College Costs 101: Different Ways to Save

It’s that time of year again; summer is drawing to a close and kids around the country, whether they like it or not, are getting ready to go …

It’s that time of year again; summer is drawing to a close and kids around the country, whether they like it or not, are getting ready to go back to school. Many parents may flinch at the cost of back-to-school supplies and clothes, but those costs pale in comparison to the expense of college. For the 2007-2008 school year, the average cost of attending a private four-year college was $23,712, up 6.3 percent from the prior school year, according to College Board. The average for the same year at a public four-year college was $6,185, up 6.6 percent from the previous year. With college costs outpacing inflation, paying for college is a struggle for many.

Saving for college, rather than depending solely on loans to cover the costs, will ultimately make college cheaper. “It is less expensive to save for college than to borrow. Either way, you’re setting aside a portion of your income to pay for college. But when you save, the money earns interest, while when you borrow, you’re paying the interest,” according to FinAid.org.

Two of the most common vehicles for college savings, as well as some alternative options, are compared below.

State-sponsored section 529 savings plans

Perhaps the most well known college savings option is a state-sponsored 529 savings plan. Introduced in 1996 and named after the section of the tax code that applies to them, “529s let you save large sums while your earnings accumulate tax-free; the earnings remain tax-free as long as you use the money to pay for college,” according to Money Magazine.

The tax break is one feature that makes 529s stand out as a savings method that’s hard to beat. “Say you’re in the 28% tax bracket, have a five-year-old and save $200 a month in Utah’s low-cost 529, which has annual expenses of 0.38%. Assuming annual average returns of 5%, you’ll have $39,100 by the time your kid is 18. Invest the same amount in a taxable account with equal fees and returns, and you’ll have $36,200 after taxes. In other words, you’ll lose $2,900,” according to Money Magazine.

In a deal-sweetening addition, 33 states and the District of Columbia allow plan participants to write off some or all of their contributions. Also, as of January 2009, 529s will be treated as parental assets in terms of financial aid, even if they are in the child’s name; this helps to ensure that students are eligible for financial aid, since students are expected to contribute 20 percent of college costs, while parents are expected to contribute just about 6 percent.

And more and more people are being enticed by the benefits offered by 529s. “Assets in 529 college savings plans reached an estimated $108.7 billion at the end of the first quarter of 2008, up 15.6% from $96.8 billion at the end of the first quarter of 2007,” according to the College Savings Foundation.

There is one major drawback to participating in a 529: management costs. 529s run by Vanguard and TIAA-CREF each have annual expenses of less than 0.5 percent, but commissions for 529s purchased via brokers can reach 5.75 percent. It is best to shop around for the best deal a purchase a 529 direct to maximize the contributions and the tax benefits. Another drawback is that investment choices are somewhat limited; many states simply offer a small range of investment tracks that range from conservative to aggressive.

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But, while 529s are state-sponsored, there are no residency requirements. Consumers can live in one state and participate in another state’s 529. Kiplinger didn’t call 529s “the hands-down best choice for your college dollars” for nothing.

Coverdell Education Savings Account

Established in 1997, these plans were known until July 2001 as Education IRAs. “Coverdell accounts are trusts created exclusively for the purpose of paying the qualified education expenses of the designated beneficiary of the trust,” according to FinAid.org.

Unlike 529s, this plan has eligibility requirements: an adjusted gross income of $220,000 or less for couples or $110,000 or less for singles. There are more investment options available through Coverdell plans than 529 plans. The current rules allow for maximum contributions of $2,000 a year, but that will drop to $500 a year in 2010 unless Congress intervenes.

“Contributions are not deductible on federal or state income tax, but earnings accumulate tax-free,” according to FinAid.org. “Qualified distributions are exempt from federal income tax.”

Contributions can be made only up until the beneficiary reaches age18. Money in a Coverdell account must be used by the time the beneficiary reaches age 30, or else the balance will be taxed as ordinary income and subject to a 10 percent penalty. These age limits do not apply to special needs beneficiaries. Accounts can be rolled over from one beneficiary to another, as long as the new beneficiary is a family member of the original beneficiary. When rollovers are involved, the $2,000 annual contribution limit does not apply.

“The Coverdell is best as a supplement to a 529, not as a substitute,” according to Money Magazine.

Alternative options

There are also options for those seeking alternatives to traditional college savings methods. These include a KissTrust and the Infinite Banking Concept.

Glen Armand, CEO of KissTrust, founded the company after the birth of his twin grandchildren when he was compelled to start them off on the right foot financially and was unable to find a plan with the particular characteristics he wanted. Undeterred, he started his own.

A KissTrust is an irrevocable trust that emphasizes long-term compounded growth. Some of the attributes unique to a KissTrust are protection from third party creditors, bankruptcy, divorce and unauthorized withdrawal, as well as specifications about when and why the funds can be can accessed. Anyone can start a KissTrust for a child, provided the child is a U.S. citizen with a Social Security number, and a KissTrust can be passed on to the beneficiary’s heirs.

There are two investment options for a KissTrust: a tax-deferred annuity or an after-tax mutual fund.  An asset allocation strategy is available which automatically reallocates investments in increasingly conservative portfolios as the beneficiary ages.

There is a $199 set-up fee for a KissTrist, and $99 fee set-up fee for every subsequent trust. There are no income eligibility requirements or annual contribution limits outside of the rules about gifting put in place by the IRS.

The Infinite Banking Concept, pioneered by R. Nelson Nash, is another savings option available. Essentially, Infinite Banking and other individualized banking systems are centered on whole life insurance policies with insurance companies that allow policy holders to take out loans collateralized on their policies.

Policy holders can borrow up to 100 percent of the cash value of their whole life policy without being subject to any tax penalties. Whole life insurance policies provide annual dividends and a guaranteed sum to be distributed to the policy holder’s beneficiaries at the time of the policy holder’s death.

To build up equity in their policies so that they are able to borrow from them, policy holders first must participate in something known as the “capitalization phase” of the Infinite Banking process. This is when policy holders pay premiums into the policy, generally for a period of five to seven years, to increase the policy’s value. After that phase is complete, the returns on the policy, which are based on the company’s success in a year, are typically enough to cover the premiums. Policy holders can use a paid-up additions rider to funnel their dividends directly into their policy, increasing its value and the amount of the death benefit.

With the policy in place, policy holders can borrow money from themselves rather than from a bank or other lender; the interest payments on the loan will go back into their own accounts rather than to an outside lender. Thus, policy holders can finance a major purchase with no additional expense for financing. Further, all insurance policies are protected from creditors and litigation. However, Infinite Banking is certainly not for everyone. It requires several years of devoted payments into the policy before seeing any benefit. Also, those who may lack the discipline to pay themselves back should not use the system as they would simply derail their own efforts.

Conclusion

While the cost of college may seem like a burden, the benefits of going can justify the costs. “People with a bachelor’s degree earn over 60 percent more than those with only a high school diploma,” according to Education Pays, a 2007 College Board study. “Over a lifetime, the gap in earning potential between a high school diploma and a B.A. is more than $800,000. In other words, whatever sacrifices you make for your college education in the short term are more than repaid in the long term.”

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