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Financial Awareness Bulletin

 

Vol. XII, No. 9

August 2004

Other Ways to Save for College

 

 

INTRODUCTION

 

Tuition rates for public and private colleges and universities continue to climb.  The last few years have seen two higher education savings options become popular: Section 529 qualified tuition plans (see Financial Awareness Bulletin Vol. XI, No. 7, August 2002) and Coverdell Education Savings Accounts. 

 

This Financial Awareness Bulletin focuses on lesser known, but just as important, higher education saving programs: U.S. Savings Bonds, Individual Retirement Accounts, UGMA’s, and life insurance policies.  In addition, the Bulletin reviews federal tax incentive programs aimed at higher education: Hope Scholarship Credit, Lifetime Learning Credit, Section 222 Deduction, and Student Loan Interest Deduction.

 

SAVINGS PROGRAMS

 

U.S. Savings Bonds

 

U.S. Series EE bonds are issued by the U.S. Treasury with low denominations and variable interest rates.  When a Series EE bond is purchased (usually at a local bank), its price is half its face value, with face values ranging from $50 to $10,000.  The interest rate paid on these bonds varies, and EE bonds reach face value in a maximum of 17 years.  Series EE bonds purchased after 1989 by someone at least 24 years old may be redeemed tax-free (state and federal) when the bond owner, the spouse, or dependent pays for college tuition and fees.  However, remember that redeeming bonds before the maturity date will result in lower yields (i.e., less interest earned).

 

In 2004, the tax-free redemption is phased-out for adjusted gross incomes (AGI) between $59,850 and $74,850 ($89,750 and $119,750 for married taxpayers filing jointly); these income limits increase each year.

 

Individual Retirement Accounts

 

Money withdrawn from individual retirement accounts (deductible for Roth) before age 59½ is subject to federal and state taxes, as well as a 10 percent penalty tax.  However, monies withdrawn to pay for higher education costs for yourself, your spouse, your children, or your grandchildren will not be assessed the 10 percent penalty tax.

 

UGMA

 

You can put assets in a Uniform Gift to Minors Act (UGMA) custodial account for a child.  However, if the child is under age 14, all income earned by the assets above a certain level (determined annually by the IRS) is taxed at the parents' income rate, whether or not the parent is the custodian.  For children 14 years old and older, the income on assets in a UGMA account is generally taxed at the child's rate.  Note that putting assets in a child's name may reduce the amount of financial aid he or she is eligible to receive.

 

Life Insurance

 

Permanent (whole) life insurance policies paid with fixed, annual premiums generally have the option of borrowing against their cash value.  Of course, the amount of cash value available varies depending on the specific policy.  The death benefit is decreased by the amount of the outstanding loan.  The interest rate charged on such loans is often quite reasonable, and in many cases you can pay back the loan on a flexible schedule.

 

Comparison Chart

 

The following chart provides an overview of the five main higher education savings programs.

                                                                                                                                               

	U.S. Savings Bonds	UGMA	Life Insurance	Coverdell ESA	Section 529 Plan
AGI Limits	Single: $74,850 Married: $119,750	None	None	Single: $110,000 Married: $220,000	None
Annual Contribution Limit	None	None	None	$2,000	None
Maximum Contribution	None	None	None	None	Varies by state ($100,000 - $305,000)
Taxes on Withdrawals Used for Higher Education Expenses	State: No Federal: No	Yes (taxed at child’s state and federal tax rate if over age 14)	Yes (taxed at owner’s state and federal tax rate)	State: Yes Federal: No	State: Varies Federal: No
Tax Deductible	No	No	No	No	Varies by state
Ownership	Student or Parent	Student	Parent	Student	Parent
Financial Aid Calculation*	5.6% (parent) or 35% (student) of account value	35% of account value	5.6% of account value	35% of account value	5.6% of account value

 

*Note:   Federal financial aid is calculated by a formula that counts certain assets owned by the parent (2.6% - 5.6%) or child (35%).  The financial aid formula also considers parent’s income (22% - 47%) and student’s income (50%).

 

FEDERAL TAX INCENTIVE PROGRAMS

 

Hope Scholarship Credit

 

The HOPE Scholarship Credit allows you to claim a maximum credit of $1,500 per student (100 percent of the first $1,000 of tuition and fees and 50 percent of the next $1,000) for expenses paid on your own behalf, or for your spouse or a dependent, for the first two years of post-secondary education at an eligible institution approved by the government.  The student must be enrolled at least halftime for at least one academic period during the year for the expenses to qualify.

 

 

Lifetime Learning Credit

 

The Lifetime Learning Credit allows you to claim a maximum credit equal to 20 percent of up to $10,000 of expenses you paid during the tax year for qualified tuition and fees for eligible students for post-secondary education (college junior and senior years), post-graduate education, and courses/seminars used to acquire or improve job skills (including teaching certification courses).

 

Both tax credits limit qualified expenses to the expenses for you, your spouse, or legal dependent. In addition, both credits are phased-out for taxpayers with a modified AGI between $42,000 and $52,000 for single filers (between $85,000 and $105,000 for joint filers).  For each qualifying student, you must choose to claim only one of the following:

 

·                     HOPE Scholarship Credit

 

·                     Lifetime Learning Credit

 

·                     The exclusion for certain distributions from a Coverdell ESA for the tax year

 

Section 222 Deduction

 

An above-the-line deduction for up to $4,000 of the college tuition and related expenses for yourself, your spouse, or your dependent in 2004 and 2005 is available if your income is $65,000 or less for singles ($130,000 for married filing jointly).  The deduction is not available if anyone claims a Hope Scholarship or Lifetime Learning credit in the same tax year.  This tax incentive is currently scheduled to cease after 2005.

 

Student Loan Interest Deduction

 

A maximum above-the-line deduction of up to $2,500 for interest paid is provided to taxpayers on qualified education loans.  The deduction is phased out for taxpayers with a modified AGI between $50,000 and $65,000 ($100,000 and $130,000 for joint filers).  The deduction is available even if the taxpayer does not itemize deductions.

 

 

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