College Savings Plan Options

Parents are not limited to standard taxable investment accounts when saving for college costs. There are several college-specific investment plans that offer significant tax advantages. These include:

• 529 Plans
• Coverdell Education Savings Accounts
• UGMAs/UTMAs
• Other Approaches

529 plans are among the most popular approaches to building college savings. Most states and the District of Columbia offer some type of 529 plan, and most major financial institutions (including T. Rowe Price) have established relationships that allow them to offer 529 plans directly to investors.

Savings plans let you set aside money (typically $320,000 or more) in a professionally managed account that can be used at nearly every U.S. college and university.

Prepaid tuition plans let you pay for future education at discounted rates set today. These plans are appealing in that they offer cost certainty, especially if you are targeting a specific school. Plan assets typically also can be used to pay for other schools, though they may not cover all expenses.

• Any withdrawals used to pay qualified higher education expenses are free of federal income tax and may be state tax-free as well.
• There are no income restrictions.
• The account holder (usually a parent) retains control of the assets.
• Some states offer additional tax benefits-for example, there may be a state income tax deduction for your contribution.
• 529 plans can largely be used in conjunction with other federal education incentives, such as Education Savings Accounts and the Hope Scholarship and Lifetime Learning Credits.

Earnings on withdrawals not used for qualified educational costs may be subject to federal and state income taxes and a 10% federal tax penalty. In addition, an account holder may have limited investment options, depending on the particulars of the plan you select.

529 plans vary from state to state, and each has somewhat different costs, investment options, and tax incentives. A good game plan is to compare national plans with those that your state offers.

Please note the plan's disclosure document includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing.

Coverdell Education Savings Accounts are a federally sponsored, tax-advantaged way to save for a child's education. These accounts can be used to pay for elementary, secondary, or higher education. Education Savings Accounts are simple and offer you great flexibility in choosing investments. In addition, withdrawals are income tax-free if the proceeds are used for qualified educational expenses.

Coverdells have a modest contribution limit, however: The annual contributions to all Coverdell accounts for any one beneficiary cannot exceed $2,000. These accounts are also subject to income limitations. Individuals making less than $110,000 annually, or couples filing jointly earning less than $220,000 annually, can contribute on behalf of any beneficiary. But the $2,000 maximum contribution is gradually reduced if the individual's modified adjusted gross income (MAGI) is between $95,000 and $110,000 (between $190,000 and $220,000 for a joint return).

They also may be used in conjunction with the Hope Scholarship and Lifetime Learning Credits (as long as they aren't applied to the same expenses). Exhibit B shows how much an Education Savings Account can add to your college savings.

This chart shows how much you could compound in an Education Savings Account over various time periods if you invested $2,000 at the beginning of each year and earned 8% annually. This rate of return is for illustrative purposes only and is not intended to represent the return of any specific investment.

Before the creation of 529 plans, many parents used Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) accounts to save for college. UGMAs/UTMAs allow you to maintain assets in a child's name and take advantage of their generally lower tax rate.

If the child is under age 18, the first $900 (in tax year 2008) of his or her unearned income in an UGMA/UTMA is tax-free, and income between $901 and $1,800 (in tax year 2008) is taxed at the child's rate. Unearned income over $1,800 generally is taxed at the parents' top marginal rate until the child turns 18.

Depending on your circumstances, UGMAs/UTMAs may offer considerable tax benefits. They also have no income restrictions or maximum contribution limits and no restrictions on the type of investments that can be used. A principal drawback of UGMAs/UTMAs is that the child generally gains full control over the assets in the account when he or she reaches the age of majority (varies by state) - and there are no requirements that the assets be used for college costs.

There are a number of other plans and tax-savings strategies parents can use to enhance their college savings efforts. These include:

• Select investments that limit taxes on investment earnings. For example, some mutual funds focus on minimizing taxable distributions.
• Interest on redeemed U.S. government Series EE and Series I savings bonds is exempt from federal taxation when the proceeds are used for college tuition or for contributions to 529 plans or Education Savings Accounts and certain conditions are met.
• Federal gift tax exclusion limits do not apply when a family member pays a college tuition bill directly to the institution.
• Hope Scholarship Credit allows a tax credit of up to $1,800 per student for the first two years of college. Beyond the first two years, individuals can use a Lifetime Learning Credit of up to $2,000 per return for additional post-secondary learning. Full tax benefits for the two programs are available to individuals making less than $50,000 in 2009 ($48,000 in 2008) or families filing a joint return with incomes below $100,000 ($96,000 in 2008).
• IRA withdrawals can be used to pay for qualifying family educational expenses without incurring the 10% penalty for premature withdrawals before age 59½ (although income taxes in most cases will still be assessed, and you will lose the benefit of using those assets for retirement).

Interest paid on college loans may be tax-deductible up to $2,500 per year. Full benefits under this provision for tax year 2008 are available to individuals with incomes of less than $55,000 or married couples filing jointly earning less than $115,000. In tax year 2009, the benefits are available to individuals earning less than $60,000 or married couples filing jointly earning less than $120,000. You may wish to consult a financial or tax advisor to determine which strategies could benefit your family.