from the account can be made only for purposes that directly benefit your child• You can't change the beneficiary• When the child reaches the age of majority (either 18 or 21, as defined by state law), the custodianship ends and the child has the right to complete control of the funds• The account is treated as an asset of the child for federal financial aid purposes and assessed at a rate of 20 percent• When total contributions exceed $13,000, or $26,000 for joint gifts (in 2010), a federal gift tax may result



Advantages and Disadvantages of Coverdell Education Savings Accounts

Advantages

• Withdrawals that are used to pay the beneficiary's qualified education expenses are completely income tax free at the federal level• Qualified education expenses include elementary and secondary school expenses• You have complete freedom to choose the investments you put in the account• You can change the beneficiary without penalty if certain conditions are met• You can contribute to a 529 plan and a Coverdell ESA in the same year for the same beneficiary without triggering a penalty• A Coverdell ESA is considered an asset of the parent for federal financial aid purposes and assessed at a rate of 5.6 percent (distributions aren't counted as parent or student income)

Disadvantages

• You can contribute a maximum of only $2,000 each year*• Your ability to contribute depends on your income--to make the full $2,000 contribution, single filers must have a modified adjusted gross income (MAGI) of $95,000 or less (a partial contribution is allowed if MAGI is between $95,000 and $110,000) and joint filers must have a MAGI of $190,000 or less (a partial contribution is allowed if MAGI is between $190,000 and $220,000)• Contributions aren't allowed after the beneficiary reaches age 18, unless the beneficiary has special needs• The account must be closed after the beneficiary reaches age 30, unless the beneficiary has special needs• Withdrawals from a Coverdell ESA that are not used for the beneficiary's qualified education expenses are taxed and penalized (the earnings portion of the withdrawal is subject to a 10 percent federal penalty and is taxed at the rate of the person who receives the withdrawal)• Depending on the financial institution, there may be fees associated with opening and/or maintaining the account

* The provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 that raised the annual contribution limit for Coverdell ESAs to $2,000 will expire on December 31, 2010. Unless Congress extends the law, after December 31, 2010, the annual contribution limit for Coverdell ESAs will revert to $500, the limit in effect prior to January 1, 2002.



529 Plans vs. Coverdell Education Savings Accounts

Question 529 Plan Coverdell ESA

What is the maximum contribution limit?

Varies by state. Lifetime contributions are typically over $300,000.

$2,000 per year1

Is your ability to contribute based on your adjusted gross income (AGI)?

No Single filers can make a full contribution if modified adjusted gross income (MAGI) is $95,000 or less (a partial contribution is allowed if MAGI is between $95,000 and $110,000). Joint filers can make a full contribution if MAGI is $190,000 or less (a partial contribution is allowed if MAGI is between $190,000 and $220,000).

Can the account stay open indefinitely?

Varies by state and type of 529 plan. Prepaid tuition plans usually have a limit; most college savings plans don't.

No, cannot exist for any beneficiary 30 or older, unless the beneficiary is a special needs child. Also, contributions aren't allowed after the beneficiary turns 18, unless the beneficiary has special needs.

Do you get a federal income tax deduction for contributions?

No No

Are qualified withdrawals (those used for the beneficiary's education expenses) exempt from federal income tax?

Yes Yes. Qualified education expenses also include elementary and secondary school expenses.

Are withdrawals subject to federal income tax and penalty if not used for qualified education expenses?

Yes (earnings portion only)2 Yes (earnings portion only)2

Do contributions have federal gift tax consequences?

No, for contributions up to the annual gift tax exclusion.3Additional gifts made to the beneficiary outside the 529 plan may trigger gift tax.

No, maximum contribution allowed per year is less than the annual gift tax exclusion. However, additional gifts made to the beneficiary outside the Coverdell ESA may trigger gift tax.

Are you free to change the beneficiary?

Yes, if you are the account owner. No penalty applies if the new beneficiary is a qualified member of the prior beneficiary's family.4

Depends on trustee's policies, but generally yes. No penalty applies if the new beneficiary is a qualified member of the prior beneficiary's family and is not over age 30 when the change is made.



Can you choose your own investments?

Varies by state and type of 529 plan. Prepaid tuition plans generally don't let you choose your investments; college savings plans may give you limited chances to choose from several pre-established portfolios.

Yes, choices are virtually unlimited.

Can you roll over your account to a new one?

A penalty-free "same-beneficiary" rollover to a different 529 plan is allowed once every 12 months. You may also do a rollover anytime the beneficiary is changed. Any rollover must be done within 60 days to avoid tax and penalty.

Unlimited trustee-to-trustee transfers allowed. For distributions received, one rollover allowed every 12 months to a different Coverdell ESA (must be done within 60 days to avoid tax and penalty).

What is the federal financial aid impact?

A 529 plan is considered a parental asset if the parent is the account owner, and assessed at 5.6% per year. Distributions from a 529 plan are not counted as parent or student income and thus do not affect aid award.

Same treatment as 529 plans. A Coverdell ESA is considered a parental asset if the parent is the account owner, and assessed at 5.6% per year. Distributions from a Coverdell ESA are not counted as parent or student income and thus do not affect aid award.

1The provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 that raised the annual contribution limit for Coverdell ESAs to $2,000 will expire on December 31, 2010. Unless Congress extends the law, after December 31, 2010 the annual contribution limit for Coverdell ESAs will revert to $500, the limit in effect prior to January 1, 2002.

2A 10% federal penalty is assessed on the earnings portion of all nonqualified withdrawals from a 529 plan and a Coverdell ESA. The penalty generally doesn't apply to nonqualified withdrawals made due to the beneficiary's death, disability, or receipt of a tax-free scholarship (to the extent of the scholarship's value).

3The annual gift tax exclusion is currently $13,000. However, you may contribute up to $65,000 to a 529 plan in one year (for the same beneficiary) and not owe gift tax if you elect to spread the gift over a five-year period and you make no additional gifts to the beneficiary during that period.

4Qualified family members include children and their descendants, stepchildren, siblings, stepsiblings, parents, stepparents, nieces, nephews, aunts, uncles, first cousins, and in-laws of the original beneficiary.





Investing for Major Financial Goals

Go out into your yard and dig a big hole. Every month, throw $50 into it, but don't take any money out until you're ready to buy a house, send your child to college, or retire. It sounds a little crazy, doesn't it? But that's what investing without setting clear-cut goals is like. If you're lucky, you may end up with enough money to meet your needs, but you have no way to know for sure.

How do you set goals?

The first step in investing is defining your dreams for the future. If you are married or in a long-term relationship, spend some time together discussing your joint and individual goals. It's best to be as specific as possible. For instance, you may know you want to retire, but when? If you want to send your child to college, does that mean an Ivy League school or the community college down the street?

You'll end up with a list of goals. Some of these goals will be long term (you have more than 15 years to plan), some will be short term (5 years or less to plan), and some will be intermediate (between 5 and 15 years to plan). You can then decide how much money you'll need to accumulate and which investments can best help you meet your goals.

Looking forward to retirement

After a hard day at the office, do you ask, "Is it time to retire yet?" Retirement may seem a long way off, but it's never too early to start planning--especially if you want your retirement to be a secure one. The sooner you start, the more ability you have to let time do some of the work of making your money grow.

Let's say that your goal is to retire at age 65 with $500,000 in your retirement fund. At age 25 you decide to begin contributing $250 per month to your company's 401(k) plan. If your investment earns 6 percent per year, compounded monthly, you would have more than $500,000 in your 401(k) account when you retire. (This is a hypothetical example, of course, and does not represent the results of any specific investment.)

But what would happen if you left things to chance instead? Let's say you wait until you're 35 to begin investing. Assuming you contributed the same amount to your 401(k) and the rate of return on your investment dollars was the same, you would end up with only about half the amount in the first example. Though it's never too late to start working toward your goals, as you can see, early decisions can have enormous consequences later on.

Some other points to keep in mind as you're planning your retirement saving and investing strategy:

• Plan for a long life. Average life expectancies in this country have been increasing for many years. and many people live even longer than those averages.

• Think about how much time you have until retirement, then invest accordingly. For instance, if retirement is a long way off and you can handle some risk, you might choose to put a larger percentage of your money in stock (equity) investments that, though more volatile, offer a higher potential for long-term return than do more conservative investments. Conversely, if you're nearing retirement, a greater portion of your nest egg might be devoted to investments focused on income and preservation of your capital.

• Consider how inflation will affect your retirement savings. When determining how much you'll need to save for retirement, don't forget that the higher the cost of living, the lower your real rate of return on your investment dollars.



Facing the truth about college savings

Whether you're saving for a child's education or planning to return to school yourself, paying tuition costs definitely requires forethought--and the sooner the better. With college costs typically rising faster than the rate of inflation, getting an early start and understanding how to use tax advantages and investment strategy to make the most of your savings can make an enormous difference in reducing or eliminating any post-graduation debt burden. The more time you have before you need the money, the more you're able to take advantage of compounding to build a substantial college fund. With a longer investment time frame and a tolerance for some risk, you might also be willing to put some of your money into investments that offer the potential for growth.

Consider these tips as well:

• Estimate how much it will cost to send your child to college and plan accordingly. Estimates of the average future cost of tuition at two-year and four-year public and private colleges and universities are widely available.

• Research financial aid packages that can help offset part of the cost of college. Although there's no guarantee your child will receive financial aid, at least you'll know what kind of help is available should you need it.

• Look into state-sponsored tuition plans that put your money into investments tailored to your financial needs and time frame. For instance, most of your dollars may be allocated to growth investments initially; later, as your child approaches college, more conservative investments can help conserve principal.

• Think about how you might resolve conflicts between goals. For instance, if you need to save for your child's education and your own retirement at the same time, how will you do it?

Investing for something big

At some point, you'll probably want to buy a home, a car, maybe even that yacht that you've always wanted. Although they're hardly impulse items, large purchases often have a shorter time frame than other financial goals; one to five years is common.

Because you don't have much time to invest, you'll have to budget your investment dollars wisely. Rather than choosing growth investments, you may want to put your money into less volatile, highly liquid investments that have some potential for growth, but that offer you quick and easy access to your money should you need it.



The Best Ways to Save for College

In the college savings game, all strategies aren't created equal. The best savings vehicles offer special tax advantages if the funds are used to pay for college. Tax-advantaged strategies are important because over time, you can potentially accumulate more money with a tax-advantaged investment compared to a taxable investment. Ideally, though, you'll want to choose a savings vehicle that offers you the best combination of tax advantages, financial aid benefits, and flexibility, while meeting your overall investment needs.

529 plans

Since their creation in 1996, 529 plans have become to college savings what 401(k) plans are to retirement savings--an indispensable tool for helping you amass money for your child's or grandchild's college education. That's because 529 plans offer a unique combination of benefits unmatched in the college savings world.

There are two types of 529 plans--college savings plans and prepaid tuition plans. Though each is governed under Section 529 of the Internal Revenue Code (hence the name "529" plans), college savings plans and prepaid tuition plans are very different college savings vehicles. There are typically fees associated with opening and maintaining each type of account.

Note:Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about specific 529 plans is available in each issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.

529 plans: college savings plans

A 529 college savings plan is a tax-advantaged college savings vehicle that lets you save money for college in an individual investment account. Some plans let you enroll directly, while others require that you go through a financial professional.

The details of college savings plans vary by state, but the basics are the same. You'll need to fill out an application, where you'll name a beneficiary and select one or more of the plan's investment portfolios to which your contributions will be allocated. Also, you'll typically be required to make an initial minimum contribution, which must be in cash.

529 college savings plans offer a unique combination of features that no other college savings vehicle can match:

• Federal tax advantages: Contributions to your account grow tax deferred and are completely tax free if the money is used to pay the beneficiary's qualified education expenses. The earnings portion of any withdrawal not used for college expenses is taxed at the recipient's rate and subject to a 10 percent federal penalty.

• State tax advantages: Many states offer income tax incentives for state residents, such as a tax deduction for contributions or a tax exemption for qualified withdrawals. However, be aware that some states limit their tax deduction to contributions made to the in-state 529 plan only.

• High contribution limits: Most college savings plans have lifetime maximum contribution limits over $300,000.

• Unlimited participation: Anyone can open a 529 college savings plan account, regardless of income level.

• Professional money management: College savings plans are managed by designated financial companies who are responsible for managing the plan's underlying investment portfolios.



• Flexibility: Under federal rules, you can change the beneficiary of your account to a qualified family member at any time without penalty. And you can rollover the money in your 529 plan account to a different 529 plan once per year without income tax or penalty implications.

• Wide use of funds: Money in a 529 college savings plan can be used at any college in the United States or abroad that's accredited by the U.S. Department of Education and, depending on the individual plan, for graduate school.

• Accelerated gifting: 529 plans offer an excellent estate planning advantage in the form of accelerated gifting. This can be a favorable way for grandparents to contribute to their grandchildren's college education. Individuals can make a lump-sum gift to a 529 plan in 2010 of up to $65,000 ($130,000 for married couples) and avoid federal gift tax, provided a special election is made to treat the gift as having been made in equal installments over a five-year period and no other gifts are made to that beneficiary during the five years.

• Variety: Currently, there are over 50 different college savings plans to choose from because many states offer more than one plan. You can join any state's college savings plan.

But college savings plans have drawbacks too. You relinquish some control of your money. Returns aren't guaranteed--you roll the dice with the investment portfolios you've chosen, and your account may gain or lose money.

529 plans: prepaid tuition plans

Prepaid tuition plans are distant cousins to college savings plans--their federal tax treatment is the same, but just about everything else is different. A prepaid tuition plan is a tax-advantaged college savings vehicle that lets you pay tuition expenses at participating colleges at today's prices for use in the future. Prepaid tuition plans can be run either by states or colleges. For state-run plans, you prepay tuition at one or more state colleges; for college-run plans, you prepay tuition at the participating college(s).

As with 529 college savings plans, you'll need to fill out an application and name a beneficiary. But instead of choosing an investment portfolio, you purchase an amount of tuition credits or units (which you can then do again periodically), subject to plan rules and limits. Typically, the tuition credits or units are guaranteed to be worth a certain amount of tuition in the future, no matter how much college costs may increase between now and then. As such, prepaid tuition plans provide some measure of security over rising college prices.

• Federal and state tax advantages: The federal and state tax advantages given to prepaid tuition plans are the same as for college savings plans.

• Other similarities to college savings plans: Prepaid tuition plans are open to people of all income levels, and they offer flexibility in terms of changing the beneficiary or rolling over to another 529 plan once per year, as well as accelerated gifting.

Prepaid tuition plans have some limitations, though, compared to college savings plans. One major drawback is that your child is generally limited to your own state's prepaid tuition plan, and then your child is limited to the colleges that participate in that plan. If your child attends a different college, prepaid plans differ on how much money you'll get back. Also, some prepaid plans have been forced to reduce benefits after enrollment due to investment returns that have not kept pace with the plan's offered benefits. Even with these limitations, some college investors appreciate the peace of mind that comes with not worrying about college inflation each year by locking in college costs today.

Coverdell education savings accounts

A Coverdell education savings account (Coverdell ESA) is a tax-advantaged education savings vehicle that lets you save money for college, as well as for elementary and secondary school (K-12) at public, private, or religious schools. Here's how it works:



• Application process: You fill out an application at a participating financial institution and name a beneficiary. Depending on the institution, there may be fees associated with opening and maintaining the account. The beneficiary must be under age 18 when the account is established (unless he or she is a child with special needs).

• Contribution rules: You (or someone else) make contributions to the account, subject to the maximum annual limit of $2,000. This means that the total amount contributed for a particular beneficiary in a given year can't exceed $2,000, even if the money comes from different people. Contributions can be made up until April 15 of the year following the tax year for which the contribution is being made.

• Investing contributions: You invest your contributions as you wish (e.g., stocks, bonds, mutual funds, certificates of deposit)--you have sole control over your investments.

• Tax treatment: Contributions to your account grow tax deferred, which means you don't pay income taxes on the account's earnings (if any) each year. Money withdrawn to pay college or K-12 expenses (called a qualified withdrawal) is completely tax free at the federal level(and typically at the state level too). If the money isn't used for college or K-12 expenses (called a nonqualified withdrawal), the earnings portion of the withdrawal will be taxed at the beneficiary's tax rate and subject to a 10 percent federal penalty.

• Rollovers and termination of account: Funds in a Coverdell ESA can be rolled over without penalty into another Coverdell ESA for a qualifying family member. Also, any funds remaining in a Coverdell ESA must be distributed to the beneficiary when he or she reaches age 30 (unless the beneficiary is a person with special needs).

Unfortunately, not everyone can open a Coverdell ESA--your ability to contribute depends on your income. To make a full contribution, single filers must have a modified adjusted gross income (MAGI) of $95,000 or less, and joint filers must have a MAGI of $190,000 or less. And with an annual maximum contribution limit of $2,000, a Coverdell ESA probably can't go it alone in meeting today's college costs.

Note: The provision of the Economic Growth and Tax Relief Reconciliation Act of 2001 that increased the annual contribution limit for Coverdell ESAs to $2,000 is scheduled to expire on December 31, 2010. Unless Congress acts, after this date, the annual contribution limit for Coverdell ESAs will revert to $500, its status prior to January 1, 2002.

Custodial accounts

Before 529 plans and Coverdell ESAs, there were custodial accounts. A custodial account allows your child to hold assets--under the watchful eye of a designated custodian--that he or she ordinarily wouldn't be allowed to hold in his or her own name. The assets can then be used to pay for college or anything else that benefits your child (e.g., summer camp, braces, hockey lessons, a computer). Here's how a custodial account works:

• Application process: You fill out an application at a participating financial institution and name a beneficiary. Depending on the institution, there may be fees associated with opening and maintaining the account.

• Custodian: You also designate a custodian to manage and invest the account's assets. The custodian can be you, a friend, a relative, or a financial institution. The assets in the account are controlled by the custodian.

• Assets: You (or someone else) contribute assets to the account. The type of assets you can contribute depends on whether your state has enacted the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA). Examples of assets typically contributed are stocks, bonds, mutual funds, and real property.

• Tax treatment: Earnings, interest, and capital gains generated from assets in the account are taxed every year to your child. Assuming your child is in a lower tax bracket than you, you'll reap some tax savings compared to if you had held the assets in your name. But this opportunity is very limited



because of special rules, called the "kiddie tax" rules, that apply when a child has unearned income. Under these rules, children are generally taxed at their parents' tax rate on any unearned income over a certain amount. For 2010, this amount is $1,900 (the first $950 is tax free and the next $950 is taxed at the child's rate). The kiddie tax rules apply to: (1) those under age 18, (2) those age 18 whose earned income doesn't exceed one-half of their support, and (3) those ages 19 to 23 who are full-time students and whose earned income doesn't exceed one-half of their support.

A custodial account provides the opportunity for some tax savings, but the kiddie tax sharply reduces the overall effectiveness of custodial accounts as a tax-advantaged college savings strategy. And there are other drawbacks. All gifts to a custodial account are irrevocable. Also, when your child reaches the age of majority (as defined by state law, typically 18 or 21), the account terminates and your child gains full control of all the assets in the account. Some children may not be able to handle this responsibility, or might decide not to spend the money for college.

U.S. savings bonds

Series EE and Series I bonds are types of savings bonds issued by the federal government that offer a special tax benefit for college savers. The bonds can be easily purchased from most neighborhood banks and savings institutions, or directly from the federal government. They are available in face values ranging from $50 to $10,000. You may purchase the bond in electronic form at face value or in paper form at half its face value.

If the bond is used to pay qualified education expenses and you meet income limits (as well as a few other minor requirements), the bond's earnings are exempt from federal income tax. The bond's earnings are always exempt from state and local tax.

In 2010, to be able to exclude all of the bond interest from federal income tax, married couples must have a modified adjusted gross income of $105,100 or less at the time the bonds are redeemed (cashed in), and individuals must have an income of $70,100 or less. A partial exemption of interest is allowed for people with incomes slightly above these levels.

The bonds are backed by the full faith and credit of the federal government, so they are a relatively safe investment. They offer a modest yield, and Series I bonds offer an added measure of protection against inflation by paying you both a fixed interest rate for the life of the bond (like a Series EE bond) and a variable interest rate that's adjusted twice a year for inflation. However, there is a limit on the amount of bonds you can buy in one year, as well as a minimum waiting period before you can redeem the bonds, with a penalty for early redemption.

Financial aid impact

Your college saving decisions impact the financial aid process. Come financial aid time, your family's income and assets are run through a formula at both the federal level and the college (institutional) level to determine how much money your family should be expected to contribute to college costs before you receive any financial aid. This number is referred to as the expected family contribution, or EFC.

In the federal calculation, your child's assets are treated differently than your assets. Your child must contribute 20 percent of his or her assets each year, while you must contribute 5.6 percent of your assets.

For example, $10,000 in your child's bank account would equal an expected contribution of $2,000 from your child ($10,000 x.20), but the same $10,000 in your bank account would equal an expected $560 contribution from you ($10,000 x.056).

Under the federal rules, an UGMA/UTMA custodial account is classified as a student asset. By contrast, 529 plans and Coverdell ESAs are considered parental assets if the parent is the account owner (so accounts owned by grandparents or other relatives or friends don't count at all). And distributions (withdrawals) from 529 plans and Coverdell ESAs that are used to pay the beneficiary's qualified education expenses are not classified as parent or student income on the federal government's aid form, which means that some or all of the money is not counted again when it's withdrawn. Other investments you may own in your name, such as mutual funds, stocks, U.S. savings bonds (e.g., Series EE and Series I), certificates of deposit, and real estate, are also classified as



parental assets.

Regarding institutional aid, colleges are generally a bit stricter than the federal government in assessing a family's assets and their ability to pay college costs. Most use a standard financial aid application that considers assets the federal government does not, for example, home equity. Typically, though, colleges treat 529 plans, Coverdell accounts, and UTMA/UGMA custodial accounts the same as the federal government, with the caveat that distributions from 529 plans and Coverdell accounts are often counted again as available income.



Saving for Retirement and a Child's Education at the Same Time

You want to retire comfortably when the time comes. You also want to help your child go to college. So how do you juggle the two? The truth is, saving for your retirement and your child's education at the same time can be a challenge. But take heart--you may be able to reach both goals if you make some smart choices now.

Know what your financial needs are

The first step is to determine what your financial needs are for each goal. Answering the following questions can help you get started:

For retirement:

• How many years until you retire?

• Does your company offer an employer-sponsored retirement plan or a pension plan? Do you participate? If so, what's your balance? Can you estimate what your balance will be when you retire?

• How much do you expect to receive in Social Security benefits? (You can estimate this amount by using your Personal Earnings and Benefit Statement, now mailed every year by the Social Security Administration.)

• What standard of living do you hope to have in retirement? For example, do you want to travel extensively, or will you be happy to stay in one place and live more simply?

• Do you or your spouse expect to work part-time in retirement?

For college:

• How many years until your child starts college?

• Will your child attend a public or private college? What's the expected cost?

• Do you have more than one child whom you'll be saving for?

• Does your child have any special academic, athletic, or artistic skills that could lead to a scholarship?

• Do you expect your child to qualify for financial aid?

Many on-line calculators are available to help you predict your retirement income needs and your child's college funding needs.

Figure out what you can afford to put aside each month

After you know what your financial needs are, the next step is to determine what you can afford to put aside each month. To do so, you'll need to prepare a detailed family budget that lists all of your income and expenses. Keep in mind, though, that the amount you can afford may change from time to time as your circumstances change. Once you've come up with a dollar amount, you'll need to decide how to divvy up your funds.

Retirement takes priority

Though college is certainly an important goal, you should probably focus on your retirement if you have limited



funds. With generous corporate pensions mostly a thing of the past, the burden is primarily on you to fund your retirement. But if you wait until your child is in college to start saving, you'll miss out on years of tax-deferred growth and compounding of your money. Remember, your child can always attend college by taking out loans (or maybe even with scholarships), but there's no such thing as a retirement loan!

If possible, save for your retirement and your child's college at the same time

Ideally, you'll want to try to pursue both goals at the same time. The more money you can squirrel away for college bills now, the less money you or your child will need to borrow later. Even if you can allocate only a small amount to your child's college fund, say $50 or $100 a month, you might be surprised at how much you can accumulate over many years. For example, if you saved $100 every month and earned 8 percent, you'd have $18,415 in your child's college fund after 10 years. (This example is for illustrative purposes only and does not represent a specific investment.)

If you're unsure how to allocate your funds between retirement and college, a professional financial planner may be able to help you. This person can also help you select the best investments for each goal. Remember, just because you're pursuing both goals at the same time doesn't necessarily mean that the same investments will be appropriate. Each goal should be treated independently.

Help! I can't meet both goals

If the numbers say that you can't afford to educate your child or retire with the lifestyle you expected, you'll have to make some sacrifices. Here are some things you can do:

• Defer retirement: The longer you work, the more money you'll earn and the later you'll need to dip into your retirement savings.

• Work part-time during retirement.

• Reduce your standard of living now or in retirement: You might be able to adjust your spending habits now in order to have money later. Or, you may want to consider cutting back in retirement.

• Increase your earnings now: You might consider increasing your hours at your current job, finding another job with better pay, taking a second job, or having a previously stay-at-home spouse return to the workforce.

• Invest more aggressively: If you have several years until retirement or college, you might be able to earn more money by investing more aggressively (but remember that aggressive investments mean a greater risk of loss).

• Expect your child to contribute more money to college: Despite your best efforts, your child may need to take out student loans or work part-time to earn money for college.

• Send your child to a less expensive school: You may have dreamed your child would follow in your footsteps and attend an Ivy League school. However, unless your child is awarded a scholarship, you may need to lower your expectations. Don't feel guilty--a lesser-known liberal arts college or a state university may provide your child with a similar quality education at a far lower cost.

• Think of other creative ways to reduce education costs: Your child could attend a local college and live at home to save on room and board, enroll in an accelerated program to graduate in three years instead for four, take advantage of a cooperative education where paid internships alternate with course work, or defer college for a year or two and work to earn money for college.



Can retirement accounts be used to save for college?

Yes. Should they be? Probably not. Most financial planners discourage paying for college with funds from a retirement account; they also discourage using retirement funds for a child's college education if doing so will leave you with no funds in your retirement years. However, you can certainly tap your retirement accounts to help pay the college bills if you need to. With IRAs, you can withdraw money penalty free for college expenses, even if you're under age 59½ (though there may be income tax consequences for the money you withdraw). But with an employer-sponsored retirement plan like a 401(k) or 403(b), you'll generally pay a 10 percent penalty on any withdrawals made before you reach age 59½ (age 55 in some cases), even if the money is used for college expenses. You may also be subject to a six month suspension if you make a hardship withdrawal. There may be income tax consequences, as well. (Check with your plan administrator to see what withdrawal options are available to you in your employer-sponsored retirement plan.)



Sticker Shock: Creative Ways to Lower the Cost of College

Even with all of your savvy college shopping and research about financial aid, college costs may still be prohibitive. At these prices, you expect you'll need to make substantial financial sacrifices to send your child to college. Or maybe your child won't be able to attend the college of his or her choice at all. Before you throw in the towel, though, you and your child should consider steps that can actually lower college costs. Although some of these ideas deviate from the typical four-year college experience, they just might be your child's ticket to college--and your ticket to financial sanity.

Ask about tuition discounts and flexible repayment programs

Before you rule out a college completely, ask whether it offers any tuition discounts or flexible repayment programs. For example, the school may offer a discount if you pay the entire semester's bill up front, or if you allow the money to be directly debited from your bank account. The college may also allow you to spread your payments over 12 months or extend them for a period after your child graduates. And if it's your alma mater, don't forget to inquire about any discounts for the children of alumni. Finally, ask if some charges are optional (e.g., full meal plan versus limited meal plan).

Graduate in three years instead of four

Some colleges offer accelerated programs that allow your child to graduate in three years instead of four. This can save you a whole year's worth of tuition and related expenses. Some colleges offer a similar program that combines an undergraduate/graduate degree in five years. The main drawback is that your child will have to take a heavier course load each semester and may have to forgo summer breaks to meet his or her academic obligations. Also, some educators believe that students need four years of college to develop to their fullest potential--intellectually, emotionally, and occupationally.

Earn college credit while still in high school

By taking advanced placement courses or special academic exams, your child may be able to earn college credits while still in high school. This means that your child may be able to take fewer classes in college, saving you money.

Think about cooperative education

Cooperative (co-op) education is a type of education where semesters of course work alternate with semesters of paid work at internships that your child helps select. Although a co-op degree usually takes five years to obtain, your child will be earning money during these years that can be used for tuition costs. In addition, your child gains valuable job experience.

Enroll in a community college, then transfer to a four-year college

One surefire way to cut college costs is to have your child enroll in a local community college for a couple of years, where costs are often substantially less than four-year institutions. Then, after two years, your child can transfer to a four-year institution. Your child's diploma will be from the four-year institution, but your expenses won't. Before choosing this route, though, make sure that any credits your child earns at the community college will be transferable to another institution.



Defer enrollment for a year

Your child might be aching to get to college, but taking a year off can give you both some financial breathing room and allow your child to work and save money for a full year before starting college. Your child will apply under the college's normal application deadline with the rest of his or her classmates and, once accepted, can ask for a one-year deferment. But make sure the college offers deferred enrollment before your child goes through the time and expense of applying.

Live at home

It's not every child's dream, but attending a nearby college and living at home, even for a year or two, can substantially reduce costs by eliminating room-and-board expenses (though your child will incur commuting costs). This arrangement may work out best at a college that has a student commuter population, because the college is likely to try to meet these students' needs. If your child does live at home, you'll both need to sit down beforehand and discuss mutual expectations. For example, now that your child's in college, it's not realistic to expect him or her to adhere to a rigid weekend curfew.

Consider distance learning

Taking courses on-line is a trend that's here to stay, and many colleges are in the process of creating or expanding their opportunities for distance learning. Your child might be able to take a year's worth of classes from home and then attend the same school in person for the remaining years.

Work part-time throughout the college years

Part-time work during college can help your child defray some costs, though working during school can be both a physical and emotional strain. To make sure that your child's academic work doesn't suffer, one option might be for your child to focus on school for the first two years and then obtain a part-time job in the remaining years.

Join the military

There are several options here. Under the Reserve Officers' Training Corps (ROTC) scholarship program, your child can receive a free college education in exchange for a required period of active duty following graduation. Your child can apply for an ROTC scholarship at a military recruiting office during his or her junior or senior year of high school. Or, your child can serve in the military and then attend college under the GI Bill. Your child can also attend a service academy, like the U.S. Military Academy at West Point, for free. Be aware, though, that these schools are among the most competitive in the country, and your child must serve a minimum number of years of active duty upon graduation. For more information, visit your local military recruiting office, or speak to your child's high school guidance counselor.

Go to school in Canada

Canadian schools generally offer an excellent education at a price comparable to that of an average four-year public college in the United States. And in the global economy, many employers tend to look favorably on studying abroad. Your child will even be eligible for need-based federal student loans (but not grants), as well as the two federal education tax credits--the Hope credit (renamed the American Opportunity credit for 2009 and 2010) and the Lifetime Learning credit.

Check to see if your employer offers any educational assistance

Does your employer offer any educational benefits for the children of its employees, like partial tuition reimbursement or company scholarships? Check with your human resources manager.



Have grandparents pay tuition directly to the college

Payments that grandparents (or others) make directly to a college aren't considered gifts for purposes of the federal gift tax rules. So, grandparents can be as generous as they want without having to worry about the tax implications for themselves. Keep in mind, though, that any payments must go directly to the college. They can't be delivered to your child with instructions to apply them to the college bills.



ABCs of Financial Aid

These days, it's hard to talk about college without mentioning financial aid. Yet this pairing isn't a marriage of love, but one of necessity. In many cases, financial aid may be the deciding factor in whether your child attends the college of his or her choice or even attends college at all. That's why it's important to develop a basic understanding of financial aid before your child applies to college. Without such knowledge, you may have trouble understanding the process of aid determination, filling out the proper aid applications, and comparing the financial aid awards that your child receives.

But let's face it. Financial aid information is probably not on anyone's top ten list of bedtime reading material. It can be an intimidating and confusing topic. There are different types, different sources, and different formulas for evaluating your child's eligibility. Here are some of the basics to help you get started.

What is financial aid?

Financial aid is money distributed primarily by the federal government and colleges in the form of loans, grants, scholarships, or work-study jobs. A student can receive both federal and college aid.

Grants and scholarships are more favorable than loans because they don't have to be repaid--they're free money. In a work-study program, your child works for a certain number of hours per week (either on or off campus) to earn money for college expenses. Obviously, an ideal financial aid package will contain more grants and scholarships than loans.

Need-based aid vs. merit aid

Financial aid can be further broken down into two categories--need-based aid, which is based on your child's financial need; and merit aid, which is awarded according to your child's academic, athletic, musical, or artistic merit.

The majority of financial aid is need-based aid. However, in recent years, merit aid has been making a comeback as colleges (particularly private colleges) use favorable merit aid packages to lure the best and brightest students to their campuses, regardless of their financial need. However, the availability of merit aid tends to fluctuate from year to year as colleges decide how much of their endowments to spend, as well as which specific academic and extracurricular programs they want to target.

Sources of merit aid

The best place to look for merit aid is at the colleges that your child is applying to. Does the college offer any grants or scholarships for academic, athletic, musical, or other abilities? If so, what is the application procedure? College guidebooks can give you an idea of how much merit aid (as a percentage of a general student's overall aid package) each college has provided in past years.

Besides colleges, a wide variety of private and public companies, associations, and foundations offer merit scholarships and grants. Many have specific eligibility criteria. In the past, sifting through the possibilities could be a daunting task. Now, with the Internet, there are websites where your child can input his or her background, abilities, and interests and receive (free of charge) a matching list of potential scholarships. Then it's up to your child to meet the various application deadlines. However, though this avenue is certainly worth exploring, such research (and subsequent work to complete any applications) shouldn't come at the expense of researching and applying for the more common need-based financial aid.

Sources of need-based aid

The main provider of need-based financial aid is the federal government, followed by colleges. States come in at



a distant third. The amount of federal aid available in any given year depends on the amount that the federal budget appropriates, and this aid is spread over several different financial aid programs. For colleges, need-based aid comes from a college's endowment, and policies may differ from year to year, resulting in an uneven availability of funds. States, like the federal government, must appropriate the money in their budgets.

The federal government's aid application is known as the FAFSA, which stands for Free Application for Federal Student Aid. The federal government and colleges use the FAFSA when federal funds are being distributed (colleges are responsible for administering certain federal financial aid programs). When colleges distribute their own financial aid, they use one of two forms. The majority of colleges use the PROFILE application, created by the College Scholarship Service of Princeton, New Jersey. A minority of colleges use their own institutional applications. The states may use the FAFSA or may require their own application. Contact your state's higher education authority to learn about the state aid programs available and the applications that you'll need to complete.

The FAFSA is filed as soon after January 1 as possible in the year your child will be attending college. You must wait until after January 1 because the FAFSA relies on your tax information from the previous year. The PROFILE (or individual college application) can usually be filed earlier than the FAFSA. The specific deadline is left up to the individual college, and you'll need to keep track of it.

How is my child's financial need determined?

The way your child's financial need is determined depends on which aid application you're filling out. The FAFSA uses a formula known as the federal methodology; the PROFILE (or a college's own application) uses a formula known as the institutional methodology. The general process of aid assessment is called needs analysis.

Under the FAFSA, your current income and assets and your child's current income and assets are run through a formula. You are allowed certain deductions and allowances against your income, and you're able to exclude certain assets from consideration. The result is a figure known as the expected family contribution, or EFC. It's the amount of money that you'll be expected to contribute to college costs before you are eligible for aid.

Your EFC remains constant, no matter which college your child applies to. An important point: Your EFC is not the same as your child's financial need. To calculate your child's financial need, subtract your EFC from the cost of attendance at your child's college. Because colleges aren't all the same price, your child's financial need will fluctuate with the cost of a particular college.

For example, you fill out the FAFSA, and your EFC is calculated to be $5,000. Assuming that the cost of attendance at College A is $18,000 per year and the cost at College B is $25,000, your child's financial need is $13,000 at College A and $20,000 at College B.

The PROFILE application (or the college's own application) basically works the same way. However, the PROFILE generally takes a more thorough look at your income and assets to determine what you can really afford to pay (for example, the PROFILE looks at your home equity and retirement assets). In this way, colleges attempt to target those students with the greatest financial need.

What factors the most in needs analysis? Your current income is the most important factor, but other criteria play a role, such as your total assets, how many family members are in college at the same time, and how close you are to retirement age.

How does financial need relate to my child's financial aid award?

When your child is accepted at a particular college, the college's financial aid administrator will attempt to create a financial aid package to meet your child's financial need. Sometime in early spring, your child will receive these financial aid award letters that detail the specific amount and type of financial aid that each college is offering.

When comparing awards, first check to see if each college is meeting all of your child's need (colleges aren't obligated to meet all of it). In fact, it's not uncommon for colleges to meet only a portion of a student's need, a phenomenon known as getting "gapped." If this happens to you, you'll have to make up the shortfall, in addition to



paying your EFC. College guidebooks can give you an idea of how well individual colleges meet their students' financial need under the entry "average percentage of need met" or something similar. Next, look at the loan component of each award and compare actual out-of-pocket costs. Remember, grants and scholarships don't have to be repaid and so don't count toward out-of-pocket costs. Again, you would like your child's need met with the highest percentage of grants, scholarships, and work-study jobs and the least amount of loans.

If you'd like to lobby a particular school for more aid, tread carefully. A polite letter to the financial aid administrator followed up by a telephone call is appropriate. Your chances for getting more aid are best if you can document a change in circumstances that affects your ability to pay, such as a recent job loss, unusually high medical bills, or some other unforeseen event. Also, your chances improve if your child has been offered more aid from a direct competitor college, because colleges generally don't like to lose a prospective student to a direct competitor.

How much should our family rely on financial aid?

With all this talk of financial aid, it's easy to assume that it will do most of the heavy lifting when it comes time to pay the college bills. But the reality is you shouldn't rely too heavily on financial aid. Although aid can certainly help cover your child's college costs, student loans make up the largest percentage of the typical aid package, not grants and scholarships. As a general rule of thumb, plan on student loans covering up to 50 percent of college expenses, grants and scholarships covering up to 15 percent, and work-study jobs covering a variable amount. But remember, parents and students who rely mainly on loans to finance college can end up with a considerable debt burden.



The ABCs of 529 Plans

If you're already saving for college, you've probably heard about 529 plans. 529 plans are revolutionizing the way parents and grandparents save for college, similar to the way 401(k) plans revolutionized retirement savings. Americans are pouring billions of dollars into 529 plans, and contributions are expected to increase dramatically in the coming decade. Where did these plans come from, and what makes them so attractive?

The history of 529 plans

Congress created Section 529 plans in 1996 in a piece of legislation that had little to do with saving for college--the Small Business Job Protection Act. The law on 529 plans was later refined in 1997 by the Taxpayer Relief Act, in 2001 by the Economic Growth and Tax Relief Reconciliation Act, and in 2006 by the Pension Protection Act. In this short period, 529 plans have emerged as one of the top ways to save for college.

Section 529 plans are officially known as qualified tuition programs under federal law. The reason "529 plan" is commonly used is because 529 is the section of the Internal Revenue Code that governs their operation.

What exactly is a 529 plan?

A 529 plan is a college savings vehicle that has federal tax advantages. There are two types of 529 plans: college savings plans and prepaid tuition plans. Though college savings plans and prepaid tuition plans share the same federal tax advantages, there are important differences between them.

College savings plans

College savings plans let you save money for college in an individual investment account. These plans are run by the states, which typically designate an experienced financial institution to manage their plan. To open an account, you fill out an application, choose a beneficiary, and start contributing money. However, you can't hand pick your own investments as you would with a Coverdell ESA, custodial account, or trust. Instead, you typically choose one or more portfolios offered by the plan--the underlying investments of which are exclusively chosen and managed by the plan's professional money manager. After this, you simply decide when, and how much, to contribute.

With early college savings plans, plan managers commonly invested your money based only on the age of your beneficiary (known as an age-based portfolio). Under this model, when a child is young, most of the portfolio's assets are allocated to aggressive investments. Then, as a child grows, the portfolio's assets are gradually and automatically shifted to less volatile investments to preserve principal. The idea is to take advantage of the stock market's potential for high returns when a child is still many years away from college, while recognizing the need to lessen the risk of these investments in later years.

Though the age-based portfolio model is certainly logical (indeed, many parents were already trying to invest this way on their own), offering only this type of portfolio made college savings plans seem a bit inflexible. After all, with other college savings options like Coverdell ESAs, custodial accounts, mutual funds, and trusts, you can invest in practically anything (thereby taking into account your risk tolerance), and you have complete freedom to sell an investment that's performing poorly (though in some cases the proceeds must still be used for education purposes, or for the child's benefit in general).

Now, college savings plans are older and wiser. Today, more plans offer a wide array of portfolio choices. So, in addition to choosing an age-based portfolio, you may also be able to direct your 529 plan contributions to one or more "static portfolios," where the asset allocation in each portfolio remains the same over time. These static portfolios usually range from aggressive to conservative, so you can match your risk tolerance. But keep in mind that college savings plans don't guarantee your return. If the portfolio doesn't perform as well as you expected, you may lose money.



When it's time for college, the beneficiary of your account can use the funds at any college in this country and abroad (as long as the school is accredited by the U.S. Department of Education).

Prepaid tuition plans

Prepaid tuition plans let you save money for college, too. But prepaid tuition plans work differently than college savings plans. Prepaid tuition plans may be sponsored by states (on behalf of public colleges) or by private colleges.

A prepaid tuition plan lets you prepay tuition expenses now for use in the future. The plan's money manager pools your contributions with those from other investors into one general fund. The fund assets are then invested to meet the plan's future obligations (some plans may guarantee you a minimum rate of return). At a minimum, the plan hopes to earn an annual return at least equal to the annual rate of college inflation for the most expensive college in the plan.

The most common type of prepaid tuition plan is a contract plan. With a contract plan, in exchange for your up-front cash payment (or series of payments), the plan promises to cover a predetermined amount of future tuition expenses at a particular college in the plan. For example, if your up-front cash payment buys you three years' worth of tuition expenses at College ABC today, the plan might promise to cover two and a half years of tuition expenses in the future when your beneficiary goes to college. Plans have different criteria for determining how much they'll pay out in the future. And if your beneficiary attends a school that isn't in the prepaid plan, you'll typically receive a lesser amount according to a predetermined formula.

The other type of prepaid tuition plan is a unit plan. Here, you purchase units or credits that represent a percentage (typically 1 percent) of the average yearly tuition costs at the plan's participating colleges. Instead of having a predetermined value, these units or credits fluctuate in value each year according to the average tuition increases for that year. You then redeem your units or credits in the future to pay tuition costs; many plans also let you use them for room and board, books, and other supplies.

A final note to keep in mind: Make sure you understand what will happen if a plan's investment returns can't keep pace with tuition increases at the colleges participating in the plan. Will your tuition guarantee be in jeopardy? Will your future purchases be limited or more expensive?

What's so special about 529 plans?

Section 529 plans--both college savings plans and prepaid tuition plans--offer a combination of features that have made them attractive to college investors:

• Federal and state tax-deferred growth: The money you contribute to a 529 plan grows tax deferred each year.

• Federal tax-free earnings if the money is used for college: If you withdraw money to pay for college (known under federal law as a qualified withdrawal), the earnings are not subject to federal income tax, similar to the treatment of Coverdell ESA earnings.

• Favorable federal gift tax treatment: Contributions to a 529 plan are considered completed, present-interest gifts for gift tax purposes. This means that contributions qualify for the $13,000 annual gift tax exclusion. And with a special election, you can contribute a lump sum of $65,000 to a 529 plan, treat the gift as if it were made over a five-year period, and completely avoid gift tax.

• Favorable federal estate tax treatment: Your plan contributions aren't considered part of your estate for federal tax purposes. You still retain control of the account as the account owner but you don't pay a federal estate tax on the value of the account. But if you spread today's gift over five years and you die within the five years, a portion of the gift will be included in your estate.

• State tax advantages: States can also add their own tax advantages to 529 plans. For example, some states exempt qualified withdrawals from income tax or offer an annual tax deduction for your



contributions. A few states even provide matching scholarships or matching contributions.

• Availability: Section 529 plans are open to anyone, regardless of income level. And you don't need to be a parent to set up an account. By contrast, your income must be below a certain level if you want to contribute to a Coverdell ESA or qualify for tax-exempt interest on U.S. education savings bonds (Series EE bonds, which may also be called Patriot bonds, and Series I bonds).

• High contribution limits: The total amount you can contribute to a 529 plan is generally high. Most plans have limits of $300,000 and up. Coupled with the tax-deferred growth of your principal and the income tax-free treatment of qualified withdrawals, it's easy to see how valuable your money can be in a 529 plan.

• Professional money management: For college investors who are too busy, too inexperienced, or too reluctant to choose their own investments, 529 plans offer professional money management.

• College savings plan variety: In many cases, you're not limited to the college savings plan in your own state. You can shop around for the plan with the best money manager, performance record, investment options, fees, state tax benefits, and customer service. (You can't generally shop around with prepaid tuition plans, though.)

• Rollovers: You can take an existing 529 plan account (college savings plan or prepaid tuition plan) and roll it over to a new 529 plan once every 12 months without paying a penalty. This lets you leave a plan that's performing poorly and join a plan with a better track record or more investment options (assuming the new plan allows nonresidents to join).

• Simplicity: It's relatively easy to open a 529 account, and most plans offer automatic payroll deduction or electronic funds transfer from your bank account to make saving for college even easier.

• Innovation: Section 529 plans are a creature of federal law, but the states are the ones that interpret and execute them. As Congress periodically revises the law on 529 plans, states will continue to refine and enhance their plans (and their tax laws) in order to make them as attractive as possible to college investors from all over the country.

What are the drawbacks of 529 plans?

No college savings option is perfect, and 529 plans aren't, either. Here are some of the drawbacks:

• Investment options: 529 plans offer little control over your specific investments. With a college savings plan, you may be able to choose among a variety of investment portfolios when you open your account, but you can't direct the portfolio's underlying investments. With a prepaid tuition plan, you don't pick anything--the plan's money manager is responsible for investing your contributions.

• Investment guarantees: College savings plans don't guarantee your investment return. You can lose some or all of the money you have contributed. And even though prepaid tuition plans typically guarantee your investment return, some plans sometimes announce modifications to the benefits they'll pay out due to projected actuarial deficits.

• Investment flexibility: If you're unhappy with your portfolio's investment performance in your college savings plan, you typically can direct future contributions to a new portfolio (assuming your plan allows it), but it may be more difficult to redirect your existing contributions. Some plans may allow you to make changes to your existing investment portfolio once per calendar year or upon a change in the beneficiary. (For 2009 only, states may permit 529 college savings plan investors to change the investment options for their existing contributions twice per year instead of once per year.) But in either case, it depends on the rules of the plan. However, you do have one option that's allowed by federal law and not subject to plan rules. You can do a "same beneficiary" rollover (a rollover without a change of beneficiary) to another 529 plan (a college savings plan or a prepaid tuition plan) once every 12 months, without penalty. This gives you the opportunity to shop around for the investment options you prefer.



• Nonqualified withdrawals: If you want to use the money in your 529 plan for something other than college, it'll cost you. With a college savings plan, you'll pay a 10 percent federal penalty on the earnings part of any withdrawal that is not used for college expenses (a state penalty may also apply). You'll pay income taxes on the earnings, too. With a prepaid tuition plan, you must either cancel your contract to get a refund or take whatever predetermined amount the plan will give you for a nonqualified withdrawal (some plans may make you forfeit your earnings entirely; others may give you a nominal amount of interest).

• Fees and expenses: There are typically fees and expenses associated with 529 plans. College savings plans may charge an annual maintenance fee, administrative fees, and an investment fee based on a percentage of your account's total value. Prepaid tuition plans may charge an enrollment fee and various administrative fees.



Choosing a College Savings Plan

With so many 529 plans to choose from, you'll need to ask a lot of questions in order to select the best plan for you.

Compare the plans offered by different states

If you're interested in joining a college savings plan, you should consider all of your options. Compare the plans offered by different states in terms of flexibility, tax considerations, investment selection, contribution rules, and costs and fees. Any state that offers a 529 plan can provide you with a free packet of information that describes the program and its rules. You can also check out a plan's website.

Keep in mind that some states allow nonresidents to join their plans, and others don't. The vast majority of states that offer college savings plans allow nonresidents to participate.

Consider the plan's account ownership and beneficiary designation rules

When comparing college savings plans, keep plan flexibility in mind, particularly with respect to account ownership and beneficiary designation rules. These rules may vary from state to state. A college savings plan can be an expensive undertaking. And your child's education is certainly important to you. As an account owner, you'll want to make sure the account works the way you want it to work.

Generally, the account owner retains ownership and a certain amount of control over the college savings plan account. For example, he or she can change the beneficiary of the account or terminate the account and receive a refund of contributions. However, keep in mind that if you terminate the account, you'll typically receive back only a portion of your earnings, if any, and a penalty will generally apply, unless you terminate the account because the beneficiary has died or is disabled. Here are some questions to ask when researching various plans:

• Can I own the account jointly with my spouse or another person?

• Can a trust or other entity be an account owner?

• Can I name a successor owner when I open the account? If not, what happens to the account when I die?

• Must the account owner be a state resident? Must the beneficiary be a state resident?

• What happens if the account owner or beneficiary later moves out of state?

• Are account statements issued only to the account owner or also to the beneficiary?

• Can I view the account on-line?

• If I terminate the account, how much of my contributions and earnings will I get back, and will I pay a penalty?

Tax considerations

Some individuals favor 529 college savings plans over other college savings vehicles because of the federal (and sometimes state) tax advantages associated with 529 plans. Let's face it--we all want to keep our taxes to a minimum. No matter which college savings plan you join, all qualified withdrawals will be free of federal income tax. But things differ at the state level.

Some states exempt a college savings plan's earnings from income tax if used to pay qualified higher education



expenses. Some states may also let you deduct on your state income tax return some or all of your plan contributions in a given year. Other states offer no such income tax benefits. Since state tax benefits can vary widely, compare the tax benefits. But remember--you're entitled only to the state tax benefits (if any) offered by the state in which you reside. So, look at your own state's plan first and research the state tax benefits available, especially if you're thinking about moving to another state in the near future. Also, keep in mind that states may limit their tax benefits to individuals who participate in the in-state 529 plan only.

Consider, also, any state gift tax issues regarding contributions, and whether there are state penalties for withdrawals that are not used for permitted education expenses. The following questions can help you determine what tax advantages each state offers:

• Can I claim a deduction on my state income tax return for my contributions to the college savings plan?

• Is my deduction recaptured into income if later withdrawals are not used for qualified education purposes?

• Is there a limitation or cap placed on the amount of my state income tax deduction? If so, what is it?

• If a withdrawal from the college savings plan is used to pay qualified education expenses, are the plan's earnings exempt from state income tax? Must I join my own state's 529 plan to get its tax benefits?

Number and type of investment vehicles offered

If you're interested in opening a college savings plan account, you should consider the number and type of investment vehicles offered by each plan. Since some investors are more comfortable with risk than others, investment choice is important. For example, if you're a conservative investor with very limited funds, you might not want to open an account in a state that offers only one type of plan--an aggressive, high-risk portfolio. Investment choice may also be important if you're a sophisticated investor who wants to maximize return.

The plans in some states may restrict you to a certain portfolio based on the beneficiary's age (known as an age-based portfolio), while others may let you choose a portfolio that's not tied to the beneficiary's age. Some plans provide you with an extensive menu of investment options, and some offer only one or two portfolios. Some states also allow you to change your investment choice when you change the beneficiary or once per calendar year. (For 2009 only, states may permit 529 college savings plan investors to change the investment options for their existing contributions twice per year instead of once per year.)

You may want to look at the past investment performance of a particular portfolio and compare it with other portfolios in different plans. You should also think about the reputation of the plan manager. Here are some investment-related questions to ask:

• How many investment options does the college savings plan provide?

• Is an age-based asset allocation approach offered? If so, can I select a portfolio other than one designed to match the age of my designated beneficiary?

• If the college savings plan offers more than one investment option, can I spread a contribution among the options without opening multiple accounts?

• Who manages the plan's investments, and how solid is that company's reputation?

• Can I choose one investment portfolio with today's contribution, and a different portfolio with future contributions?

• Will the plan let me switch my account from one portfolio to another portfolio?

• When does the investment manager's contract with the plan end? What happens to my account if the state changes investment managers?



Contribution rules

Although we all have different financial situations, money is important to each of us. So, to ensure that you select a college savings plan that best matches your financial means, you should investigate the contribution rules of each plan. For example, if you have plenty of funds to invest, you might be interested in the college savings plan that allows you to accumulate the most funds (the maximum contribution limit). Most plans have maximum contribution limits of $300,000 and up. But if money is tight for you, you might want to avoid plans that require a high annual plan contribution. Find out the answers to the following questions:

• What's the maximum contribution limit for the plan?

• What's the minimum amount I must contribute to establish the college savings plan?

• Are annual contributions required? If so, how much?

• Can someone other than the account owner make plan contributions?

• Are the contribution limits different if I am a resident of the state or a nonresident?

Costs and fees

Since plan costs and fees can really add up and take a sizable bite out of your funds, you should consider the expenses associated with each plan. Sometimes, nonresidents joining a plan must pay higher broker's fees or higher annual account fees. Investigate whether a break is given to residents, and compare the overall costs of different plans. Consider the following questions:

• Are residents and nonresidents treated differently in terms of plan costs and fees?

• Is there an application fee, beneficiary substitution fee, or account owner substitution fee?

• What other fees and costs are charged, and what are the amounts?

• Will my fees be less if I contribute through payroll deduction or automatic deduction from my checking account?

• Is there a fee to do a rollover to another state's plan?

• Will I be penalized if I move my account out of the plan within a short time after I open the account? How short a time?

• Is there a fee if I terminate the account?

• Do I pay the fees separately, or is the fee deducted from my account?

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in the issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.



College Savings Plans vs. Prepaid Tuition Plans

Section 529 plans are popular college savings vehicles. Due to the demand for them, nearly every state now operates at least one type of 529 plan (either a prepaid tuition plan or a college savings plan), and an increasing number are offering both. To choose the type of 529 plan that's right for you, it's important to understand how prepaid tuition plans and college savings plans work and the differences between them.

How does each plan work?

As 529 plans, both college savings plans and prepaid tuition plans offer significant federal tax advantages. Funds in each type of plan grow tax deferred, and withdrawals from either plan used for the beneficiary's qualified education expenses are completely income tax free at the federal level. But despite these shared tax advantages, college savings plans and prepaid tuition plans are different creatures.

A college savings plan lets you build an education fund within an individual investment account. Money you contribute is invested in one or more specific investment portfolios. Each portfolio consists of a mix of investments (typically mutual funds) that are chosen and managed exclusively by the plan's designated money manager. You generally pick your investment portfolio at the time you open an account, or else one is automatically chosen for you. Your investment return is not guaranteed.

In contrast, a prepaid tuition plan lets you purchase tuition now for use in the future. There are generally two types of prepaid tuition plans: contract plans and unit plans. A contract plan (sometimes known as a guaranteed interest plan) promises to cover a predetermined amount of tuition expenses in the future, in exchange for your lump sum or periodic contributions.

With a unit plan, you purchase a certain percentage of units or credits and the plan guarantees that whatever the percentage of college costs such units cover now, the same percentage will be covered in the future. For example, assume that 100 tuition credits are required to fund one year's worth of tuition at State University today. You purchase 100 credits today for $8,000. The result is that when your child starts college at State University in 12 years, your $8,000 will theoretically pay the entire first year of tuition, even though tuition costs may have risen to $20,000 per year by then.

Note: Even though prepaid tuition plans typically guarantee your investment return, plans sometimes announce modifications to the benefits they'll pay out due to projected actuarial deficits.

Who can offer these plans?

At one time, only states could offer prepaid tuition plans and college savings plans. (In practice, the states designate an agent, usually an experienced financial institution, to manage and administer their plans). But colleges and universities can now offer their own prepaid tuition plans. These plans are sometimes referred to as private prepaid tuition plans, and the beneficiary is limited to attending the college(s) in the plan. However, the remainder of this discussion refers to state-sponsored prepaid tuition plans.

How are your contributions invested with each type of plan?

College savings plans and prepaid tuition plans differ on the way your contributions are invested. With a prepaid tuition plan, there are no individual investment accounts. Instead, your contributions go into a general fund, and the plan's money manager is solely responsible for investing the pooled money to meet the plan's future obligations to its participants. Your only concern is with the predetermined amount of tuition that the plan has agreed to cover in the future, or the percentage of tuition costs that the units or credits you've just purchased will eventually cover.

With a college savings plan, your contributions are held in an individual investment account in one or more specific investment portfolios. The trend is for plans to let you choose your investment portfolio at the time you



open an account. Typically, plans offer a variety of options--from aggressive to conservative--so you can choose a portfolio that matches your risk tolerance, time horizon, and other factors. But remember, the plan's money manager handles the underlying investment mix in each portfolio on a day-to-day basis--you have no say in this process.

Some states may not let you choose your investment portfolio when you join the plan. Instead, they will automatically assign you a portfolio based on the beneficiary's age (called an age-based portfolio). With an age-based portfolio, the underlying asset mix consists of more aggressive investments when the beneficiary is young (such as stock mutual funds) and then is gradually and automatically shifted to less volatile investments (like bond funds and money market funds) as the beneficiary nears college. The idea is to take advantage of the potential for higher returns (with the accompanying risk) when the beneficiary is young, and then preserve principal as the beneficiary approaches college age.

Once you've settled on an investment portfolio for your college savings plan account, you have limited opportunities to change it if you're not happy with its investment performance. Under IRS rules, plans are authorized, but not required, to let you change your investment portfolio once per calendar year or at any time you change the beneficiary. (For 2009 only, states may permit 529 college savings plan investors to change the investment options for their existing contributions twice per year instead of once per year.) Some plans may also allow you to direct future contributions to a new portfolio. Such investment flexibility can make one plan stand out among others, so it's always a good idea to check the specific investment rules of any plan you're considering.

You also have another option guaranteed by federal law. You can roll over the funds in your existing college saving plan account to another 529 plan (college savings plan or prepaid tuition plan) once every 12 months without penalty. The beneficiary stays the same.

In your effort to pick a suitable portfolio, keep in mind that no investment in a college savings plan is guaranteed--you could lose money that you've contributed. That's why it's important to investigate the reputation and overall investment performance of the institution that manages the college savings plan, as well as the performance history of individual portfolios in the plan.

Are there any restrictions on joining either type of plan or accessing the funds?

Yes. Most college savings plans are open to residents of every state. This means you can shop around for the plan that offers the combination of features you want. (But keep in mind that if you join another state's college savings plan, you'll generally be entitled only to the state tax benefits offered by your state.) Beyond that, you can open a college savings plan at any time of the year, and the account can generally remain open indefinitely. This gives you flexibility if your child decides to postpone his or her education.

By contrast, most prepaid tuition plans are limited to state residents only. And once you open an account, all tuition credits generally must be used by the time your child turns 30, and all withdrawals completed within 10 years from the time your child starts college. Also, at some point before your child starts college, you (the account owner) are required to inform the plan administrator when you expect to start redeeming credits. Finally, some prepaid tuition plans let you join only during specific enrollment periods.

What education expenses are covered by each plan?

College savings plans give you more flexibility in paying your beneficiary's education expenses. Funds in a college savings plan account can be used to pay for tuition, books, equipment, fees, other costs, and room and board (assuming the beneficiary is enrolled at least half-time) at any college accredited by the U.S. Department of Education. This includes undergraduate colleges, graduate and professional schools, two-year colleges, technical and trade schools, as well as some foreign colleges and universities.

By contrast, prepaid tuition plans are typically designed to pay only for undergraduate tuition costs at in-state public colleges--other expenses like room and board, books, and graduate school may not be covered. However, such restrictions are imposed by the individual prepaid tuition plans themselves, because Section 529 of the Internal Revenue Code allows a broader interpretation of qualified education expenses. Make sure you



understand exactly what education expenses your prepaid tuition plan covers, as well as the tuition equivalent you'll receive if your child attends a private or out-of-state college.

And for 2009 and 2010, qualified education expenses for both college savings plans and prepaid tuition plans include computers, certain software, and internet access while the beneficiary is in college.

What are the fees and expenses associated with each type of plan?

College savings plans, like other types of managed accounts such as mutual funds and annuities, are managed by professional money managers who pass along their investment expenses to account owners. In addition, the plan manager will charge you a fee for administering your account. Both of these fees are usually equal to a percentage of your total account value. Some college savings plans may also tack on a flat annual maintenance fee, though this may be waived if you sign up for automatic payroll deduction or direct debiting of your checking account. Because fees and expenses vary among plans and can affect your account's total return, examine them carefully.

Prepaid tuition plans typically charge a flat enrollment fee at the time you open your account, but generally there are no ongoing charges. However, you may be assessed fees for late payment, returned checks, changing the beneficiary, changing the beneficiary's enrollment date, document replacement, or other administrative matters.

You may want to ask the following questions to help you better compare the fees of college savings plans vs. prepaid tuition plans:

• Is there an application fee, beneficiary substitution fee, or account owner substitution fee?

• What other fees and costs are charged, and what are the amounts?

• Will my fees be less if I contribute through payroll deduction or automatic deduction from my checking account?

• Is there a fee to do a rollover to another state's plan?

• Will I be penalized if I move my account out of the plan within a short time after I open the account? How short a time?

• Is there a fee if I terminate the account?

• Do I pay the fees separately, or is the fee deducted from my account?

What is the income tax treatment of withdrawals from each plan?

Withdrawals from a college savings plan or a prepaid tuition plan used to pay the beneficiary's qualified education expenses (as defined by the individual plan within federal guidelines) are completely income tax free at the federal level. And if your state exempts such withdrawals from income tax too, it does so for both college savings plans and prepaid tuition plans.

A withdrawal not used for the beneficiary's qualified education expenses is called a nonqualified withdrawal. If you make a nonqualified withdrawal from a college savings plan account or a unit type of prepaid tuition plan (where you purchase tuition credits), a 10 percent federal penalty will apply on the earnings portion of the withdrawal (a state penalty may also apply). What's more, the earnings portion of the withdrawal will be subject to federal and state income tax.

A nonqualified withdrawal isn't possible if you have a contract type of prepaid tuition plan. If you want to get your money out of this type of plan, your only choice is to cancel your contract and have your money refunded. (If you do cancel, you may only get back your actual contributions, with no interest or earnings included. Other plans will refund your principal plus a low rate of interest, which is then taxable at regular income tax rates.)



What impact does each type of plan have on financial aid?

Under the federal financial aid rules, assets are classified either as a parent's asset or a child's asset. This classification determines the assessment rate of the asset. The assessment rate is the portion of the asset that you are expected to use for the current year's college expenses. (Income is also classified this way.)

The federal government treats prepaid tuition plans the same as college savings plans for financial aid purposes. These plans are reported on the federal aid application as an asset of the parent, if the parent is the account owner, and assessed at a rate of 5.6 percent (they're not reported at all if the account owner is someone else, for example, a grandparent). Any distributions (withdrawals) from the plan that are used to pay the beneficiary's qualified education expenses are not counted as either parent or student income.

Regarding institutional aid (aid distributed by colleges from their own endowments), most colleges treat both college savings plans and prepaid tuition plans as parental assets and withdrawals as student income.

Note: Investors should consider the investment objectives, risks, changes, and expenses associated with 529 plans before investing. More information about 529 plans is available in the issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.




Opening a 529 Account

You've decided to enroll in a 529 plan to fund your child's college education, but how do you go about doing it? Opening an account is actually quite simple as long as you understand the process. Here is an overview to help you get started.

Completing an account application

To enroll in a 529 plan, you'll need to request an enrollment kit from the plan manager. The enrollment kit generally contains an application and a handbook that contains information on plan rules and investment options (if any). After carefully studying the materials in the enrollment kit, fill out and sign the application. You may be asked to give the following information on your 529 plan application:

• Name, address, and phone number of the account owner

• Name and address of the beneficiary

• Social Security number (or tax ID number) of the account owner and the beneficiary

• Birth date, school grade, and state of residence of beneficiary

• Relationship between the account owner and beneficiary

• Your funding schedule for the account

• Automatic payment information

• The investment option you wish to choose

• The successor owner you wish to designate (in the event of your death)

To make the application process easier, nearly every plan now has a downloadable version of its application available on the Internet. A growing number of states also allow you to complete your enrollment on-line.

Naming a beneficiary

When you open an account, you'll need to designate someone as beneficiary. The beneficiary is the person who will receive the plan proceeds. You can generally name anyone you choose as the beneficiary--your child, grandchild, niece, nephew, or other relative or friend. (Your choice of a beneficiary may have gift tax and generation-skipping transfer tax consequences.) Some plans even allow you to name yourself. But rules vary from state to state, so read the guidelines set out in the plan handbook before you name a beneficiary.

Choosing an investment option

Most 529 college savings plans allow you to choose among several diversified investment options chosen by the plan's professional fund manager. These options fall into two categories: age-based portfolios and static portfolios. If you choose an age-based portfolio, contributions will be placed in a portfolio of investments based on your child's age (or in some plans, the date you intend to use the funds). When your child is young, the portfolio may allocate its investments primarily to equity funds that may entail higher risk but offer higher returns than fixed income funds and money market funds. As your child approaches college age, the allocation may gradually shift to fixed income funds and money market funds.

If you choose a static portfolio, contributions will be placed in a portfolio with a fixed allocation of investments from the various investment categories. You may be able to choose an equity fund, where 70 to 100 percent of



the holdings are in stocks; a fixed income fund, containing 70 to 100 percent bond and money market instruments; or a balanced fund that includes a mixture of equity and fixed income assets. You'll need to choose a fund based on factors like your child's age, your tolerance for risk, and your overall financial plan.

Although most college savings plans allow you to choose investment portfolios when you make a contribution, your opportunity to change the investment options is limited. Most plans allow you to change the investment portfolios once in each calendar year. A change of investment portfolios when you change the designated beneficiary is also permitted by most plans. (For 2009 only, states may permit 529 college savings plan investors to change the investment options for their existing contributions twice per year instead of once per year.)

529 prepaid tuition plans work differently. With prepaid tuition plans, you can't choose among different portfolios. Instead, you buy tuition credits that are guaranteed to increase in value and meet their equivalent cost of tuition when your child starts college.

Making an initial contribution

When you submit your application, you'll need to make an initial contribution. The amount required to open an account varies from state to state, so you'll need to follow plan guidelines. Many college savings plans allow you to make a small initial contribution (e.g., $25 or $50) if you agree to set up automatic contributions through payroll deductions or automatic bank transfers. (A growing number of companies let their employees contribute to college savings plans via payroll deduction.) Thereafter, minimum contributions of at least $15 to $25 are generally required, although a few states have much higher minimums. The amount of the minimum contribution may also be different for residents and nonresidents of the state that sponsors the plan.

With a prepaid tuition plan, you purchase a contract that covers the cost of tuition and fees for a certain number of years. Most prepaid tuition plans require that accounts be fully funded in five years. The cost of a contract varies from state to state and may depend on the beneficiary's age at the time the contract is purchased. You can generally pay for the contract in either a lump sum or through installment payments.

Managing the account

Once you've opened your 529 account, make sure you periodically check how the plan is performing. Even though a professional fund manager will handle day-to-day investment decisions, you should monitor the progress of your account's growth (although you will have limited opportunities to change your investment portfolios). Also, if you're currently making installment payments, you might consider making a lump-sum contribution in the future. In that case, you'll need to become aware of federal gift tax rules. And as you approach the day when you'll begin withdrawing money from the account, you'll want to find out how the timing of withdrawals can affect financial aid to your child.

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in the issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.



529 Plans: The Ins and Outs of Contributions and Withdrawals

Section 529 plans can be powerful college savings tools, but you need to understand how your plan works before you can take full advantage of it. Among other things, this means becoming familiar with the finer points of contributions and withdrawals. A little knowledge could save you money and maximize your chances of reaching the educational goals you've set for your children.

How much can you contribute?

To qualify as a 529 plan under federal rules, a state program must not accept contributions in excess of the anticipated cost of a beneficiary's qualified education expenses. At one time, this meant five years of tuition, fees, and room and board at the costliest college under the plan, pursuant to the federal government's "safe harbor" guideline. Now, however, states are interpreting this guideline more broadly, revising their limits to reflect the cost of attending the most expensive schools in the country and including the cost of graduate school. As a result, most states have contribution limits of $300,000 and up (and most states will raise their limits each year to keep up with rising college costs).

A state's limit will apply to either kind of 529 plan: prepaid tuition plan or college savings plan. For a prepaid tuition plan, the state's limit is a limit on the total contributions. For example, if the state's limit is $300,000, you can't contribute more than $300,000. On the other hand, a college savings plan limits the value of the account for a beneficiary. When the value of the account (including contributions and investment earnings) reaches the state's limit, no more contributions will be accepted. For example, assume the state's limit is $300,000. If you contribute $250,000 and the account has $50,000 of earnings, you won't be able to contribute anymore--the total value of the account has reached the $300,000 limit.

These limits are per beneficiary, so if you and your mother each set up an account for your child in the same plan, your combined contributions can't exceed the plan limit. If you have accounts in more than one state, ask each plan's administrator if contributions to other plans count against the state's maximum. Some plans may also have a contribution limit, both initially and each year.

Note: Generally, contribution limits don't cross state lines. Contributions made to one state's 529 plan don't count toward the lifetime contribution limit in another state. But check the rules of your state's plan to find out if that plan takes contributions from other states' plans into consideration when determining if the lifetime contribution limit has been reached.

How little can you start off with?

Some plans have minimum contribution requirements. This could mean one or more of the following: (1) you have to make a minimum opening deposit when you open your account, (2) each of your contributions has to be at least a certain amount, or (3) you have to contribute at least a certain amount every year. But some plans may waive or lower their minimums (e.g., the opening deposit) if you set up your account for automatic payroll deductions or bank-account debits. Some will also waive fees if you set up such an arrangement. (A growing number of companies are letting their employees contribute to college savings plans via payroll deduction.) Like contribution limits, minimums vary by plan, so be sure to ask your plan administrator.

Know your other contribution rules

Here are a few other basic rules that apply to most 529 plans:

• Only cash contributions are accepted (e.g., checks, money orders, credit card payments). You can't contribute stocks, bonds, mutual funds, and the like. If you have money tied up in such assets and would like to invest that money in a 529 plan, you must liquidate the assets first.



• Contributions may be made by virtually anyone (e.g., your parents, siblings, friends). Just because you're the account owner doesn't mean you're the only one who's allowed to contribute to the account.

• Contributions generally may not be directed toward particular investments of your choice. However, most college savings plans offer several different investment portfolios, and many let you choose one or more portfolios to invest your contributions. You make this choice at the time you make your contribution. Some states have also added two opportunities to change your investment choice. Savings plans in these states let you change your investment choice when you change the beneficiary of the account. These plans let you change the investment portfolio once each calendar year, as well.

Maximizing your contributions

Although 529 plans are tax-advantaged vehicles, there's really no way to time your contributions to minimize federal taxes. (If your state offers a generous income tax deduction for contributing to its plan, however, consider contributing as much as possible in your high-income years.) But there may be simple strategies you can use to get the most out of your contributions. For example, investing up to your plan's annual limit every year may help maximize total contributions. Also, a contribution of $13,000 a year or less (in 2010) qualifies for the annual federal gift tax exclusion ($65,000 if you make no contributions for the next four years). This is something to keep in mind if you wish to remove assets from your taxable estate.

Lump-sum vs. periodic contributions

A common question is whether to fund a 529 plan gradually over time, or with a lump sum. The lump sum would seem to be better because 529 plan earnings grow tax deferred--the sooner you put money in, the sooner you can start to generate earnings. Investing a lump sum may also save you fees over the long run. But the lump sum may have unwanted gift tax consequences, and your opportunities to change an investment portfolio are limited. Gradual investing may let you easily direct future contributions to other portfolios in the plan.

Qualified withdrawals are tax free

Withdrawals from a 529 plan that are used to pay qualified higher education expenses are completely free from federal income tax and may also be exempt from state income tax. Qualified higher education expenses generally include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an "eligible" educational institution (as defined by the Higher Education Act). In addition, the definition includes a limited amount of room-and-board expenses for students attending college on at least a half-time basis. Also, for 2009 and 2010, qualified expenses include computers, certain software, and internet access while the beneficiary is in college. The definition does not currently include the cost of transportation or personal expenses.

Note: A 529 plan must have a way to make sure that a withdrawal is really used for qualified education expenses. Many plans require that the college be paid directly for education expenses; others will prepay or reimburse the beneficiary for such expenses (receipts or other proof may be required).

Beware of nonqualified withdrawals

By now, you can probably guess what a nonqualified withdrawal is. Basically, it's any withdrawal that's not used for qualified higher education expenses. For example, if you take money from your account to buy your son a new Porsche, that's a nonqualified withdrawal. Even if you take money out for medical bills or other necessary expenses, you're still making a nonqualified withdrawal.

One reason not to make this type of withdrawal is to avoid depleting your college fund. Another compelling reason is that these withdrawals don't enjoy tax-favored treatment. The earnings part of a nonqualified withdrawal will be subject to federal income tax, and the tax will typically be assessed at the account owner's rate, not at the beneficiary's rate. Plus, the earnings part of a nonqualified withdrawal will be subject to a 10 percent federal penalty, and possibly a state penalty too.



Is timing withdrawals important?

As account owner, you can decide when to withdraw funds from your 529 plan and how much to take out--and there are ways to time your withdrawals for maximum advantage. It's important to coordinate your withdrawals with the education tax credits. That's because the tuition that's used to generate a credit may reduce your available pool of qualified education expenses. A financial aid or tax professional can help you sort this out to ensure that you get the best overall results. It's also a good idea to wait as long as possible to withdraw from the plan. The longer the money stays in the plan, the more time it has to grow tax deferred.

Note:Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about specific 529 plans is available in each issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.



Making Changes to Your 529 Account

Section 529 plans are designed to accommodate the account changes that you may need to make over the years. Whether you need to change the account owner or beneficiary, your investment options, or your monthly contributions, here's what you'll need to know.

Changing the beneficiary

If the existing beneficiary no longer needs the funds in your 529 account (e.g., he or she gets a full scholarship or decides not to go to college), you may want to designate a new beneficiary. All 529 plans allow the account owner to change the designated beneficiary, and it's actually quite simple to do. Just fill out a change of beneficiary form and submit it to your 529 plan administrator. Depending on your plan, you may have to pay an administrative fee.

If the existing beneficiary needs only some of the funds in your 529 account, you can also do a partial change of beneficiary, which involves establishing another 529 account for a new beneficiary and rolling over some funds from the old account into the new account.

Note, though, that in order to avoid penalties and taxes when changing beneficiaries, the new beneficiary must be a family member of the old beneficiary. According to Section 529 of the Internal Revenue Code, "family members" include children and their descendants, stepchildren, siblings, parents, stepparents, nieces, nephews, aunts, uncles, in-laws, and first cousins. States are free to impose additional restrictions, such as age and residency requirements.

Changing the account owner

Most states allow a change in ownership of a 529 account. And unlike a change in beneficiary, there is usually no requirement that the new account owner have any particular relationship with the original account owner. Many states, however, allow a change in account owner only when the original account owner dies or in special circumstances (e.g., divorce). Check with your plan administrator for more details.

Changing your investment options

One of the disadvantages of a college savings plan is the lack of investment control an account owner has. Participants in a 529 plan aren't allowed to direct the investment decisions of the plan.

However, there are ways you can gain limited control over how your contributions are invested. For example, college savings plans generally offer you a variety of investment portfolios when you open your account, allowing you to choose one that matches your investment objectives, time frame, and risk tolerance. But even if you can choose your portfolio, you can't direct the portfolio's underlying investments.

And keep in mind that once you make your portfolio selection, your contributions will generally be committed to that portfolio. If you're not happy with the portfolio's investment performance, you might be able to direct future contributions to a new portfolio, assuming your plan allows it. But it may be more difficult to redirect your existing contributions. Depending on the plan, you may be allowed to make changes to your existing portfolio once each calendar year without having to change the beneficiary. (For 2009 only, states may permit 529 college savings plan investors to change the investment options for their existing contributions twice per year instead of once per year.) Also, some plans may allow you to make changes to your existing investment portfolio if you change the beneficiary of the account. Make sure to check the rules of any plan you're considering.

Yet there's another option that's allowed by federal law and not subject to a plan's own rules. You can shop around for the investment options you prefer by doing a "same beneficiary" rollover to another 529 plan (college savings plan or prepaid tuition plan) once every 12 months without penalty.



Changing your monthly contributions

Most 529 plans allow you to make contributions by having them automatically debited from your bank account. Some plans may even offer discounts for enrolling in an automatic payment plan. If you are using this method and wish to change the amount of your contribution or the date you contribute each month, contact the plan administrator for more details.

Switching to a new 529 plan

If you're unhappy with your current 529 plan's investment performance or you believe that another plan offers more advantages, you may want to switch to another 529 plan. As mentioned before, a rollover to another 529 plan (college savings plan or prepaid tuition plan) without a change in beneficiary is allowed once every 12 months without penalty. However, if you want to roll over your account more than once a year, you'll need to change the beneficiary to another qualifying family member to avoid paying a penalty. Make sure to check with your existing plan to see if there is a fee to exit the plan or change the beneficiary.

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about specific 529 plans is available in the issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.



529 Plans and Financial Aid Eligibility

If you're thinking about joining a 529 plan, or if you've already opened an account, you might be concerned about how 529 funds will affect your child's chances of receiving financial aid. Of all the areas related to 529 plans, financial aid is perhaps the most uncertain, and the one most likely to change in the future. But here's where things stand now.

First, why should you be concerned?

The financial aid process is all about assessing what a family can afford to pay for college and trying to fill the gap. To do this, the institutions that offer financial aid examine a family's income and assets to determine how much a family should be expected to contribute before receiving financial aid. Financial aid formulas weigh assets differently, depending on whether they are owned by the parent or the child. So, it's important to know how your college savings plan account or your prepaid tuition plan account will be classified, because this will affect the amount of your child's financial aid award.

A general word about financial aid

Financial aid is money given to a student to help that student pay for college or graduate school. This money can consist of one or more of the following:

• A loan (which must be repaid in the future)

• A grant (which doesn't need to be repaid)

• A scholarship

• A work-study job (where the student gets a part-time job either on campus or in the community and earns money for tuition)

The typical financial aid package contains all of these types of aid. Obviously, grants are more favorable than loans because they don't need to be repaid. However, over the past few decades, the percentage of loans in the average aid package has been steadily increasing, while the percentage of grants has been steadily decreasing. This trend puts into perspective what qualifying for more financial aid can mean. There are no guarantees that a larger financial aid award will consist of favorable grants and scholarships--your child may simply get (and have to pay back) more loans.

The two main sources of financial aid are the federal government and colleges. In determining a student's financial need, the federal government uses a formula known as the federal methodology, while colleges use a formula known as the institutional methodology. The treatment of your 529 plan may differ, depending on the formula used.

How is your child's financial need determined?

Though the federal government and colleges use different formulas to assess financial need, the basic process is the same. You and your child fill out a financial aid application by listing your current assets and income (exactly what assets must be listed will depend on the formula used). The federal application is known as the FAFSA (Free Application for Federal Student Aid); colleges generally use an application known as the PROFILE.

Your family's asset and income information is run through a specific formula to determine your expected family contribution (EFC). The EFC represents the amount of money that your family is considered to have available to put toward college costs for that year. The federal government uses its EFC figure in distributing federal aid; a college uses its EFC figure in distributing its own private aid. The difference between your EFC and the cost of attendance (COA) at your child's college equals your child's financial need. The COA generally includes tuition,



fees, room and board, books, supplies, transportation, and personal expenses. It's important to remember that the amount of your child's financial need will vary, depending on the cost of a particular school.

The results of your FAFSA are sent to every college that your child applies to. Every college that accepts a student will then attempt to craft a financial aid package to meet that student's financial need. In addition to the federal EFC figure, the college has its own EFC figure to work with. Eventually, the financial aid administrator will create an aid package made up of loans, grants, scholarships, and work-study jobs. Some of the aid will be from federal programs (e.g., Stafford Loan, Perkins Loan, Pell Grant), and the rest will be from the college's own endowment funds. Keep in mind that colleges aren't obligated to meet all of your child's financial need. If they don't, you're responsible for the shortfall.

The federal methodology and 529 plans

Now let's see how a 529 account will affect federal financial aid. Under the federal methodology, 529 plans--both college savings plans and prepaid tuition plans--are considered an asset of the parent, if the parent is the account owner.

So, if you're the parent and the account owner of a 529 plan, you must list the value of the account as an asset on the FAFSA. Under the federal formula, a parent's assets are assessed (or counted) at a rate of no more than 5.6 percent. This means that every year, the federal government treats 5.6 percent of a parent's assets as available to help pay college costs. By contrast, student assets are currently assessed at a rate of 20 percent.

There are two points to keep in mind regarding the classification of 529 plans as a parental asset:

• A parent is required to list a 529 plan as an asset only if he or she is the account owner of the plan. If a grandparent, other relative, or friend is the account owner, then the 529 plan doesn't need to be listed on the FAFSA. Similarly, if the student is considered the account owner (as may be the case with a "custodial 529 account," which results when UGMA/UTMA assets are transferred to an existing 529 account), then the 529 plan doesn't need to be listed on the FAFSA.

• If your adjusted gross income is less than $50,000 and you meet a few other requirements, the federal government doesn't count any of your assets in determining your EFC. So, your 529 plan wouldn't affect financial aid eligibility at all.

Distributions (withdrawals) from a 529 plan that are used to pay the beneficiary's qualified education expenses aren't classified as either parent or student income on the FAFSA.

The federal methodology and other college savings options

How do other college savings options fare under the federal system? Coverdell education savings accounts, mutual funds, and U.S. savings bonds (e.g., Series EE and Series I) owned by a parent are considered parental assets and counted at a rate of 5.6 percent. However, UGMA/UTMA custodial accounts and trusts are considered student assets. Under the federal methodology, student assets are assessed at a rate of 20 percent in calculating the EFC.

Also, distributions (withdrawals) from a Coverdell ESA that are used to pay qualified education expenses are treated the same as distributions from a 529 plan--they aren't counted as either parent or student income on the FAFSA, so they don't reduce financial aid eligibility.

One final point to note is that the federal government excludes some assets entirely from consideration in the financial aid process. These assets include all retirement accounts (e.g., traditional IRAs, Roth IRAs, employer-sponsored retirement plans), cash value life insurance, home equity, and annuities.

The institutional methodology and 529 plans

When distributing aid from their own endowment funds, colleges aren't required to use the federal methodology.



As noted, most colleges use the PROFILE application (a few colleges use their own individual application). Generally speaking, the PROFILE digs a bit deeper into your family finances than the FAFSA.

Regarding 529 plans, the PROFILE treats both college savings plans and prepaid tuition plans as a parental asset. And once funds are withdrawn, colleges generally treat the entire amount (contributions plus earnings) from either type of plan as student income.

Note:Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about specific 529 plans is available in the issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.



Income Tax Planning and 529 Plans

The income tax benefits offered by 529 plans make these plans attractive to parents (and others) interested in saving for college. Qualified withdrawals from a 529 plan are tax free at the federal level, and some states also offer tax breaks to their residents. It's important to evaluate the federal and state tax consequences of plan withdrawals and contributions before you invest in a 529 plan.

Federal income tax treatment of qualified withdrawals

There are two types of 529 plans--college savings plans and prepaid tuition plans. The federal income tax treatment of these plans is identical. Your contributions to college savings plans and prepaid tuition plans are tax deferred. This means that you don't pay income taxes on the plan's earnings each year.

Then, if you take out money and use it to pay for qualified education expenses, the earnings portion of your withdrawal is free from federal income tax. This presents a significant opportunity to help you accumulate funds for college.

Qualified education expenses include tuition, fees, and books for college and graduate school. Room-and-board expenses are also considered qualified if the beneficiary is attending college or graduate school on at least a half-time basis.

State income tax treatment of qualified withdrawals

States differ in the 529 plan tax benefits they offer to their residents. For example, some states may offer no tax benefits, while others may exempt earnings on qualified withdrawals from state income tax and/or offer a deduction for contributions. However, keep in mind that states may limit their tax benefits to individuals who participate in the in-state 529 plan.

You should look to your own state's laws to determine the income tax treatment of withdrawals (and deductions). In general, you won't be required to pay income taxes to another state simply because you opened a 529 account in that state. But you'll probably be taxed in your state of residency on the earnings distributed by your 529 plan (whatever state sponsored it) unless your state grants a specific exemption. Also, make sure you understand your state's definition of "qualified education expenses," since it may differ from the federal definition.

Income tax treatment of nonqualified withdrawals (federal and state)

If you make a nonqualified withdrawal (i.e., one not used for qualified education expenses), the earnings portion of the distribution will usually be taxable on your federal (and probably state) income tax return in the year of the distribution. The earnings are usually taxed at the rate of the person who receives the distribution (known as the distributee). In most cases, the account owner will be the distributee. Some plans specify who the distributee is, while others may allow you (as the account owner) to determine the recipient of a nonqualified withdrawal.

You'll also pay a federal 10 percent penalty on the taxable amount of the nonqualified withdrawal (usually, that means on the earnings). There are a couple of exceptions, though. The penalty is usually not charged if you terminate the 529 account because the beneficiary has died or become disabled, or if you withdraw funds not needed for college because the beneficiary has received a scholarship. A state penalty may also apply.

Deducting your contributions to a 529 plan

Unfortunately, you can't claim a federal income tax deduction for your contributions to a 529 plan. Depending on where you live, though, you may qualify for a deduction on your state income tax return. A number of states now allow a state income tax deduction for contributions to a 529 plan, and several other states are considering such a measure. Again, keep in mind that most states let you claim an income tax deduction on your state tax return



only if you contribute to your own state's 529 plan.

Most of the states that provide a deduction for contributions impose a deduction cap, or limitation, on the amount of the deduction. For example, if you contribute $10,000 to your son's 529 plan this year, your state might allow you to deduct only $4,000 on your state income tax return. Check the details of your 529 plan and the tax laws of your state to learn whether your state imposes a deduction cap.

Also, if you're planning to claim a state income tax deduction for your contributions, you should learn whether your state applies income recapture rules to 529 plans. Income recapture means that deductions allowed in one year may be required to be reported as taxable income if you make a nonqualified withdrawal from the 529 plan in a later year. Again, check the laws of your state for details.

Coordination with the Coverdell education savings account and education tax credits

You can fund a Coverdell education savings account and a 529 account in the same year for the same beneficiary without triggering a penalty.

You can also claim an education tax credit in the same year you withdraw funds from a 529 plan to pay for qualified education expenses. But your 529 plan withdrawal will not be completely tax free on your federal income tax return if it's used for the same higher education expenses for which you're claiming a credit. (When calculating the amount of your qualified higher education expenses for purposes of your Section 529 withdrawal, you'll have to reduce your qualified expenses figure by any expenses used to compute the education tax credit.)

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about specific 529 plans is available in the issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.



Estate Planning and 529 Plans

When you contribute to a 529 plan, you'll not only help your child, grandchild, or other loved one pay for college, but you'll also remove money from your taxable estate. This will help you minimize your tax liability and preserve more of your estate for your loved ones after you die. So, if you're thinking about contributing money to a 529 plan, it pays to understand the gift and estate tax rules.

Overview of gift and estate tax rules

If you give away money or property during your life, you may be subject to federal gift tax (and, in certain states, state gift tax). The money and property you own when you die may also be subject to federal estate tax and some form of state death tax.

Federal gift tax generally applies if you give someone more than the annual gift tax exclusion amount, currently $13,000, during the tax year. (There are several exceptions, though, including gifts you make to your spouse.) That means you can give up to $13,000 each year, to as many individuals as you like, gift tax free. In addition, you're allowed a gift tax credit, which effectively exempts from gift tax up to $1 million in gifts that you make during your lifetime which would otherwise be subject to tax.

When you die, your estate will be entitled to a tax credit for federal estate tax purposes. In 2009, this credit effectively exempts up to $3.5 million from federal estate tax. However, this estate tax credit will be reduced by the amount of any gift tax credit used during your lifetime. Because the credit works this way, it is often referred to as the "unified credit," but the amount excluded from tax is more properly known as the "applicable exclusion amount."

Note: Since state tax treatment may differ from federal tax treatment, look to the laws of your state to find out how your state will treat a 529 plan gift.

Contributions to a 529 plan are treated as (federal) gifts to the beneficiary

A contribution to a 529 plan is treated under the federal gift tax rules as a completed gift from the donor to the designated beneficiary of the account. Such contributions are considered present interest gifts (as opposed to future or conditional gifts) and qualify for the annual federal gift tax exclusion. This means that you can contribute up to $13,000 per year to the 529 account of any beneficiary without incurring federal gift tax.

So, if you contribute $15,000 to your daughter's 529 plan in a given year, for example, you'd ordinarily apply this gift against your $13,000 annual gift tax exclusion. This means that although you'd need to report the entire $15,000 gift on a federal gift tax return, you'd show that only $2,000 is taxable. Bear in mind, though, that you must use up your applicable exclusion amount of $1 million before you'd actually have to write a check for the gift tax.

Special rule if you contribute over $13,000 in a year

Section 529 plans offer a special gifting feature. Specifically, you can make a lump-sum contribution to a 529 plan of up to $65,000, elect to spread the gift evenly over five years, and completely avoid federal gift tax, provided no other gifts are made to the same beneficiary during the five-year period. A married couple can gift up to $130,000.

For example, if you contribute $65,000 to your son's 529 account in one year and make the election, your contribution will be treated as if you'd made a $13,000 gift for each year of a five-year period. That way, your $65,000 gift would be nontaxable (assuming you didn't make any additional gifts to your son in any of those five years). A married couple can make a joint gift of up to $130,000.

If you contribute more than $65,000 ($130,000 for joint gifts) to a particular beneficiary's 529 plan in one year,



the averaging election applies only to the first $65,000 ($130,000 for joint gifts); the remainder is treated as a gift in the year the contribution is made.

What about gifts from a grandparent?

Grandparents need to keep the federal generation-skipping transfer tax (GSTT) in mind when contributing to a grandchild's 529 account. The GSTT is a tax on transfers made during your life and at your death to someone who is more than one generation below you, such as a grandchild. The GSTT is imposed in addition to (not instead of) federal gift and estate taxes. Like the applicable exclusion amount, though, there is a GSTT exemption, which is $3.5 million in 2009. No GSTT will be due until you've used up your GSTT exemption, and no gift tax will be due until you've used up your applicable exclusion amount.

If you contribute no more than $13,000 to your grandchild's 529 account during the tax year (and have made no other gifts to your grandchild that year), there will be no federal tax consequences--your gift qualifies for the annual federal gift tax exclusion, and it is also excluded for purposes of the GSTT.

If you contribute more than $13,000, you can elect to treat your contribution as if made evenly over a five-year period (as discussed previously). Only the portion that causes a federal gift tax will also result in a GSTT.

Note: Contributions to a 529 account may affect your eligibility for Medicaid. Contact an experienced elder law attorney for more information.

What if the owner of a 529 account dies?

If the owner of a 529 account dies, the value of the 529 account will not usually be included in his or her estate. Instead, the value of the account will be included in the estate of the designated beneficiary of the 529 account.

There is an exception, though, if you made the five-year election (as described previously) and died before the five-year period ended. In this case, the portion of the contribution allocated to the years after your death would be included in your federal gross estate. For example, assume you made a $50,000 contribution to a college savings plan in Year 1 and elected to treat the gift as if made evenly over five years. You die in Year 2. Your Year 1 and Year 2 contributions of $10,000 each ($50,000 divided by 5 years) are not part of your federal gross estate. The remaining $30,000 would be included in your gross estate.

Some states have an estate tax like the federal estate tax; many states calculate estate taxes differently. Review the rules in your state so you know how your 529 account will be taxed at your death.

When the account owner dies, the terms of the 529 plan will control who becomes the new account owner. Some states permit the account owner to name a contingent account owner, who'd assume all rights if the original account owner dies. In other states, account ownership may pass to the designated beneficiary. Alternatively, the account may be considered part of the account owner's probate estate and may pass according to a will (or through the state's intestacy laws if there is no will).

What if the beneficiary of a 529 account dies?

If the designated beneficiary of your 529 account dies, look to the rules of your plan for control issues. Generally, the account owner retains control of the account. The account owner may be able to name a new beneficiary or else make a withdrawal from the account. The earnings portion of the withdrawal would be taxable, but you won't be charged a penalty for terminating an account upon the death of your beneficiary.

Keep in mind that if the beneficiary dies with a 529 balance, the balance may be included in the beneficiary's taxable estate.

Note:



Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about specific 529 plans is available in the issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.



529 Plans vs. Coverdell Education Savings Accounts

Section 529 plans and Coverdell education savings accounts are two of the most popular ways to save for college. But which savings option is right for you?

Definitions

A Coverdell ESA is a tax-advantaged savings vehicle that lets you save money for the qualified education expenses of a named beneficiary, such as a child or grandchild. Qualified education expenses include college expenses and certain elementary and secondary school expenses.

529 plans are tax-advantaged savings vehicles that let you save money for the college expenses of a named beneficiary, such as a child or grandchild. There are two types of 529 plans--college savings plans and prepaid tuition plans. A college savings plan lets you save money in an individual investment account. A prepaid tuition plan pools your contributions with those of other investors and allows you to prepay the cost of college at today's prices for use in the future.

Contribution limits and restrictions

The annual contribution limit for Coverdell ESAs is $2,000 per beneficiary. That's considerably less than you can contribute to most 529 plans (most plans have lifetime contribution limits of at least $300,000 total). So the more money you have to invest, the more attractive a 529 plan becomes. Just make sure you're familiar with all the contribution rules before you invest in a 529 plan. In addition to the lifetime contribution limit, some plans impose annual maximums and/or minimums.

Another potential drawback of the Coverdell ESA is that you may not be able to contribute if you earn over a certain amount for the year. The allowable contribution is gradually phased out based on your modified adjusted gross income (MAGI) for the year. For single tax filers, your annual MAGI must be less than $95,000 for you to make a full contribution (a partial contribution is allowed if your income is $95,000 to $110,000). For joint filers (if you're married, you must file a joint return to be eligible to contribute to a Coverdell ESA), your annual MAGI must be less than $190,000 to make a full contribution ($190,000 to $220,000 to make a partial contribution). But you don't have to worry about any of this with a 529 plan, because no income limits apply.

The age of the beneficiary also limits the use of a Coverdell ESA. You can't start a Coverdell ESA for any beneficiary who's age 18 or older, because you can't make any contributions to a Coverdell ESA after the beneficiary reaches age 18. The exception is if the beneficiary is a child who has special needs. This typically means that you can't keep adding to the kitty once your child's in college, since most children are at least 18 when they start college. And a Coverdell ESA that you have properly established cannot continue after the beneficiary reaches age 30 (unless the beneficiary has special needs). By contrast, the federal government imposes no age restrictions on 529 plans. However, a minority of states impose such restrictions of their own (usually only on 529 prepaid tuition plans), so make sure to check with your plan administrator.

Income tax treatment

The tax treatment of Coverdell ESAs and 529 plans is generally similar. At the federal level, there is no deduction for contributions made to a Coverdell ESA or a 529 plan (though states may offer one). And withdrawals from both a Coverdell ESA and a 529 plan that are used to pay the beneficiary's qualified education expenses (called qualified withdrawals) are free from income tax at the federal level. At the state level, whether the withdrawal is income tax free or deductible from income depends on the state you live in. And keep in mind that states may limit their tax benefits to individuals who participate in the in-state 529 plan.

Withdrawals from a 529 plan or a Coverdell ESA that are used for purposes other than the beneficiary's qualified education expenses (called nonqualified withdrawals) aren't treated as favorably. First, you'll pay income tax on the earnings portion of the withdrawal. For 529 plans, the person who receives the distribution (typically the



account owner) pays the tax, while for Coverdell ESAs, the beneficiary generally pays the tax. Second, you'll pay a 10 percent federal penalty on the earnings portion. Plus, depending on the state you live in, you may also owe an additional state penalty on the earnings portion.

Control of the account

As the account owner of a 529 account, you decide when withdrawals will be made and for what purpose. You're also free to change the designated beneficiary, and as long as the new beneficiary fits the definition of a qualified family member of the previous beneficiary, you won't be penalized for making the change. As a parent or guardian, you generally have these same rights with a Coverdell ESA, but the exact degree of control may depend on the trustee's policies. For example, control will sometimes pass to the beneficiary once he or she is no longer a minor. And when the beneficiary (who is not a beneficiary who has special needs) turns age 30, the funds in a Coverdell ESA must be distributed within 30 days. The earnings may be subject to tax and penalty, and the beneficiary will have control of the funds. By contrast, the money in a 529 account can generally stay there as long as you like (though prepaid tuition plans may have restrictions on how long an account can remain open).

In terms of investment control, though, Coverdell ESAs have the edge. You can set up a Coverdell ESA with any number of banks, mutual fund companies, and other institutions. And you can customize your portfolio, choosing investments on your own. You're also typically free to move money among a company's investments or to transfer your Coverdell ESA from one trustee to another as often as you like. Finally, you can take a withdrawal from your Coverdell ESA and roll it over to a Coverdell ESA with a different trustee. The new account can be for the same beneficiary or for a new one within the same family. You can only do one rollover per year, though, and you must complete the rollover within 60 days to avoid tax and penalty.

By contrast, you lack such investment freedom with a college savings plan, though the trend is for college savings plans to offer more investment choices and flexibility. If you're lucky, at the time you join a college savings plan you'll get to choose one or more investment portfolios offered by the plan, which typically consist of mutual funds tailored to different investment styles. Otherwise, your contributions will automatically go into a single investment portfolio based solely on your child's age. In either case, though, you don't get to choose the underlying mutual funds held in an investment portfolio--the plan's professional money managers make those decisions. And you can't move money from fund to fund within the portfolio that you have.

Once you've invested money in a portfolio, you have limited opportunities to change investment options if you're unhappy with the portfolio's investment performance. Depending on a plan's individual rules, some plans may let you direct future contributions to a different portfolio. As for your existing contributions, some plans may let you change the investment option once each calendar year without changing the beneficiary, or they may let you change the investment option anytime you do change the beneficiary.

But there's one option that's mandated by federal law and not subject to a plan's discretion. You can change the investment option on your existing contributions without penalty by doing a rollover to another 529 plan (college savings plan or prepaid tuition plan) without changing the beneficiary. However, you're limited to one such rollover every 12 months. If you want to do more than one rollover in a 12-month period, you'll need to change the beneficiary to avoid a penalty and taxes.

Note: With a prepaid tuition plan, your money is generally invested in a trust fund that's managed by professional money managers. You don't get to choose a portfolio, and you have virtually no say in how your money is invested. But you are typically guaranteed a minimum rate of return.

Gift tax

You may be concerned about the gift tax consequences of contributing to a 529 plan or a Coverdell ESA. The treatment will be similar in both cases--your contribution is considered a completed gift to the account beneficiary, and so it qualifies for the annual federal gift tax exclusion. This means that you can gift up to $13,000 a year, per person, to an unlimited number of people without triggering federal gift tax.

However, because the annual maximum contribution allowed to a Coverdell ESA is $2,000, you won't trigger the



gift tax rules if this is your only gift to the beneficiary for the year. As for 529 plans, they offer a special gifting feature that's not available with any other college savings vehicle. Specifically, you can make a lump-sum contribution to a 529 plan of up to $65,000 in 2010, elect to spread the gift evenly over five years, and completely avoid federal gift tax, provided no other gifts are made to the same beneficiary during the five-year period. A married couple can gift up to $130,000. And the fact that you're making a completed gift generally means that those funds are removed from your taxable estate. Keep in mind, though, that because the annual maximum contribution allowed to a Coverdell ESA is $2,000, you won't trigger the gift tax rules if this is your only gift to the beneficiary for the year.

Federal financial aid

The federal financial aid treatment of Coverdell ESAs and 529 college savings plans is identical. Each is considered an asset of the parent if the parent is the account owner (which is a more favorable result than if the account were classified as a student asset). Also, distributions (withdrawals) from either a Coverdell ESA or a college savings plan that are used to pay the beneficiary's qualified education expenses aren't classified as either parent or student income, which means that some or all of the money is not counted again when it's withdrawn.

Note: The financial aid treatment of 529 plans and Coverdell ESAs is complex and subject to change. You should consult a financial planner experienced in financial aid issues for more information.

Can you have both?

Yes. You can open both a Coverdell ESA and a 529 account for the same beneficiary. And you can contribute to both types of plans in the same year for the same beneficiary. However, if withdrawals are made from a Coverdell ESA and a 529 account in the same year for the same beneficiary, you'll need to allocate the qualified education expenses you're covering between the two accounts. For more information, consult an experienced tax professional.

Legislative impact

A provision of the Economic Growth and Tax Relief Reconciliation Act of 2001 that raised the annual contribution limit for Coverdell ESAs to $2,000 is scheduled to expire on December 31, 2010. Unless Congress acts, after this date, the annual contribution limit for Coverdell ESAs will revert to $500, which is the limit that was in effect prior to January 1, 2002.




529 Plans vs. Other College Savings Options

Section 529 plans can be a great way to save for college--in many cases, the best way--but they're not the only way. When you're investing for a major goal like education, it makes sense to be familiar with all of your options.

U.S. savings bonds

U.S. savings bonds are backed by the full faith and credit of the federal government. They're very easy to purchase, and available in face values as low as $50 ($25 if purchased electronically). Two types of savings bonds, Series EE (which may also be called Patriot bonds) and Series I bonds, are popular college savings vehicles. Not only is the interest earned on them exempt from state and local tax at the time you redeem (cash in) the bonds, but you may be able to exclude at least some of the interest from federal income tax if you meet the following conditions:

• Your modified adjusted gross income (MAGI) must be below $85,100 if you're filing single and $135,100 if you're married filing jointly in 2010

• The bond proceeds must be used to pay for qualified education expenses

• The bonds must have been issued in 1990 or later

• The bonds must be in the name of one or both parents, not in the child's name

• Married taxpayers must file a joint return

• The bonds must have been purchased by someone at least 24 years old

• The bonds must be redeemed in the same year that qualified education expenses are being paid

But a 529 plan, which includes both college savings plans and prepaid tuition plans, may be a more attractive way to save for college. A college savings plan invests primarily in stocks through one or more pre-established investment portfolios that you generally choose upon joining the plan. So, a college savings plan has a greater return potential than U.S. savings bonds, because stocks have historically averaged greater returns than bonds (though past performance is no guarantee of future results). However, there is a greater risk of loss of principal with a college savings plan. Your rate of return is not guaranteed--you could even lose some of your original contributions. By contrast, a prepaid tuition plan generally guarantees you an annual rate of return in the same range as U.S. savings bonds (or maybe higher, depending on the rate of college inflation).

Perhaps the best advantage of 529 plans is the federal income tax treatment of withdrawals used to pay qualified education expenses. These withdrawals are completely free from federal income tax no matter what your income, and some states also provide state income tax benefits. The income tax exclusion for Series EE and Series I savings bonds is gradually phased out for couples who file a joint return and have a MAGI between $105,100 and $135,100. The same happens for single taxpayers with a MAGI between $70,100 and $85,100. These income limits are for 2010 and are indexed for inflation.

However, keep in mind that if you don't use the money in your 529 account for qualified education expenses, you will owe a 10 percent federal penalty tax on the earnings portion of the funds you've withdrawn. And as the account owner, you may owe federal (and in some cases state) income taxes on the earnings portion of your withdrawal, as well. Plus, there are typically fees and expenses associated with 529 plans. College savings plans may charge an annual maintenance fee, an administrative fee, and an investment fee based on a percentage of total account assets, while prepaid tuition plans typically charge an enrollment fee and various administrative fees.



Mutual funds

At one time, mutual funds were more widely used for college savings than 529 plans. Mutual funds do not impose any restrictions or penalties if you need to sell your shares before your child is ready for college. However, if you withdraw assets from a 529 plan and use the money for noneducational expenses, the earnings part of the withdrawal will be taxed and penalized. Also, mutual funds let you keep much more control over your investment decisions because you can choose from a wide range of funds, and you're typically free to move money among a company's funds, or from one family of funds to another, as you see fit.

By contrast, you can't choose your investments with a prepaid tuition plan, though you are generally guaranteed a certain rate of return or that a certain amount of tuition expenses will be covered in the future. And with a college savings plan, you may be able to choose your investment portfolio at the time you join the plan, but your ability to make subsequent investment changes is limited. Some plans may let you direct future contributions to a new investment portfolio, but it may be more difficult to redirect your existing contributions. However, states have the discretion to allow you to change the investment option for your existing contributions once per calendar year or when you change the beneficiary. Check the rules of your plan for more details.

In the area of taxes, 529 plans trump mutual funds. The federal income tax treatment of 529 plans is a real benefit. You don't pay federal income taxes each year on the earnings within the 529 plan. And any withdrawals that you use to pay qualified higher education expenses will not be taxed on your federal income tax return. (But if you withdraw money for noneducational expenses, you'll owe income taxes on the earnings portion of the withdrawal, as well as a 10 percent federal penalty)

Tax-sheltered growth and tax-free withdrawals can be compelling reasons to invest in a 529 plan. In many cases, these tax features will outweigh the benefits of mutual funds. This is especially true when you consider how far taxes can cut into your mutual fund returns. You'll pay income tax every year on the income earned by your fund, even if that income is reinvested. And when you sell your shares, you'll pay capital gains tax on any gain in the value of your fund. Many 529 college savings plans offer mutual funds whose returns may beat the after-tax return on a taxable mutual fund account.

Custodial accounts

A custodial account holds assets in your child's name. A custodian (this can be you or someone else) manages the account and invests the money for your child until he or she is no longer a minor (18 or 21 in most states). At that point, the account terminates and your child has complete control over the funds. Many college-age children can handle this responsibility, but there's still a risk that your child might not use the money for college. But you don't have to worry about this with a 529 plan because you, as the account owner, decide when to withdraw the funds and for what purpose.

A custodial account is not a tax-deferred plan. The investment earnings on the account will be taxed to your child each year. Under special rules commonly referred to as the "kiddie tax" rules, children are generally taxed at their parent's (presumably higher) tax rate on any unearned income over a certain amount. For 2010, this amount is $1,900 (the first $950 is tax free and the next $950 is taxed at the child's rate). The kiddie tax rules apply to: (1) those under age 18, (2) those age 18 whose earned income doesn't exceed one-half of their support, and (3) those ages 19 to 23 who are full-time students and whose earned income doesn't exceed one-half of their support. The kiddie tax rules significantly reduce the tax savings potential of custodial accounts as a college savings strategy. Remember that earnings from a 529 plan will escape federal income tax altogether if used for qualified higher education expenses; the state where you live may also exempt the earnings from state tax.

But a custodial account might appeal to you for some of the same reasons as regular mutual funds. Though the funds must be used for your child's benefit, custodial accounts don't impose penalties or restrictions on using the funds for noneducational expenses. Also, your investment choices are virtually unlimited (e.g., stocks, mutual funds, real estate), allowing you to be as aggressive or conservative as you wish. As discussed, 529 plans don't offer this degree of flexibility.

Note: Custodial accounts are established under either the Uniform Gifts to Minors Act (UGMA) or the Uniform



Transfers to Minors Act (UTMA). The two are similar in most ways, though an UTMA account can stay open longer and can hold certain assets that an UGMA account can't.

Finally, there is the issue of fees and expenses. Depending on the financial institution, you may not have to pay a fee to open or maintain a custodial account. But generally you can count on incurring at least some type of fee with a 529 plan. College savings plans may charge an annual maintenance fee, an administrative fee, and an investment fee based on a percentage of total account assets, while prepaid tuition plans typically charge an enrollment fee and various administrative fees.

Trusts

Though trusts can be relatively expensive to establish, there are two types you may want to investigate further:

Irrevocable trusts: You can set up an irrevocable trust to hold assets for your child's future education. This type of trust lets you exercise control over the assets through the trust agreement. However, trusts can be costly and complicated to set up, and any income retained in the trust is taxed to the trust itself at a potentially high rate. Also, transferring assets to the trust may have negative gift tax consequences. A 529 plan avoids these drawbacks but still gives you some control.

2503 trusts: There are two types of trusts that can be established under Section 2503 of the Tax Code: the 2503c "minor's trust" and the 2503b "income trust." The specific features and tax consequences vary depending on the type of trust that is used, and the details are beyond the scope of this discussion. Suffice it to say that either type of trust is much more costly and complicated to establish and maintain than a 529 plan. In most cases, a 529 plan is a better way to save for college.

Legislative impact

The Jobs and Growth Tax Relief Reconciliation Act of 2003 and the Tax Increase Prevention and Reconciliation Act of 2005 reduced the tax rates on dividends and long-term capital gains. (Through 2010, the maximum tax rate on dividends and long-term capital gains is 15 percent, and for individuals in the 10 and 15 percent tax brackets, the tax rate is zero percent in 2008-2010.) As a result, the comparative advantage of a tax-favored strategy like a 529 plan over a non tax-advantaged strategy like a mutual fund is somewhat lessened. However, further complicating the picture, the reduced tax rates for dividends and long-term capital gains are scheduled to expire beginning in 2011.




Are college savings plans a good way to save for college?

Question:

Are college savings plans a good way to save for college?

Answer:

Yes, they can be an excellent way to save for college. College savings plans are established by states and typically managed by an experienced financial institution designated by the state. Each plan has slightly different features.

A 529 college savings plan lets you save money for college in an individual investment account that offers federal tax advantages. You (or anyone else) open an account in your child's name and thereafter contribute as much money as you wish, subject to the plan's limit.

The state's selected money manager takes your contribution and invests it in one or more of the plan's pre-established investment portfolios, which typically consist of mutual funds. Some plans automatically place your contribution in a portfolio that's tailored to the age of your child. (The younger your child, the more aggressive the percentage of stocks. As your child grows older, the portfolio gradually shifts to more conservative investments.) Other plans let you choose the portfolio you want at the time you join the plan, without regard to your child's age. This lets you take into account your risk tolerance and other factors that may be important to you.

College savings plans are popular because they combine many desirable tax features with the ability to use the money at any accredited college in the country or abroad. Your contributions grow tax deferred, and if withdrawals are used to pay the beneficiary's qualified education expenses, the earnings are completely free from income tax at the federal level. Many states also add their own tax benefits, such as tax deductions for contributions and exemption of the earnings from state income tax. However, if a withdrawal isn't used to pay the beneficiary's qualified education expenses (known as a nonqualified withdrawal), the earnings portion is subject to a 10 percent federal penalty and is taxed as income at the rate of the person who receives the withdrawal (a state penalty may also apply).

There are no income limits that determine whether you are eligible to open a college savings plan account--everyone is eligible. And if your child decides not to go to college or gets a full scholarship, the money in the plan can be transferred to a qualified family member without penalty.

But investment returns aren't guaranteed. If your investment portfolio performs poorly, you're still bound by the investment decisions of the plan's money manager, unless the plan lets you change the investment strategy for your existing contributions, which it may do once per calendar year. (For 2009 only, states may permit 529 college savings plan investors to change the investment options for their existing contributions twice per year instead of once per year.) College savings plans are also free to let you change your investment option for future contributions. If your plan doesn't provide this flexibility, then you are allowed by federal law to roll over your college savings plan account to a different 529 plan (college savings plan or prepaid tuition plan) without penalty once every 12 months.

One final note: You are not limited to your own state's college savings plan. Most states allow anyone to participate in their plan. You may also participate in the college savings plan of more than one state.



How can I save for my child's college education?

Question:

How can I save for my child's college education?

Answer:

This is a very broad question that's difficult to answer without knowing your individual situation. The option(s) you choose will depend on a number of factors:

• Your need for strategies with tax advantages (some investments and savings vehicles offer special tax advantages if the money is used to pay college expenses)

• Your certainty that your child will want to attend college (tax- sheltered plans have restrictions on the use of funds)

• Your income (some savings vehicles exclude parents above certain income limits)

• Your willingness to put funds in your child's name

• Your risk tolerance

• Your expectation of qualifying for financial aid

• The amount of money you have available to invest

• The number of years you have to invest

You may need to consult a professional financial planner or tax advisor to determine the best course of action in your particular situation.

Yet there is one universal truth: It's recommended that you start saving for your child's college education as early as possible, preferably with regular, manageable contributions that increase over time.

But what if your child is only a couple of years away from college? Your emphasis then won't be on a savings program so much as it will be on what assets, if any, you might use for college expenses. Do you have retirement accounts? A cash value life insurance policy? Home equity? These are all sources of potential cash.

Finally, if you expect to qualify for financial aid, you should familiarize yourself with the financial aid process before your child starts college. It's often a good idea to do a dry run through the federal financial aid application. This will help you estimate how much money your family will be required to pay toward college costs each year before any financial aid is forthcoming.



Can an UGMA/UTMA account reduce my child's financial aid for college?

Question:

Can an UGMA/UTMA account reduce my child's financial aid for college?

Answer:

It can, but in the same way that any other asset held by your child can. An UGMA/UTMA account is a custodial account established at a financial institution for a minor child and managed by a parent or other designated custodian. It is established under either a state's Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA).

Because an UGMA/UTMA account is held in your child's name, it is considered your child's asset. The federal government's financial aid formula treats your child's assets differently than your assets. Under the current federal formula, children must contribute 20 percent of their assets to college costs each year before becoming eligible for financial aid, while parents must contribute only 5.6 percent of their assets.

For example, $10,000 in your child's UGMA/UTMA account would result in a $2,000 required contribution from your child. The same $10,000 in your bank account would result in a $560 required contribution from you.

As a result of this formula, any asset that your child holds, including an UGMA/UTMA account, will always translate into a higher monetary contribution to college costs than if the same asset were in your hands. It follows that the more money your family is required to pay up front for college costs, the less financial aid your child will be eligible for. But even though your child will be entitled to less financial aid, that may not be such a bad thing. Remember, the main component of the average financial aid package consists of loans that must be paid back.



Should I use my 401(k) to fund my child's college education?

Question:

Should I use my 401(k) to fund my child's college education?

Answer:

You can, but it isn't your best option. Your 401(k) plan should be dedicated primarily to your retirement.

There are two primary drawbacks to using your 401(k) for college funding. First, if you withdraw funds from your 401(k) before you are 59½, you may owe a 10 percent premature distribution penalty on the withdrawal. This penalty is in addition to income taxes you will owe on the withdrawal. Second, frequent dips into your 401(k) reduce the amount of money you ultimately have available to reap the benefits of compounding and tax deferral. This, in turn, reduces the overall funds for your retirement.

If you really need to use your 401(k) to pay for college, a better option might be to borrow from it if your plan allows loans. Plan loans are not taxed or penalized, as long as you repay the funds within a specified time period. But make sure you compare the cost of borrowing college funds from your plan with other finance options. Although interest rates on plan loans may be favorable, the amount you can borrow is limited, and you generally must repay the loan within five years. In addition, some plans require you to repay the loan immediately if you leave your job. Your retirement earnings will also suffer as a result of removing funds from a tax-deferred investment.

If you want to save for college in a retirement vehicle, consider using a traditional IRA or Roth IRA instead. With these IRAs, you will not owe the 10 percent premature distribution penalty on withdrawals you make before age 59½, as long as the money is used to pay your child's qualified college expenses. If you have some time to plan your child's college fund, you might consider a Coverdell education savings account or a 529 plan established and maintained by a state or eligible educational institution. Each of these vehicles is specifically geared to college investors and offers numerous tax advantages.



Should I open a Coverdell education savings account?

Answer:

A Coverdell education savings account can play an important part in your college savings program. Once an account is open, you can contribute at any time during the year, and you even have until April 15 of the following taxable year to make a contribution for the current taxable year. In addition, contributions can be made by an entity, including a tax-exempt entity, on behalf of a selected beneficiary.

The main benefit of Coverdell ESAs is tax related. Specifically, money you withdraw to pay your child's college education expenses is completely tax free, including earnings. (Generally, distributions are tax free if they are not more than the beneficiary's education expenses for the year.) Coverdell ESAs have many favorable features:

• You can contribute up to $2,000 per year for a selected beneficiary

• You can use Coverdell ESA funds to pay elementary and secondary school expenses

• You can contribute to both a Coverdell ESA and a 529 plan (prepaid tuition plan or college savings plan) in the same year for the same beneficiary

• You can claim either the Hope credit (renamed the American Opportunity tax credit for 2009 and 2010) or the Lifetime Learning credit in the same year you take a tax-free distribution from a Coverdell ESA (though the expenses paid with the Coverdell ESA distribution can't be the same expenses used to qualify for the credit)

Before you consider opening a Coverdell ESA, though, you'll have to meet certain income limits. Single filers must have a modified adjusted gross income (MAGI) of $95,000 or less to make the maximum $2,000 contribution, and joint filers must have a MAGI of $190,000 or less. A partial contribution is allowed for single filers with a MAGI between $95,000 and $110,000, and for joint filers with a MAGI between $190,000 and $220,000.



Should I save for college in my name or my child's name?

Answer:

There are three potential drawbacks to saving in your child's name--the kiddie tax, federal financial aid rules, and control issues.

First, the kiddie tax. At one time, saving money in a child's name was recommended because of the tax saving opportunities that resulted when children were taxed at their own rate. However, Congress partially closed this loophole some years ago with passage of special rules commonly referred to as the "kiddie tax." The kiddie tax makes a child's unearned investment income over a certain amount subject to tax at the parents' tax rate. For 2010, this amount is $1,900 (the first $950 is tax free and the next $950 is taxed at the child's rate). The kiddie tax rules significantly reduce the tax savings potential of a child holding assets in his or her name.

The kiddie tax rules apply to: (1) those under age 18, (2) those age 18 whose earned income doesn't exceed one-half of their support, and (3) those ages 19 to 23 who are full-time students and whose earned income doesn't exceed one-half of their support. To lessen the impact of the kiddie tax, choose tax-free or tax-deferred investments in which the annual expected income does not exceed the threshold amount of $1,900.

Second, the federal financial aid rules have a more negative impact on child assets than parent assets. Under the current federal aid formula, a child must contribute 20 percent of his or her assets to college costs each year, whereas parents must contribute 5.6 percent of their assets each year. So $10,000 in your child's bank account would equal a $2,000 contribution from your child, but that same $10,000 in your bank account would equal a $560 contribution from you.

The more assets a child has, the more he or she will be expected to contribute to college costs, and the less financial aid he or she will receive, because the financial need is less. However, keep in mind that obtaining less financial aid is not necessarily a bad thing. The average financial aid package consists mostly of loans, so by paying more up front, chances are you or your child will just incur less debt, as opposed to losing grants and scholarships (which do not have to be repaid).

Finally, there is the control issue. Many parents open a custodial account for their child (UGMA or UTMA) to save for college. However, when the child reaches the age of majority (18 or 21, depending on the state), he or she gets full control over the money in the account and can use the money for anything--college, or perhaps a backpacking trip to Europe. Some parents aren't willing to relinquish this control to their child.

For all these reasons, it's generally recommended that parents save for college in their own names, not their children's names.



Do Series EE bonds offer any special advantages if used for college savings?

Question:

Do Series EE bonds offer any special advantages if used for college savings?

Answer:

Yes. Series EE bonds (which may also be called Patriot bonds) are generally inexpensive, low-risk investments whose earnings are exempt from state and local taxes. In addition, in the college savings game, the interest earned by Series EE bonds (and Series I bonds) may be exempt from federal tax if the following requirements are met:

• The bond must be issued in the name of one or both parents (not the child's name), and the owner of the bond must be at least 24 years old

• The bond proceeds must be used to pay qualified higher education expenses (generally tuition and fees, not room and board)

• The bond must be redeemed (cashed in) by the owner in the year it's used to pay the qualified education expenses of the owner, the owner's spouse, or their child

• You must file a joint tax return if you're married

• You must fall under established income limits (these limits are adjusted annually for inflation)

If you meet these requirements, you'll pay no federal tax on the interest earned by the bond when you cash it in. This saved amount can then be applied to the college bill.

However, despite this potential tax advantage, Series EE bonds have relatively low growth potential in an arena where it's crucial to keep up with annual college cost increases.



How can we possibly save for retirement and our child's college education at the same time?

Question:

How can we possibly save for retirement and our child's college education at the same time?

Answer:

It's seldom easy to achieve a balance between saving for your retirement and saving for the ever-increasing costs of a college education within your present income. Yet it's imperative that you save for both at the same time. To postpone saving for your retirement means missing out on years of tax-deferred growth and playing a near-impossible game of catch-up. To accomplish both goals, you may need to compromise.

The first step is to thoroughly examine your funding needs for both college and retirement. On the retirement side, remember to include the estimated value of any employer pension plans, as well as your Social Security benefits. This evaluation will likely prompt you to examine some deeply held beliefs about your financial goals. For example, is it important that you travel regularly in retirement, or is it more important that your child attend a prestigious Ivy League college?

If you discover that you can't afford to save for both goals, the second step is to consider some compromises:

• Defer your retirement and work longer.

• Reduce your standard of living, now or in retirement.

• Increase the family income by seeking a better paying position in your present career, getting a second job, or having a previously stay-at-home spouse join the work force. Beware, though, of potential drawbacks like day-care costs, commuting costs, and tax disadvantages on the increased income.

• Seek out more aggressive investments (but beware of the risks).

• Expect your child to contribute more money to college. Some parents may find it difficult to accept, but the majority of college students finance a portion of their education with student loans.

• Investigate less expensive colleges. You may find that some less expensive state universities have more to offer in certain programs than their pricey private counterparts.

The third step is to re-evaluate your plan from time to time as your circumstances and wishes change. Remember, the important thing is to earmark a portion of your present income for both goals and do the best you can.



Help! My child is only two years away from college and we haven't saved much. What should we do?

Question:

Help! My child is only two years away from college and we haven't saved much. What should we do?

Answer:

Your late start means you've missed most of the best opportunities to grow the money you have. With only two years until your child starts college, you'll need to refine the college selection process, accumulate enough of a down payment for the early college bills, and establish a savings plan for the later college years. Here are some constructive steps you can take.

First, help your child investigate schools that provide a good value. Some less expensive state universities and second-tier private colleges may offer better programs than their more expensive private counterparts. Think creatively. Your child could attend a nearby school and live at home for a year or two to save money on room and board. He or she could attend a community college for two years and then transfer to a private four-year college. Or, your child could consider cooperative education, where semesters of academic work alternate with semesters of paid work. If your finances are severely limited, your child might consider taking a year off before starting college.

Second, learn all you can about financial aid. Do a dry run through the federal government's financial aid application to determine whether your child is likely to qualify for financial aid, and, if so, for how much. For financial aid references, ask a librarian or your child's high school guidance counselor, or conduct a search on the Internet. When you've zeroed in on a few colleges, examine their financial aid statistics. For example, what percentage of students receive financial aid? What percentage of the average package consists of loans? What percentage of a student's financial need is generally met--100 percent? 75 percent? Does the college offer merit scholarships?

Third, start investigating potential scholarships. There are a number of websites where your child can type in his or her interests, abilities, and goals to obtain a list of relevant scholarships. However, outside scholarships generally make up only a small portion of a student's overall aid package, so it's very important that this search be made in addition to, not in place of, the quest for federal and college-sponsored financial aid.

Fourth, examine any current financial resources that you can draw on for the early college bills. Do you have savings accounts, stocks, mutual funds, or cash value life insurance? Can you pay a portion of the tuition bills from current income? Can you increase the family income by getting a second job or having a previously stay-at-home spouse return to the work force? If you're still short, you'll need to investigate a personal loan, a home equity loan, or the federally sponsored PLUS loan, which is tailored especially to parents. In other cases, you may need to tap your retirement accounts, though this is generally recommended only as a last resort.

Finally, you'll need to start earmarking a portion of your current income for college bills that won't come due until four or five years, when your child is a junior or senior in college. Because you'll need the money relatively soon, you should avoid high-risk investments. Instead, choose a low-risk, stable investment, such as a certificate of deposit that is timed to mature when you need it, or a money market mutual fund.



What is the CollegeSure CD?

Question:

What is the CollegeSure CD?

Answer:

The CollegeSure CD is an FDIC-insured certificate of deposit (CD) with an interest rate that is tied to the annual increase in college costs. The interest rate adjusts annually on July 31. The CollegeSure CD is offered in terms of 1 to 22 years. The term you choose usually coincides with the number of years until your child enters college.

CollegeSure CDs are sold in whole or partial units. A unit is simply a measure of the portion of college costs you have prepaid. At maturity, each whole unit is guaranteed to pay the average cost of one year of tuition, fees, and room and board at a four-year private college. This guarantee assumes interest and principal remain on deposit until maturity. If you choose to purchase only a partial unit, at maturity it will be worth only a portion of the average yearly college cost. Because the interest rate varies annually, a CollegeSure CD might provide a better return than a traditional bank CD or Series EE government bond.

As a CD, interest earned on the CollegeSure CD is taxable, and an early withdrawal penalty applies. However, if your child decides not to go to college, you can get the entire principal and interest back when the CD matures and use it for any purpose.

The CollegeSure CD is offered only by the College Savings Bank in Princeton, New Jersey. For more information, call the College Savings Bank at (800) 888-2723.



Should I establish a trust for my child's college education fund?

Question:

Should I establish a trust for my child's college education fund?

Answer:

The answer depends first on your financial objectives and then on other factors that will influence those objectives. Trusts are frequently used to minimize estate taxes, get professional management of assets, and control funds while providing for minor children. If these features correspond with your overall financial strategy, a trust can be an efficient way to fund a college education.

However, trusts have certain disadvantages. Generally, you need a significant lump sum to initiate a trust. Also, trusts are often expensive to maintain (e.g., a trust must file a separate tax return). Tax consequences, attorney fees, and the possibility that your child's eligibility for financial aid will be negatively impacted may also be drawbacks to this type of funding.

Two types of trusts often used for college education funds are a Section 2503(c) trust and a Crummey trust. The Section 2503(c) trust controls funds like a classic trust: A trustee manages the funds for the child's benefit, and at age 21, the child receives the remaining principal and income. With a Crummey trust, the beneficiary can withdraw periodic contributions made to the trust for a set period of time after they're made. It is also unique in that it allows multiple beneficiaries and does not mandate distribution at age 21.

If your specific objective is to fund a college education through investments and fund growth, you may want to investigate other alternatives. Custodial accounts offer some of the benefits of trusts as well as other advantages. They are usually convenient, less expensive to set up and maintain, and require less initial funding than trusts. There are also tax-sheltered savings plans, if tax benefits are important to you.



What is the college inflation rate?

Answer:

The college inflation rate refers to the annual increase in college tuition and fees, similar to the way that the general inflation rate refers to the annual increase in the cost of living. The college inflation rate is usually measured separately for public and private colleges. For the 2009/2010 academic year, tuition and fees at four-year public colleges for in-state students rose an average of 6.5 percent, tuition and fees at four-year public colleges for out-of-state students rose an average of 6.2 percent, and tuition and fees at four-year private colleges rose an average of 4.4 percent. (Source: The College Board's Trends in College Pricing Report 2009)

For parents trying to keep up with their child's college fund, it's important to choose investments for college savings that keep pace with college inflation. You can use the college inflation rate for a given year or the average rate of inflation over the past decade to help project college costs in the future. Be aware, however, that the more years your child has to go until college, the greater likelihood that your cost estimate will need to be revised at a later date.



What expenses are included in the annual cost of college?

Question:

What expenses are included in the annual cost of college?

Answer:

To most parents, the annual cost of college simply refers to tuition and room and board. To the federal government, however, the annual cost of college means the cost of attendance. Twice per year, the federal government calculates the cost of attendance for each college (over 3,000 of them), adjusts the figure for inflation, and, if your child is applying for financial aid, uses this number to determine your child's financial need.

Five categories of expenses are used to determine the cost of attendance at a particular college:

• Tuition and fees: Usually the same for all students

• Books and supplies: Can vary by student, depending on your child's courses and his or her requirements

• Room and board: Can vary by student, depending on the meal plan your child selects and whether he or she lives on or off campus

• Transportation: Can vary greatly by student, depending on where your child lives in relation to the school

• Personal expenses: Can vary by student (e.g., health insurance, pizzas, telephone bills)

In the last four categories, the federal government sets a monetary figure even though the exact expenses incurred will depend on the individual student. Thus, depending on these variables, your child's actual cost may be slightly higher or lower than the cost used for official purposes like financial aid determinations.

If you're interested in obtaining the monetary amount allotted to each category for a particular college, contact that college directly.



Are there any ways to lower the cost of college?

Question:

Are there any ways to lower the cost of college?

Answer:

You can lower the cost of college in a number of ways. The deciding factors in achieving your cost goals may be limited only by your flexibility.

The primary way to lower the cost of college is to choose a less expensive school. You may find that excluding prestigious colleges significantly lowers the bill with little or no impact on the quality of your child's education. Less expensive private schools and state universities often have stronger offerings in certain programs than their more prestigious private counterparts, and may offer smaller class sizes. Local colleges also offer the opportunity to live at home, which can minimize room-and-board expenses. Be aware, however, that this choice might require the purchase of a car in addition to commuting costs.

As a creative alternative, your child could enroll in a less expensive institution (e.g., a state or community college) and then transfer to the college of his or her choice after two years. Your child's degree would be from the preferred college, but the total cost would be reduced by the two years you spent paying lower tuition and fees.

You can also check to see if the schools your child wishes to attend offer accelerated programs or special academic exams. Accelerated programs offer the chance to graduate in three years, allowing you to save a year's worth of college expenses. Special academic exams offer the opportunity to earn college credits even before your child enters college. This can also cut down on the required course load and consequent expenses.

You can also investigate government military programs. Your child's options include attending a service academy, enlisting in the military first and then attending college under the GI Bill, and training for the military while in school under the ROTC program. Although such programs all offer benefits, each has specific service requirements that you should understand thoroughly.

Finally, you should investigate all possible sources of financial aid. Your child might obtain a student loan or enroll in a work-study program. None of these options actually lowers the cost of attendance, but they will diminish the bite college expenses take out of the family budget.




Question:


Answer:

Section 529 plans, also known as qualified tuition programs, or QTPs, were created by the federal government with the passage of the Small Business Job Protection Act of 1996, a piece of legislation that actually had little to do with college savings. These plans were later modified by the Taxpayer Relief Act of 1997, the Economic Growth and Tax Relief Reconciliation Act of 2001, and the Pension Protection Act of 2006.




Question:


Answer:

College savings plans and prepaid tuition plans are often referred to as 529 plans because they are governed by Section 529 of the Internal Revenue Code. Specifically, in order for these plans to gain favorable federal tax treatment, they must comply with all provisions of Section 529 of the tax code. Under federal law, 529 plans are officially called qualified tuition programs, or QTPs.

Note: In many instances, the term "529 plan" is used interchangeably with "college savings plan," but this use is not completely accurate. A college savings plan is only one type of 529 plan; a qualifying prepaid tuition plan is the other.



Do 529 plans include both college savings plans and prepaid tuition plans?

Question:

Do 529 plans include both college savings plans and prepaid tuition plans?

Answer:

Yes. Although most people associate 529 plans only with college savings plans (sometimes called college savings programs), prepaid tuition plans are another type of 529 plan. And though the two share some similarities, college savings plans and prepaid tuition plans differ in important ways (e.g., a prepaid tuition plan offers a guaranteed minimum rate of return, while a college savings plan does not). Make sure that you understand what type of 529 plan you're investing in.



What's the difference between college savings plans and prepaid tuition plans?

Question:

What's the difference between college savings plans and prepaid tuition plans?

Answer:

Although both college savings plans and prepaid tuition plans are 529 plans (assuming they meet the statutory requirements), there are important differences between them.

The main difference is that with a college savings plan, you contribute to an individual investment account to pay for a child's future education. Your money is invested in a particular investment portfolio at the time you join the plan, and you take your chances on what your rate of return will be--there are no guarantees. If your portfolio performs well, you reap the benefits. If it doesn't, you suffer the losses.

By contrast, with a prepaid tuition plan, you prepay all or part of a child's future tuition by investing in units or contracts (depending on how the particular plan is structured), and you're guaranteed a minimum rate of return. However, you aren't necessarily entitled to any extra money that the plan may earn.

There are other important differences, too. A college savings plan lets you use the funds at any college home or abroad that's accredited by the U.S. Department of Education, while funds in a prepaid tuition plan may typically be used only for undergraduate tuition at public colleges in your state. Also, there is generally no time limit on when withdrawals from a college savings plan must be made, though tuition credits in a prepaid plan must generally be used by the time the beneficiary reaches age 30. And while you can generally contribute to a college savings plan at any time, prepaid tuition plans typically have select open enrollment periods, which are the only times you can open an account or contribute money.



How many states currently have 529 plans?

Answer:

Currently, all states but Wyoming sponsor at least one 529 plan.



Who can legally offer 529 plans?

Question:

Who can legally offer 529 plans?

Answer:

It depends on the type of 529 plan. There are two types of 529 plans--college savings plans and prepaid tuition plans. With college savings plans, only states are allowed to operate them. With prepaid tuition plans, both states and colleges are allowed to operate them. To gain favorable federal tax treatment, any college savings plan or prepaid tuition plan must meet all of the requirements of Section 529 of the Internal Revenue Code.

Note: As a practical matter, states designate an agent (usually a financial institution or other professional money manager) to manage their particular college savings plan or prepaid tuition plan.



How do I know whether to choose a college savings plan or a prepaid tuition plan?

Question:

How do I know whether to choose a college savings plan or a prepaid tuition plan?

Answer:

Your investment preferences and the college you think the beneficiary (let's assume it's your child) might attend will affect your choice.

A prepaid tuition plan generally guarantees you a minimum rate of return to ensure that you keep up with college inflation. Essentially, by contributing to such a plan, you lock in tomorrow's tuition at today's prices. However, if the stock market enjoys an extended period of high returns, you'll generally still be limited to the return that your plan promises--the entire surplus won't trickle down to you. Also, to receive the maximum benefits under a prepaid tuition plan, your child must attend a college in that plan. If your child chooses a different school, you may pay a penalty.

By contrast, a college savings plan doesn't guarantee you any minimum rate of return. When you invest your money in a plan's portfolio (whether it's an age-based portfolio geared to your child's age or another portfolio), you take your chances. If your portfolio earns a high rate of return, you're entitled to all of it. But if it earns little or nothing (or even loses money), you may end up with less than you need to pay for your child's education. The good news, though, is that your child can use the funds in a college savings plan at any college in the country or abroad that is accredited by the U.S. Department of Education.

If you're a fairly conservative investor and believe that your child will attend a specific college or will choose from among a number of public colleges located in the same state, then a prepaid tuition plan may be the appropriate choice (assuming one is offered). But if you don't want to restrict your child's college options or you believe that you can earn a better rate of return than what is promised by a prepaid tuition plan, then a college savings plan that offers a range of investment options may be the right choice.



Can I invest in any state's 529 plan, or am I limited to my own state's plan?

Question:

Can I invest in any state's 529 plan, or am I limited to my own state's plan?

Answer:

529 college savings plans are typically open to residents of any state, while 529 prepaid tuition plans are typically limited to state residents. States that let nonresidents join their 529 college savings plan may have different rules for residents and nonresidents (such as higher annual fees and higher minimum contribution requirements for nonresidents). And keep in mind that if you join a different state's 529 plan (either college savings plan or prepaid tuition plan), you won't enjoy any tax benefits offered by that state--your own state's tax laws would apply.



I've decided on a college savings plan, but how do I go about choosing one?

Question:

I've decided on a college savings plan, but how do I go about choosing one?

Answer:

Most college savings plans let nonresidents join, so you have quite a few options. In choosing a particular college savings plan, there are many factors you should consider.

First, because you're entitled only to the state tax benefits (if any) offered by the state in which you reside, it's always a good idea to look at your own state's plan first (assuming your state offers one) and research what state tax benefits are available. For example, some states exempt a plan's earnings from income tax if used to pay qualified education expenses, similar to the way the federal government exempts such earnings from tax. Some states may also let you deduct some or all of your contributions in a given year, or they may match a portion of your contributions. Remember, if you join another state's plan, you won't be entitled to any state tax benefits offered by that state.

Another important factor to consider is a plan's investment choices. Some plans may restrict you to a certain portfolio based on the beneficiary's (child's) age, while others may let you choose a portfolio that's more or less conservative than this age-based portfolio. You may also want to look at the past investment performance of a particular portfolio and compare it with other similar portfolios in different plans.

Also check to see if the plan lets you change the investment option you've chosen for your existing contributions once per calendar year, something that plans are permitted to do under federal law. Find out, too, whether the plan allows you to direct future contributions to a different portfolio in the plan.

Finally, you may want to compare fees and expenses among plans. Also, the reputation, experience, and track record of the state's designated agent who will manage the plan are important. Customer issues like the ease with which you'll be able to make contributions and otherwise manage your account are important factors, too.



Can my spouse and I open a joint 529 account for our child?

Question:

Can my spouse and I open a joint 529 account for our child?

Answer:

No. A 529 account--whether a college savings plan or a prepaid tuition plan--can only be established by one person. That person is legally referred to as the participant, though the commonly used term is the account owner. In some states, the 529 plan can only accept contributions from the participant. And under federal law, only the participant can give instructions to the plan to distribute money for college expenses or for any other reason. Although you and your spouse can't open a joint account, each of you can open an account for the same child. Then each of you would be a participant in the 529 plan.



If I open a 529 account, will my child's choice of college be restricted?

Question:

If I open a 529 account, will my child's choice of college be restricted?

Answer:

It depends on the type of 529 plan you open. There are two types of 529 plans--college savings plans and prepaid tuition plans. With a college savings plan, your child can use the money at any college in the country and abroad that is accredited by the U.S. Department of Education. By contrast, with a prepaid tuition plan, your child will only receive the maximum benefits under the plan if he or she attends one of the colleges in the plan. If your child chooses a different school, you may pay a penalty.



Can I open a 529 account for a nonrelative?

Question:

Can I open a 529 account for a nonrelative?

Answer:

Yes. There is no legal requirement that the designated beneficiary of a 529 account (college savings plan or prepaid tuition plan) be related to you. So, for example, you can open an account for a friend, neighbor, or coworker. Also, there is no federal requirement that the designated beneficiary be a certain age. States may have their own requirements, however, so check the details of any plan you're considering.



Is there an income limit on who can open an account?

Question:

Is there an income limit on who can open an account?

Answer:

No. There is no income limit that controls who is eligible to open an account in either a college savings plan or a prepaid tuition plan. In addition, contributions may be made to a 529 account regardless of your income. By contrast, to contribute to a Coverdell education savings account, your income must be below a certain limit, depending on your filing status.



Can more than one account be opened for the same child?

Question:

Can more than one account be opened for the same child?

Answer:

Yes. You (or anyone else) can open multiple 529 accounts for the same beneficiary, as long as you do so under different 529 plans (college savings plan or prepaid tuition plan). For instance, you could open college savings plan accounts with State A and State B for the same beneficiary, or you could open a college savings plan account and a prepaid tuition plan account with State A for the same beneficiary. But you can't open two college savings plan accounts in State A for the same beneficiary.

Also, keep in mind that if you do open multiple 529 accounts for the same beneficiary, each plan has a limit, and contributions can't be made after the limit is reached. Some states consider the accounts in other states to determine if the limit has been reached. For these states, the total balance of all plans (in all states) cannot exceed the current year's maximum contribution amount.



How do I enroll in a state's 529 plan?

Question:

How do I enroll in a state's 529 plan?

Answer:

Contact the plan administrator that runs the 529 plan that you want to join. (All plans have websites and toll-free numbers to help you get the information you need.) Plan administrators may be state agencies or companies established solely for the purpose of running a 529 plan, or they may be investment firms. In any case, the plan administrator operates under the authority of each state government, such as the state treasury department. The plan administrator will send you a packet of information that includes enrollment materials, along with a program description. Read the information thoroughly and make sure you understand the plan's rules before you enroll.

In addition, be sure to check the enrollment period for the plan. Many states offer open enrollment, meaning you can join the plan at any time. Other states have shortened enrollment periods, such as October to January.



Can I open a 529 account in anticipation of my future grandchild?

Question:

Can I open a 529 account in anticipation of my future grandchild?

Answer:

You can open an account before the birth of a child, though you have to go about it in a roundabout way.

First, you need to know the two key players involved in any 529 account. One is the account owner, who controls when the money is paid out and to whom. That may be you. (The account owner is usually the person who establishes the account and who puts money into the account.) The other key person is the designated beneficiary, who will use the money to pay for qualified education expenses. The account owner selects the designated beneficiary.

Since the person you want to name as the beneficiary is not yet born, you'll need to take two steps. First, you'll need to open an account and name a beneficiary who is a family member who will be related to your grandchild. Next, when your grandchild is born, you (the account owner) can change the beneficiary to your grandchild.

Check the details of each state's plan carefully, because some plans impose age restrictions on the beneficiaries (such as being under age 21). That may pose a problem if you plan to name your adult son or daughter as the initial beneficiary. Other plans may require that the funds be spent within a certain time period, such as within 10 years of when the original beneficiary would be expected to enter college.



Can I open a 529 plan with a lump sum?

Answer:

Yes, although you will want to consider both the plan's terms and the gift tax rules. Every plan has a lifetime contribution limit--in the majority of states, this limit is at least $300,000. Unlike Coverdell education savings accounts, your annual income does not limit your contributions. So, it doesn't matter how much money you earn in a particular year--you can still contribute to a 529 plan.

As a donor to a 529 account, you can contribute up to $13,000 per year, per beneficiary with no gift tax problems. If you are married, your spouse can also contribute up to $13,000. So, the two of you could use $26,000 to start a 529 account for your child without any gift tax concerns.

Although $13,000 per year is the limit for tax-free gifts, you can actually "front load" a 529 account by putting in $65,000 per beneficiary (and your spouse can do the same) and still avoid any gift tax problems. In effect, you're making five $13,000 contributions all at once. So, you can't make any more $13,000 contributions over the next five years for that same beneficiary without owing a gift tax. But in effect, two parents (or grandparents) could fund an account for one child with $130,000 all at once.

Any amounts contributed in excess of $13,000 per year (after any "front loading" as previously described) count toward an individual's lifetime gift tax exclusion amount, which is $1 million. Once you exceed the $1 million amount, gift taxes must be paid. And any time you exceed the $13,000 amount in a year, you must file IRS Form 709 (the federal gift tax return) at the same time as your income tax return. Remember that other gifts you make in the same year that you contribute to a 529 plan must be counted in the $13,000 per year limit and the $1 million lifetime exclusion amount.

By the way, 529 accounts must be funded with cash only. So, if your lump sum is coming from a potential sale of appreciated securities (e.g., stocks), it may not make sense to sell the securities and pay capital gains taxes. Consult your tax advisor before you make a decision.

Also, if you're in a state that allows a state tax deduction for 529 plan contributions, you may want to avoid a lump-sum contribution and make annual contributions instead. This approach lets you qualify for the state tax break in future years.



What happens if I open a 529 plan in one state and then move to another state?

Question:

What happens if I open a 529 plan in one state and then move to another state?

Answer:

Essentially nothing. You can leave the account assets in your former state's plan with no penalty. Alternatively, you can roll the assets over from your old state's 529 plan to your new state's plan if both plans allow it. Check the details of each plan carefully before you start any transfers.

You can keep the same beneficiary when you do the rollover. But the rollover does bring with it a restriction: You can roll the assets over from one 529 plan to another only once every 12 months. If you want to immediately get out of the 529 plan you're in now and avoid this restriction, you'll need to change the account beneficiary when you request the transfer.

Some 529 plans also require a minimum time period, such as one year, before withdrawals (including rollovers) can be made from an account for any reason. Again, check both plans to make sure there are no withdrawal limitations.

One advantage of a rollover is that you can reallocate your 529 funds to a different investment portfolio (or portfolios) when you join the new plan. So, you might be able to invest more or less aggressively, depending on your personal situation and market factors.



Are there rules on who can open a 529 account?

Question:

Are there rules on who can open a 529 account?

Answer:

In theory, almost anyone can open a 529 account, but rules vary from state to state. Here are a few you may encounter.

First, some plans require that the account owner be a certain age, such as 18. Other plans have no restrictions at all on the age of the owner.

Second, although many 529 plans have no residency requirements, a few require that an account owner live in the state for a certain period of time (e.g., at the time of application, or one year or more before application) before opening a 529 account. Some require that either the account owner or the beneficiary be a resident of the state; others require that both be residents.

Third, some plans require that an account owner be a U.S. citizen or a resident alien with a valid Social Security number or taxpayer identification number.

Fourth, some plans permit corporations, trusts, and other legal entities to open accounts, while other plans do not.

Finally, some plans allow the account owner and the beneficiary to be the same person, while other plans do not.

Check the rules of any 529 plan you're considering before you decide to open an account.



Can a non-U.S. citizen open a 529 account?

Question:

Can a non-U.S. citizen open a 529 account?

Answer:

Yes, with a few limitations. Section 529 plan account applications generally ask for the Social Security number of the account owner and the beneficiary. If you will be the account owner and you don't have a Social Security number, check with the administrator of the 529 plan before you send any money to see how you'll be handled. Some 529 plans allow resident aliens to be the account owner, but normally these plans still require a Social Security number.

Another issue can be state residency. Some 529 plans require the account owner to be a resident of their particular state (for a certain time period) before an account can be opened. Alternatively, some plans require that either the owner or the beneficiary be a resident. So if the beneficiary is a resident, you may still be able to open an account even if you're not a U.S. citizen or resident.

You may expect the beneficiary to attend a foreign college or university. Some foreign colleges and universities are recognized by the U.S. Department of Education as "eligible educational institutions"--a key factor in the income tax treatment of withdrawals from the 529 plan. You should still check the requirements of the 529 plan you are considering to make sure a particular foreign college is an eligible institution.



Does it make sense to open a 529 account if my child is only two years away from college?

Question:

Does it make sense to open a 529 account if my child is only two years away from college?

Answer:

The answer depends on your reasons for opening the account. If you have a high net worth and want to move money out of your estate, opening a 529 account still makes sense. This strategy lowers the value of your taxable estate and reduces any potential estate taxes due in the future.

If you simply want to save money for college expenses, it may still be worthwhile to open a 529 account. Even if you've waited until your child is a sophomore or junior in high school to start saving for college, you'll potentially enjoy a few years of tax-free growth on your money (assuming it eventually pays for college expenses).

You should check one issue carefully before you open an account this close to college. Some plans impose a minimum holding period, such as one or two years, before any withdrawals can be made (without penalty). If you're going to need this money for the first year of college expenses, plans with withdrawal restrictions would not make sense. Check the individual 529 plans for more details.



I have two children. Should I open one account for both children or one account for each child?

Question:

I have two children. Should I open one account for both children or one account for each child?

Answer:

From both a paperwork and account fee standpoint, opening one account makes sense. And though a 529 account can have only one beneficiary, you can change the beneficiary as needed--just be sure to check the plan for any limitations on the frequency of changes. So, for instance, after your first child finishes college, you could change the beneficiary to your second child. Keep in mind, though, that a change in the beneficiary may cause gift taxes and generation-skipping transfer taxes.

If you do decide to open just one 529 account and intend to choose an age-based portfolio (one whose asset mix grows more conservative as your child gets older), it may make sense to name your younger child as the beneficiary. This will give you the most aggressive investment allocation, which may maximize the growth in the account. Then, when you need the money for your older child's college expenses, you can change the beneficiary to your older child. Or, you could simply transfer (or roll over) the account money to an account with your older child as beneficiary.

Section 529 plans differ when it comes to rules about partial rollovers, so check the rules of any 529 plans that you're considering. In some cases, you may need to transfer money to a different state's 529 plan. Again, check on any potential withdrawal limitations before you open an account. Keep in mind, too, that although you intend to fund the college education of two children, the total amount you can contribute is limited by the contribution maximum imposed by the single 529 plan.

Yet opening just one 529 account if you have two children may have a gift tax downside. The money you contribute to a 529 account is considered a gift to the beneficiary. Ordinarily, you are free to gift up to $13,000 per year, per beneficiary. Otherwise, you'll be required to complete a federal gift tax return and report a taxable gift. However, a special rule allows you contribute up to $65,000 to a 529 account and avoid gift tax by spreading the gift evenly over five years. (Note: You must use up your applicable exclusion amount of $1 million before you're liable to pay gift tax out of pocket.)

In any case, you'd probably be able to accumulate more funds for your kids if you opened two separate 529 accounts. That way, you'd be able to give $13,000 to each child per year ($26,000 maximum) instead of depositing $13,000 into only one account. And, if you take advantage of the $65,000 special election for each child's account, the funds may grow even faster.



What expenses and fees are generally associated with 529 plans?

Question:

What expenses and fees are generally associated with 529 plans?

Answer:

Many 529 plans pass along their costs of administration to account owners through fees and other expenses. These fees vary from state to state. Typical charges include an enrollment or application fee when you set up most prepaid tuition contracts. College savings plans charge account owners for fund expenses and investment management fees imposed by the program's investment manager, as well as other fees. Charges by the investment manager are in the form of a pre-set percentage of your account's accumulated value. Many college savings plans also impose a flat account maintenance fee unless you maintain a substantial balance or make automatic payments to your account.

You may also be charged a fee for changing your 529 account's beneficiary, owner, or payment schedule. Keep in mind, however, that the program administrator can waive fees, particularly if you're a resident of the state running the plan.

Make sure you have a full understanding of the fees that apply to a 529 plan you're considering. Such charges could have a significant impact on your account's return. But the plan with the lowest fees is not necessarily the best. Weigh fees and expenses with other factors, such as investment history, program flexibility, and state tax issues.



Do 529 plan expenses vary among states?

Question:

Do 529 plan expenses vary among states?

Answer:

Yes. There are great differences in the amount and types of fees and expenses that 529 plans charge in various states. Pay close attention to those charges when choosing a plan. In some cases, fees and expenses can significantly affect your account's return.

Fees commonly charged include enrollment fees, annual account maintenance fees, expenses charged for making changes to your account, and investment management fees (for a college savings account). Some fees and expenses apply only to out-of-state residents, and some fees may be higher for nonresidents. Some fees may be waived altogether under certain circumstances (e.g., if you set up a payroll deduction plan for automatic contributions to 529 plan).

Keep in mind that plans that contain the lowest fees and expenses aren't necessarily the best plans. Be sure to weigh these charges along with other factors, including investment performance and program management. In addition, before investing in a 529 plan outside of your state of residency, find out what state tax benefits (if any) you might lose if you do so. Your state may offer tax benefits only to residents who invest in their in-state 529 plan.



Who can be a beneficiary of a 529 plan?

Question:

Who can be a beneficiary of a 529 plan?

Answer:

The language of Section 529 of the Internal Revenue Code provides that any individual, regardless of age, can be a designated beneficiary of a 529 plan. A family relationship between the account owner and the beneficiary is not required. However, states can impose more restrictive requirements. For example, some plans have limits on a designated beneficiary's age or grade in school, and a few plans won't allow the account owner and the designated beneficiary to be the same person. Check the plans you are interested in for further information.



Is there an age limit on who can be a beneficiary of a 529 plan?

Question:

Is there an age limit on who can be a beneficiary of a 529 plan?

Answer:

There is no beneficiary age limit specified in Section 529, but a few states do impose one. You'll need to check the requirements of each plan you're considering.

Also, keep in mind that several states require that the account be open for a specified minimum length of time before funds can be withdrawn. Otherwise, a fee or penalty may be imposed by the state. This is important if you expect to make withdrawals quickly because of the beneficiary's age.



Can a 529 account have more than one beneficiary?

Question:

Can a 529 account have more than one beneficiary?

Answer:

A 529 account can have only one beneficiary. If you have more than one child, you may want to open a 529 account for each. Alternatively, you could open one 529 account and, after funds have been withdrawn for your first child's college expenses, change the designated beneficiary of the remaining funds to your second child. However, this change of the designated beneficiary could have gift tax consequences.



Can I open a 529 account and name myself as beneficiary?

Question:

Can I open a 529 account and name myself as beneficiary?

Answer:

Under many 529 plans, you can be both the owner and beneficiary of the account. This can be useful if you are older and plan to attend college or graduate school in the future, or if you are planning for your future children. However, you may lose the estate tax benefits of a 529 plan by naming yourself as the designated beneficiary. And some plans don't allow the owner and beneficiary to be the same person, so check the terms of the plan you're considering.



Can I change the beneficiary of a 529 account?

Question:

Can I change the beneficiary of a 529 account?

Answer:

Yes. You can generally change the beneficiary of a 529 account as long as the new beneficiary is a family member of the old beneficiary. Members of the family include children and their descendants, stepchildren, siblings, stepsiblings, parents, stepparents, nieces, nephews, aunts, uncles, first cousins, and in-laws of the original beneficiary. There is no penalty for changing the beneficiary, although gift taxes and generation-skipping transfer taxes might be a result. Many states charge an administrative fee to process the change. Also, states are free to impose certain restrictions. For example, a state may prohibit a beneficiary switch once the original beneficiary has begun making withdrawals from the 529 account.



Under what circumstances can the account owner of a 529 plan be changed?

Question:

Under what circumstances can the account owner of a 529 plan be changed?

Answer:

Many states allow an account owner to transfer ownership of the account to someone else. Some states allow this only at limited times, such as when divorce or separation occurs. Other states will only allow a change in account ownership after an account owner's death or incapacity. In some states, you may be able to designate an alternate account owner in the event of your death. You'll need to check your plan's restrictions to see when the change may be made.



Can I roll over my existing 529 account to another state's 529 plan without penalty?

Question:

Can I roll over my existing 529 account to another state's 529 plan without penalty?

Answer:

Yes. You can do a rollover (without changing the designated beneficiary) once every 12 months without incurring a penalty. This might be attractive if you move to another state or if you simply prefer the investment options that a different state offers. However, if you want to roll over your account more than once a year, you'll need to designate a new beneficiary (you can change it back later) to avoid a penalty.

You must complete the rollover within 60 days in order to avoid a penalty. If you wish to roll over your account, be sure to check your plan's specific requirements.



Can I move funds from my Coverdell education savings account to a 529 plan?

Question:

Can I move funds from my Coverdell education savings account to a 529 plan?

Answer:

Generally, yes. You may withdraw funds from your Coverdell education savings account and not pay federal income taxes on the withdrawal if you use the funds for qualified education expenses. The rules for Coverdell ESAs consider a rollover contribution to a 529 plan (for the same person who is the beneficiary of the Coverdell ESA) as a qualified education expense. So, the transfer will usually be a nontaxable transfer from the Coverdell ESA to the 529 plan. Such a transfer may produce state income tax advantages.



Does it make sense to cash in my prepaid tuition plan and contribute to a college savings plan?

Question:

Does it make sense to cash in my prepaid tuition plan and contribute the money to a college savings plan instead?

Answer:

It might. College savings plans offer some advantages over prepaid tuition plans--withdrawals can be used for expenses not allowed under a prepaid tuition plan, and funds in a college savings plan can be used at any accredited college in the country or abroad (compared to only in-state public colleges for prepaid tuition plans). In addition, the value of your account may increase greatly, depending on how well your investments do.

On the other hand, prepaid tuition plans provide a measure of security. In effect, they allow you to buy future tuition at today's prices.

Most prepaid tuition plans require that either the owner or the beneficiary be a resident of the state operating the plan. So if you move to another state, you may have to cash in the prepaid tuition plan. And if you do cash in the plan, you will receive only your contributions (and possibly a low rate of interest).



Is my rate of return guaranteed under a 529 plan?

Question:

Is my rate of return guaranteed under a 529 plan?

Answer:

That depends on the type of 529 plan--a college savings plan or a prepaid tuition plan. Think of a college savings plan as an investment plan run by a state. The state or its agent invests your contributions in one of several pre-established investment portfolios. If the portfolio is age-based, the investments will be growth-oriented when the beneficiary is younger, and the state will shift money into more conservative investment vehicles as your child approaches college age. If the portfolio is not age-based, the types of investments (e.g., growth, balanced, conservative) will stay the same as the beneficiary grows older. Although you can potentially earn a higher rate of return with college savings plans, the rate of return is not guaranteed, and there's a chance you could lose money.

Prepaid tuition plans, though, generally guarantee you a minimum rate of return to ensure that you keep up with college inflation. In effect, you lock in tomorrow's tuition at today's prices. However, you'll generally be limited to the rate of return promised by your plan--you won't be entitled to any surplus.



What's the difference between how a college savings plan and a prepaid tuition plan invests?

Question:

What's the difference between how a college savings plan invests and how a prepaid tuition plan invests?

Answer:

The two basic types of prepaid tuition plans are contract plans and unit plans. With a contract plan, you invest your money in exchange for a promise that the plan will pay you a certain amount in future college tuition and fees. A unit plan allows you to purchase units or credits that increase in value each year (similar to an index that keeps pace with rising tuition) and are later redeemed to pay for tuition and other expenses. With both types of prepaid plans, your money is placed in a plan trust fund that also includes the money contributed by other participants in the plan. Professional money managers invest the trust fund assets in investments whose rate of return is expected to cover the future payments owed by the plan.

With a college savings plan, your contributions go into an individual account that's invested in a portfolio of investments (typically mutual funds). Many plans let you choose from a variety of investment portfolios at the time you open an account, allowing you to take into account your risk tolerance and general market conditions. At one time, most plans didn't offer you a choice--your portfolio was simply based on your child's age, and the investments in the portfolio gradually shifted to more conservative ones as your child grew.

But be aware that college savings plans entail risk because your investment returns are not guaranteed. You may even lose some of the original amount you invested. If you're not happy with the performance of your investment portfolio, you may be able to direct future contributions to a different portfolio, depending on the rules of your specific plan. Also, the IRS has given states the discretion to allow you to change the investment option for your existing contributions once per calendar year or at the time you change the beneficiary of your plan. Check with your plan for more details. Keep in mind, too, that you can roll over your college savings plan to a different 529 plan (college savings plan or prepaid tuition plan) once per year without changing the beneficiary. Please note, however, that rollover contributions may not be eligible for a state income tax deduction if your state offers one for 529 contributions. Check with your tax professional for more information.



Does a college savings plan allow me to choose my own investments?

Answer:

The quick answer is no. Under federal law, 529 plan account owners aren't allowed to directly or indirectly control their plan investments (a college savings plan is a type of 529 plan). This lack of control is often cited as the major disadvantage of college savings plans.

However, depending on the college savings plan, you may have a limited say in how your money is invested. When you open an account, you might be able to choose from a variety of investment portfolios with different levels of risk. The options might include an all-stock portfolio, an all-bond portfolio, and several "blend" portfolios. Some plans may even let you spread your contributions over several portfolios. Other plans will select a portfolio for you based solely on your child's age (known as an age-based portfolio). The more investment options you have, the better you can take into account your risk tolerance, time horizon, and overall market conditions. But keep in mind that you can never choose the underlying assets that a portfolio invests in. That job is for the plan's professional money manager.

All college savings plans entail risk, because your investment returns are not guaranteed by the state sponsoring the plan. In fact, there's a chance you could lose some of the original amount you invested. If you're not happy with your portfolio's investment performance, you have a few options. First, depending on the rules of your specific plan, you might be able to direct any future contributions into one or more different portfolios. Also, the IRS has given states the discretion to allow you to change your investment option for your existing contributions once per calendar year (twice per calendar year for 2009 only), or if you change the beneficiary of your account. Check with your plan for more details.

You're allowed to roll over your college savings plan account once every 12 months to another 529 plan (college savings plan or prepaid tuition plan) without changing the beneficiary. When you do the rollover, you may get to select from among the new plan's different investment options. Please note, however, that rollover contributions may not be eligible for a state income tax deduction if your state offers one for 529 contributions. Check with your tax professional for more information.



What recourse do I have if I'm unhappy with my college savings plan's investment performance?

Answer:

Unfortunately, not as much as you would probably like. Under federal law, 529 plan account owners aren't allowed to directly control their investments. This can present a problem if your college savings plan investments are not performing as well as you expected.

But you may have some options. First, depending on your plan's specific rules, you might be able to direct any future contributions into one or more portfolios that are different from what your existing contributions are invested in. Also, the IRS allows states to let you change your investment option for your existing contributions once per calendar year (twice per calendar year for 2009 only). But it's up to individual states whether to allow this flexibility. Check with your specific plan for more details. Keep in mind, though, that even if you can change your investment portfolio, you can never choose the underlying investments that a portfolio invests in--the plan's money manager is responsible for this.

Besides these options, there's a more drastic (though effective) way to get rid of college savings plan investments that are performing poorly. You can roll over your college savings plan account to another 529 plan (college savings plan or prepaid tuition plan) once every 12 months without penalty and without changing the beneficiary. Since different plans offer different investment choices, the rollover option gives you a way to exchange poorly performing investments for new ones. Please note, however, that rollover contributions may not be eligible for a state income tax deduction if your state offers one for 529 contributions. Check with your tax professional for more information.

Finally, if you have more than one child, you might consider changing the beneficiary of your account. If your account was previously invested in an age-based portfolio (one that depends on your child's age and gradually shifts to more conservative investments as your child grows older), many plans will change the investment option to a different portfolio to reflect the new beneficiary's age. But if the plan doesn't impose a new age-based portfolio on you, you might still be given the opportunity to change your investment option for the new beneficiary, because the IRS has given states the discretion to allow such an investment change when a new beneficiary is named.



How often can I make contributions to my child's 529 account?

Question:

How often can I make contributions to my child's 529 account?

Answer:

It depends on the rules of your 529 plan. Many plans will allow you to contribute as often as you like. This gives you flexibility to tailor the frequency of your contributions to your own needs and budget, as well as to "dollar cost average" your contributions. Remember that 529 plans stop accepting contributions when the value of the accounts for any one beneficiary reaches a maximum limit. The limit is typically the amount needed to fund five years of tuition, fees, and room and board at the highest-cost institution allowed under the plan. In addition, some plans impose a maximum limit on annual contributions.

Some plans may also have contribution minimums. This could mean one or more of the following: (1) you have to make a minimum deposit to open an account, (2) each of your contributions has to be at least a certain amount, or (3) you have to contribute at least a certain amount per year (annual minimum). However, some plans may waive (or lower) some of these minimum requirements if your contributions will be made through payroll deduction or automatic debits from your bank account. Many plans also waive or lower these minimums for residents.

Consult the plan administrator of any 529 plan you are considering for details regarding contribution minimums, maximums, and other restrictions imposed by the plan.



Can I contribute my own stocks and bonds to the 529 account I've set up for my child?

Question:

Can I contribute my own stocks and bonds to the 529 account I've set up for my child?

Answer:

No. Your contributions to a 529 plan must be made in cash (e.g., checks, credit card payments), so you cannot contribute stocks, bonds, mutual funds, or any other property. If you have money tied up in such investments and would like to move the money to a 529 account for your child, you must liquidate (sell) the investments first. But before you do so, be sure to seek sound financial advice about the tax consequences and other related issues.



How much can I invest in a 529 plan?

Question:

How much can I invest in a 529 plan?

Answer:

Section 529 of the tax code requires that a 529 account not accept more contributions than are necessary to meet the qualified education expenses of the account beneficiary. A plan will pass this test if it limits total contributions to the amount needed to fund five years of the beneficiary's tuition, fees, and room and board at the most costly college allowed under the program, and many states are including graduate school costs in the tally. Each plan can set its own limit within this guideline. When the value of a beneficiary's account reaches the limit chosen by the state, no more contributions may be made to that state's 529 plan for the beneficiary. (Some states may also impose an annual contribution limit.) In the majority of states, the maximum contribution limit is at least $300,000.

Keep in mind that the contribution limit for a 529 plan is a per-beneficiary limit. For example, you, your father, and your sister each open a 529 account in the same state's plan for the benefit of your son. The plan has a lifetime contribution limit of $300,000, but that doesn't mean that you can each contribute $300,000. Instead, none of you may contribute after the value of your son's accounts reaches $300,000. This per-beneficiary limit can work in your favor if you have more than one child who will be attending college. Using the same $300,000 limit, if you have four children, you could set up a separate 529 account for each child and invest up to $300,000 in each account (a total of $1.2 million for the four children).

Another thing to keep in mind is that plans periodically raise their contribution limit to keep pace with rising college costs. If so, make sure that you can keep contributing as the limit increases.



Can contributions to a 529 plan be directly debited from my checking account?

Question:

Can contributions to a 529 plan be directly debited from my checking account?

Answer:

It depends on the plan. In general, many plans will allow you to set up an automatic debit arrangement to make contributions to your 529 account. But the only way to know for sure is to ask your plan administrators.

If your plan offers this feature, it's generally very easy to set up--you simply complete the required paperwork with your 529 plan. You'll typically have to provide your bank account information and indicate the desired amount and frequency of your contributions (e.g., $100 a month). Then you can sit back, because the money will be automatically deducted from your bank account and invested in your 529 account--you won't have to worry about sending in a check every time you want to make a contribution. That makes these arrangements a convenient and reliable way to save for your child's education, especially if you don't consider yourself a disciplined saver.

If you set yourself up for automatic bank account debits, be aware that the contribution limits and minimums that your 529 plan imposes will still apply (though some plans may waive the minimum deposit needed to open an account if you sign up for automatic debits). And be sure to find out if you'll be subject to any special charges (or discounts, for that matter) if you opt for automatic debits.



What's the difference between how a college savings plan and a prepaid tuition plan invests?

Answer:

If you want to contribute to your college savings plan and use dollar cost averaging at the same time, you can simply invest a fixed amount in your account at regular intervals (e.g., $100 a month). One way to do this may be to arrange for automatic payroll deductions or bank account debits to be invested in your college savings account. But assuming you have a lump sum of money to invest, is dollar cost averaging better than making a single large contribution? That's a more difficult question, and the answer depends on your particular circumstances.

According to the experts, the benefit of dollar cost averaging is that it helps you ride out the ups and downs of the market--you buy more shares when the prices are low, and fewer shares when the prices are high. But your decision may be more complicated than it seems. Let's say you have $100,000 that you'd like to invest in your college savings plan over time using dollar cost averaging. Where will you keep the money in the meantime (e.g., money market fund), and how does your expected return on that investment compare with your expected return on your college savings plan? If you expect to do better with the college savings plan, it might make more sense to invest the lump sum. Remember to compare after-tax return figures, since college savings plan investments grow tax free.

Other factors may also enter into this decision. Fees imposed by your college savings plan may decrease as you contribute more money, so investing a lump sum may save you fees over the long run. But a lump-sum contribution may have gift tax consequences that could be avoided by gradually investing the money. However, under special rules unique to 529 plans, you can make a lump-sum gift of up to $65,000 ($130,000 for joint gifts) and avoid gift tax if you elect to spread the gift over five years.

Gradual investing might also help you better diversify your college savings plan holdings, since many plans let you direct new contributions to a different investment option. However, the IRS has given states the discretion to allow you to change the investment option on your existing (lump-sum) contribution once per calendar year. Check with your specific plan for more information. Also, be sure to consult a financial professional before making this decision.

Note: Dollar cost averaging does not ensure a profit or protect against a loss in a declining market. You should consider your ability to invest continuously when the market is down.



I'm contributing to a 529 plan for my grandchild. What about Medicaid spend-down requirements?

Question:

I'm putting money into a 529 plan for my grandchild. But are the 529 assets subject to Medicaid spend-down requirements?

Answer:

Very possibly. So far, state laws have largely ignored this issue. But unless future legislation in your state exempts 529 plans from Medicaid rules, you'd be wise to assume that these assets will be subject to the state's grasp.

To be eligible for Medicaid, most states require that your assets and monthly income fall below certain limits. A state may count the assets and income that are legally available to you for paying bills. You can make assets unavailable by giving them away or by holding them in certain trusts. In some cases, though, such transfers may create a period of ineligibility before you can collect Medicaid.

The potential problem with 529 plans is that your contributions are "revocable." This means that you can contribute money to your grandchild's 529 account today, and then take it back (subject to income taxes and a penalty) later. Since it's possible for you to get your hands on the money, your state Medicaid authorities may consider your 529 gift to be a countable asset when considering your eligibility for Medicaid. That might prevent or delay your eligibility for Medicaid.

In addition, your state has the right to "look back" at your finances 60 months from the date you apply for Medicaid. Contributions you've made to your grandchild's 529 account within this period may delay your eligibility for Medicaid.

You may want to consult a Medicaid planning attorney and keep abreast of changes in your state's laws with respect to Medicaid and 529 plans.



Can I contribute to a 529 account and a Coverdell ESA in the same year for the same beneficiary?• ••

Question:

Can I make contributions to a 529 account and a Coverdell education savings account in the same year for the same beneficiary?

Answer:

Yes. You can fund a Coverdell education savings account and a 529 account in the same year for the same beneficiary without giving rise to penalties. There is an annual contribution limit of $2,000 per year for Coverdell accounts, while most 529 plans have lifetime contribution limits of at least $300,000.

And keep in mind that, unlike a 529 plan, your ability to contribute to a Coverdell ESA depends on your income level. To make a full contribution, single filers must have a modified adjusted gross income (MAGI) of $95,000 or less, and joint filers must have a MAGI of $190,000 or less.



Can I deduct my contributions to my 529 account?

Question:

Can I deduct my contributions to my 529 account?

Answer:

Section 529 plans, which include college savings plans and prepaid tuition plans, offer several tax and nontax benefits. But unfortunately, a federal income tax deduction is not one of them. You can't claim a federal income tax deduction for contributions you make to your 529 plan. However, certain states offer state income tax deductions for contributions to 529 plans. You should check with your individual 529 plan or your state's taxing authority to determine the tax treatment in your state.



Will I pay income tax when the money in my 529 plan is withdrawn to pay for college expenses?

Question:

Will I pay income tax when the money in my 529 plan is withdrawn to pay for college expenses?

Answer:

If the money you withdraw from a 529 plan (college savings plan or prepaid tuition plan) is used to pay qualified education expenses, then you won't owe federal income tax on the earnings portion of your withdrawal. However, depending on the state you reside in, you may owe state income tax, even if the withdrawal is used to pay qualified education expenses. So check the laws of your state. Keep in mind that withdrawals for purposes other than qualified education expenses will be subject to normal federal income tax treatment and may be subject to an additional 10 percent federal income tax penalty.



Will I be penalized if the money in my 529 plan isn't used for college expenses?

Question:

Will I be penalized if the money in my 529 plan isn't used for college expenses?

Answer:

Whether your 529 plan is a college savings plan or a prepaid tuition plan, the money you withdraw must be used for qualified higher education expenses. These expenses include tuition, fees, books, and room and board (if the beneficiary is attending school at least half-time) for college and graduate school.

If you use the money for any other purpose, the earnings portion of the distribution will be taxable on your federal (and possibly state) income tax return in the year of the distribution. Also, you generally must pay a 10 percent federal penalty on the earnings portion of your distribution. (There are a couple of exceptions. The penalty is usually not charged if you terminate the account because your beneficiary has died or become disabled, or if you withdraw funds not needed for college because your beneficiary has received a scholarship.)

Bear in mind that the "distributee" is the one subject to tax. (The distributee is the person who actually receives the money from the 529 plan.) In most situations, this will be the account owner. So, if you fund a college savings plan for your son, for example, and withdraw the money three years later (before he reaches college age), you will probably be the one taxed and penalized. However, some plans specify who the distributee is, while others allow the account owner to determine the recipient of a nonqualified withdrawal.



I'd like to make a lump-sum contribution to my grandchild's 529 account. Will I owe gift tax?

Answer:

That depends on a few things, including the amount of your lump-sum contribution and the extent to which you've used your gift tax applicable exclusion amount of $1 million.

All contributions to 529 plans are considered present interest gifts that qualify for the $13,000 (2010 figure) annual federal gift tax exclusion. So, a gift of $13,000 or less to your grandchild's 529 account will not cause a gift tax. A contribution of $13,000 or less to your grandchild's 529 account is also excluded for purposes of the generation-skipping transfer tax (GSTT).

If your total yearly contribution to the 529 plan exceeds $13,000, you can elect to treat your contribution (up to $65,000 in 2010) as if made evenly over a five-year period to avoid federal gift tax. You make this election on your federal gift tax return (which you must file if your gift is over $13,000). Any amount over $13,000 in a year to the same beneficiary is a taxable gift. Keep in mind that you must use up your lifetime credit before any gift tax is actually paid.

You'll also need to investigate the gift tax rules of your state, since state tax treatment can differ.



I opened a college savings plan from a different state. Will I get that state's tax benefits?

Question:

I opened a college savings plan sponsored by a different state than my own. Will I get that state's tax benefits?

Answer:

No. Often, state income tax benefits are provided to a state's residents who invest in their state's 529 college savings plan. These benefits could take the form of a state income tax deduction for contributions, tax-free treatment of qualified withdrawals, or a waiver of brokers' fees.

You should look to the tax laws of your own state to determine the income tax treatment of deductions and withdrawals from a college savings plan. In general, you should expect that you won't be required to pay income taxes to another state simply because you opened an account in that state's 529 plan. You'll probably be taxed in your state of residency on the earnings in your 529 plan (no matter where situated) unless your state grants a specific exemption.



The Economic Growth and Tax Relief Reconciliation Act contains sunset provisions. Should I worry?

Question:

The Economic Growth and Tax Relief Reconciliation Act of 2001 contains sunset provisions. Should I be worried about this?

Answer:

No. The Economic Growth and Tax Relief Reconciliation Act of 2001 made qualified withdrawals from a 529 plan tax free at the federal level until December 31, 2010, when the benefit was scheduled to sunset, or expire. But the Pension Protection Act of 2006 removed the sunset provision, making qualified withdrawals from a 529 plan permanently tax free at the federal level.



I opened a 529 plan with my child as beneficiary. If my mother contributes, is that a gift to me?

Question:

I opened a 529 plan and my child is the beneficiary. If my mother makes a contribution to the plan, is that considered a gift to me or to my child?

Answer:

It's considered a gift to your child. A contribution to a 529 plan is treated as a completed gift from the donor to the designated beneficiary of the account.



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