The New Math of Paying for College

Like many parents, Eric Liebmann and Cathy Wilson once despaired of paying for college for their kids, Emma, 17, and Joe, 15. "When Emma was about 4, we met with a financial planner who told us we'd have to save $600 to $800 a month," says Wilson. "We just didn't have it." Later, after Liebmann's career as an architect took off with the real estate market, they played catch-up by pouring money into college-savings accounts. Now the Takoma Park, Md., family expects to manage tuition out of savings and income. "If the economy takes a nosedive, we'll adjust," says Wilson, who manages a fitness center. "It's a living plan."

Welcome to College Financing 101. The math involves real-world calculations -- such as income minus expenses times children -- along with variables such as the stock market and the economy. Lately, tweaks to the federal student-loan program, tax law and financial-aid formulas have also altered the equation. Meanwhile, the price keeps rising. Last year, a four-year stint at a private institution averaged $120,000, including room and board. An Ivy League degree topped $170,000.

How do you solve a problem with parameters that keep changing? Start early and keep your eye on new developments, says Deborah Fox, of Fox College Funding, a network of college financial planners. Whether your child is next year's freshman or a member of the class of 2024, it's important to keep revisiting your college plan.

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New rules for saving

Pity the parents who thought they were getting a tax break when they put money into custodial accounts for their kids under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). Until recently, the first $850 of unearned income in a custodial account was tax-free, and the next $850 was taxed at the child's rate, usually 10%. Above $1,700, parents paid tax at their rate until the child turned 14. Then, earnings were taxed at the child's lower rate. At 18 or 21, the child took ownership of the account -- and presumably used the money to pay for college, not a Porsche.

Starting this year, however, the earnings on the account are taxed at your rate until your child reaches 18. That means a bigger tax bill if, for instance, you sell stocks and owe capital-gains tax, or the account holds interest-generating investments, such as bonds. "Because of the new tax treatment, the UTMA is a new four-letter word," says Joe Hurley, of Savingforcollege.com. "People with money in their kids' names are scrambling to rework their strategies."

One strategy is to hold on to the stock in an UGMA or UTMA account until your child turns 18 and then let him sell it. Your child is likely to be in one of the two lowest tax brackets, so he'll owe only a 5% capital-gains tax on the earnings. And, wait, it gets even better: If the sale occurs during 2008, 2009 or 2010, the capital-gains tax completely disappears for those in the 10% and 15% tax brackets.

As it stands now, however, you have little reason to risk watching your college savings peel out of the driveway in a cloud of gravel. With the tax advantage diminished, "UTMAs are almost irrelevant," says Bill Raabe, a tax professor at Ohio State University.

529s get a boost. As an alternative, many parents will direct new savings into 529 plans. These state-sponsored accounts let your contributions grow tax-deferred. Distributions escape federal taxes if you use them for qualified college expenses. (If not, you pay the federal tax on earnings plus a 10% penalty.) Most states offer residents a tax deduction on contributions. Kansas, Maine and Pennsylvania let residents take the deduction for out-of-state 529s as well.

These enticements persuaded Reneacute; Sahilan of San Diego to set up an account in the Alaska 529 savings plan for his 3-year-old son, Matthew. "I'm 46," says Sahilan. "By the time he starts college, I'll be of retirement age, so I'm basically looking at aggressively saving for college." If his son skips higher ed and Sahilan has to pay taxes on the withdrawals, his age will work in his favor. As a retiree, he says, "my tax bracket will be lower."

Aside from the tax benefits, 529s have several advantages over custodial accounts. First, the parent usually owns the account and can switch beneficiaries or use the money for nonqualified expenses, paying the tax and penalty. And students benefit if they apply for financial aid because 529s are usually parent-owned assets. The government uses the parent's assessment -- 5.6% -- to calculate your family's contribution to college costs, rather than the 35% bite on student-owned accounts. That distinction becomes less meaningful next year, when the assessment on student assets drops to 20%.

A level field. Once, 529s had a leg up on prepaid-tuition plans, which let you lock in tomorrow's tuition at today's prices (or thereabouts). Rather than being considered a parental asset, prepaid plans were assessed dollar for dollar against any financial aid. Now, however, such plans are treated the same as 529s and other parent-owned assets.

Here's how the prepaid plans work: You buy chunks of in-state tuition at current rates, often plus a premium, which the state invests. If your child ends up going to college out of state or to a private school, you can transfer the funds, including the earnings, without paying federal tax on the income. If college drops off your child's radar screen, you can transfer the account to another beneficiary. Or you can withdraw the money, but you'll owe tax on any earnings, plus a 10% penalty. And the state may penalize you as well.

The Independent 529 plan offers a similar arrangement for private institutions, with the same tax advantages. Member schools sell tuition credits at a minimum 0.5% discount off the current price and guarantee a refund (plus or minus 2%) if a child attends a school outside the plan. You have to buy the credits at least 36 months in advance of using them.

Participating schools absorb most of the investment risk, but parents do face the risk that their kids will end up at a school outside the plan. Dana and Lori Klimp of St. Paul, Minn., got around that problem by waiting until each of their two children, Julie and John, had been accepted at St. Olaf College, a participating school. Then the Klimps purchased their kids' senior-year tuition at the freshman-year price.

More good news: The new pension-reform law made permanent the favorable tax treatment enjoyed by 529 plans and their sister programs, prepaid plans. Previously, the tax provisions were set to expire after 2010.

Flexible Coverdells. The Coverdell Education Savings Account is a great way to cover your bases. You set up the account on behalf of a beneficiary and contribute up to $2,000 a year, which grows tax-deferred. You must use the money by the time your child hits 30, or the earnings will be taxed as income plus a 10% penalty.

As with 529 plans, withdrawals for qualified educational expenses are tax-free, but the term "qualified" covers a broader range of expenses, including private elementary and high school tuition, which gives you more flexibility. Generally, Coverdell accounts go on the parent's side of the ledger in federal financial-aid calculations.

Not everyone qualifies for a Coverdell; to contribute, you must have an adjusted gross income of no more than $110,000 as a single filer, or no more than $220,000 if you're filing jointly. These and other provisions could revert to less generous terms after 2010. The failure of Congress to make the provisions permanent puts Coverdells "in a bad spot," says Hurley, although he expects Congress to rectify the situation before the 2010 deadline.

IRA advantage. To plug gaps in your college-savings strategy, you could turn to your retirement accounts. You can avoid the 10% penalty on early withdrawals from an IRA if you use the money for qualified educational expenses, although you will owe income tax. In the case of a Roth IRA, you can withdraw your contributions tax-free at any time. You can also withdraw earnings to pay college bills without paying a penalty, but you'll owe income tax unless you're older than 59#189; and you've had the IRA for at least five years.

New rates on loans

Just a few years ago, interest rates on federally subsidized student and parent loans were falling faster than a hard rain. But those days are over. Students now pay a fixed rate of 6.8% on new Stafford loans, and parents pay a fixed 8.5% on PLUS loans. Rates on older Staffords and PLUS loans continue to be variable -- this year, 6.5% or 7.1% (depending on when you repay) on Staffords, and 7.9% on PLUS loans.

If your loans date to earlier years, you can still consolidate them and lock in the current rate. Consolidating also lets you extend the repayment period on the loan. Some lenders offer rebates or discounts in return for timely payments.

Thanks to another new law, you can now shop for consolidation deals among lenders, regardless of your loans' origin. In the past, if your loans came from a single source, you had to apply to that lender first.

Private loans. The new math doesn't mean you should first seek private loans when you're borrowing for college. Gary Carpenter, executive director of the National Institute of Certified College Planners, says Staffords are still a bargain compared with private loans, which have variable rates that are pegged to the prime rate, recently 8%. And you can defer repayment on Staffords until after graduation (and again if you attend graduate school). Under some circumstances, the loans may be forgiven.

Tap home equity? Similar to Stafford loans, PLUS loans constitute easy borrowing, and at 8.5%, the rate is competitive with most private loans. But homeowners have a tempting alternative: a home-equity line of credit. At 8.2%, the recent average rate, home-equity lines beat the PLUS rate by a hair, and interest on up to $100,000 is tax-deductible.

But home-equity rates have been creeping up as interest rates have risen. Moreover, borrowing against your home could deplete one of your biggest assets just as you need it most. "When the kids graduate, many families want to sell the house, but they have to pay off the home-equity line," says Carpenter. "That takes cash out of their pockets." He advises clients to consider PLUS loans first.

PLUS loans were a godsend for Patrick and Barbara Brodie. When their son, Eric, was a baby, they stashed a small windfall in a custodial account that grew to six figures. The account tanked just as Eric was about to attend Emory University. Rather than take a loss, they used PLUS loans and Staffords to cover his tuition. "For four years of Emory, every bill was financed by loans," says Patrick. Eric has now earned his degree and landed a job, and his investments have rebounded. He uses the investment income to pay down the loans (his and his parents').

As far as his father is concerned, plan B worked beautifully. "I was a teacher, so I didn't have a large income," says Patrick, who is now retired. "I looked into the college bills and found a way to pay them."