College students who borrow graduate with an average of $25,250 in debt. That’s the equivalent of a new-car purchase or a down payment on a home. Even if some borrowing is inevitable for you, first explore other options to help you pay for college.
Coverdells, 529 plans and Roth IRAs come with tax advantages for college savers. Private scholarships are sources of free money. Custodial accounts offer investing flexibility. You just need a little lead time and some background on the alternatives.
We rounded up the best payment strategies, based on Kiplinger's extensive coverage of college values, college savings and student loans. We've highlighted the pros and cons of each option, as well as resources to help you get started. Check out our list of seven smart ways to pay for college.
529 Savings Plans
Pro: Tax breaks galore
Con: Portfolio limitations
Sponsored by 50 states and the District of Columbia, 529 plans let your savings grow tax-free, and the earnings escape federal tax completely if the withdrawals are used for qualified college expenses, including tuition, fees, and room and board. Two-thirds of states give residents a tax deduction or another tax break for contributions. You are permitted to invest in other states’ 529 plans.
The appeal of 529 plans lies in their easy access as well as their tax benefits. The plans set no income limit and have a high limit on contributions. If your kid skips college, you can change the designation to a sibling without losing the tax break. But use the money for non-college expenses and you’ll be on the hook for taxes and a penalty on earnings.
Another drawback of 529 plans: You lose direct control. After you pick a portfolio, usually from a limited pool of investment options, you must wait 12 months before you can change the mix or transfer the money to another plan. And a state-appointed firm manages the account, not you.
By Jane Bennett Clark
Pro: A hedge against inflation
Con: Not all states participate
Planning to send your kid to school in-state? Sign up for a prepaid-tuition plan. These plans, most of which are available only to state residents, let you lock in tuition at public colleges years in advance. They offer the same tax benefits as 529 savings plans, and you pay the same tax and penalty if you don’t use the money for qualified expenses. Currently, 20 states offer the plans, of which nine are closed to new enrollment. (More than 270 private colleges let you prepay through the Private College 529 Plan (opens in new tab).)
States use different methods for carving tuition and fees into sellable chunks, but they all require that you buy several years before your child starts college and charge you somewhat more than the current year’s tuition. If your student goes to an out-of-state or private school, you can transfer the value of the account or get a refund.
By Jane Bennett Clark
Pro: Also cover private elementary and high schools
Con: Strict -- and low -- contribution limits
Coverdell education savings accounts are similar to 529s in that the money in the accounts grows tax-deferred and escapes tax if you use it for qualified education expenses. Coverdells expand the definition of “qualified,” however, to include tuition at private elementary schools and high schools. If you withdraw the money for nonqualified expenses, you pay tax and a 10% penalty on earnings.
You can set up a Coverdell at a bank or brokerage firm and tweak the investments as often as you like, but the total amount you contribute per child cannot exceed $2,000 a year, and the beneficiary has to be younger than 18. To contribute, you must have a modified adjusted gross income of less than $110,000 as a single filer and $220,000 as a married couple filing jointly. The provisions on Coverdells will become less generous in 2013, unless Congress extends the terms.
By Jane Bennett Clark
Pro: Tax-free growth that you control
Con: Withdrawals dent your nest egg
A Roth IRA can help fund your retirement and your kid’s college education, but only if you start early enough. The money in a Roth grows tax-free, and you avoid tax on withdrawals that don’t exceed your contributions. You also avoid a 10% early-withdrawal penalty on earnings if you use the money for educational expenses.
If both you and your spouse each save the $5,000 maximum over 18 years, you’ll accumulate $180,000 in contributions alone. With earnings of 8% a year, the total tops $400,000 -- enough to fund tuition and a decent nest egg. You can contribute $6,000 annually if you’re 50 or older.
You will owe tax on any earnings you withdraw unless you are 59½ and have held the account for at least five years. In 2012, the ability to contribute to a Roth IRA disappears at a modified adjusted gross income of $183,000 for married couples filing jointly and $125,000 for single filers.
By Jane Bennett Clark
Pro: No limits on contributions
Con: Your kid ultimately controls the money
Custodial accounts, known as UGMAs (for the Uniform Gifts to Minors Act) and UTMAs (for the Uniform Transfers to Minors Act), let you put money or other assets in trust for a minor child and, as trustee, manage the account until the child reaches 18 or 21, depending on your state. At that age, Junior owns the account and can use the money for whatever he wants -- be it tuition, a trip to Europe or a new car.
There’s no limit on how much a parent can put in a custodial account. However, it’s smart to cap individual annual contributions at $13,000 to avoid triggering the gift tax. Speaking of taxes, full-time students under age 24 pay no tax on the first $950 of unearned income and the child’s rate on the next $950. Earnings above $1,900 are taxed at the parents’ marginal rate.
Investment choices in custodial accounts aren’t restricted, as they are with 529 plans. That’s a plus. On the downside, large balances in UGMAs and UTMAs can hurt chances for financial aid. Custodial accounts count as student assets, and the federal financial-aid formula calls for students to contribute 20% of savings (vs. 5.6% of savings for parents).
By Jane Bennett Clark
Pro: Free money -- enough said
Con: Financial-aid complications
You don't have to be an all-star athlete, a musical prodigy or even an “A” student to collect on private scholarships. Many are awarded to students based on need or special interests.
The best place to start your search is in the high school guidance office. A financial-aid officer at the college you're applying to can also help. Web sites for exploring scholarships abound. A favorite is FastWeb.com, which claims to list scholarships worth more than $3.4 billion. Register for free to have scholarships matched to your profile. Another free site worth visiting is CollegeAnswer.com, run by student lender Sallie Mae. Register to use the scholarship search tool.
While there are plenty of national scholarships, don’t neglect to look closer to home as well. Many local organizations offer private scholarships, and the competition for these awards is less intense. Good ties may lie no further than an employer (student's or parent's) or a community group, club or lodge. Schools may reduce aid if scholarships and aid combined equal more than a student's calculated need. But that might mean a reduction in loans.
By Anne Kates Smith
Pro: Make up for savings shortfalls
Con: You have to pay them back
Saving for college ahead of time is, of course, preferable to taking on considerable debt. But if you must borrow, borrow smart. Go with government-sponsored loans, such as Staffords (also called Federal Direct), which offer flexible repayment options and fixed interest rates. Stafford loans are subsidized (meaning you don’t owe any interest on the loans while you’re still in school) for qualifying students.
You can apply for federal programs, as well as federal work-study, state programs and institutional aid, with the Free Application for Federal Student Aid, or FAFSA (opens in new tab) form. Parents can also look into federal PLUS loans, money borrowed by Mom and Dad on behalf of a student to pay for college.
By Janet Bodnar and Jane Bennett Clark
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