According to the US Census Bureau, individuals with a bachelor’s degree have the potential to earn more than double the salary of those with just a high school diploma, so even though tuition and fees are on the rise, most people feel that a college education is well worth the investment. That said however, the need to set money aside for their child’s education often weighs heavily on parents.

Fortunately, there are two savings plans available to help parents save money that also provide certain tax benefits. Let’s take a closer look.

The two most popular college savings programs are the Qualified Tuition Programs (QTPs) or Coverdell Education Savings Accounts (ESAs). Whichever one you choose, try to start when your child is young. The sooner you begin, the less money you will have to put away each year.

Example: Suppose you have one child, age six months, and you estimate that you’ll need $120,000 to finance his college education 18 years from now. If you start putting away money immediately, you’ll need to save $3,500 per year for 18 years (assuming an after-tax return of 7%). On the other hand, if you put off saving until your son is six years old, you’ll have to save almost double that amount every year for 12 years.

Financial Calculator: College Savings Planner
Use this calculator to help develop and fine-tune your child’s college education savings plan.

How Much Will College Cost?

Based on the survey completed for the 2011 Trends in College Pricing, the average cost for tuition, fees, and room and board for 2011-12 was:

$17,131 per year for 4-year public (in state) colleges and universities, an increase of 6.0% from the 2010-11 academic year.

$38,589 per year for 4-year private colleges and universities, an increase of 4.4% from the 2010-11 academic year.

According to Trends in Student Aid, full-time students receive on average $16,000 of financial aid per year in the form of grants and tax benefits for private 4-year institutions, $6,100 per year for public 4-year institutions, and $3,400 per year for public 2-year institutions.

Saving with Qualified Tuition Programs (QTPs)

Qualified Tuition Programs, also known as 529 plans, are often the best choice for many families. Every state now has a program allowing persons to prepay for future higher education, with tax relief. There are two basic plan types, with many variations among them:

1. The prepaid education arrangement. With this type of plan one is essentially buying future education at today’s costs, by buying education credits or certificates. This is the older type of program and tends to limit the student’s choice to schools within the state; however, private colleges and universities often offer this type of arrangement.
2. Education Savings Account (ESA). With an ESA, contributions are made to an account to be used for future higher education.

Tip: When approaching state programs, one must distinguish between what the federal tax law allows and what an individual state’s program may impose.

You may open a 529 plan in any state, but when buying prepaid tuition credits (less popular than savings accounts), you will want to know what institutions the credits will be applied to.

Unlike certain other tax-favored higher education programs, such as the American Opportunity Credit (formerly the Hope Credit) and Lifetime Learning Credit, federal tax law doesn’t limit the benefit to tuition, but can also extend it to room, board, and books (individual state programs could be narrower).

The two key individual parties to the program are the Designated Beneficiary (the student-to-be) and the Account Owner, who is entitled to choose and change the beneficiary and who is normally the principal contributor to the program.

There are no income limits on who may be an account owner. There’s only one designated beneficiary per account. Thus, a parent with three college-bound children might set up three accounts. Some state programs don’t allow the same person to be both beneficiary and account owner.

Tax Rules Relating to Qualified Tuition Programs

Income Tax. Contributions made by an account owner or other contributor are not tax deductible for federal income tax purposes, but earnings on contributions do grow tax-free while in the program.

Distributions from the fund are tax-free to the extent used for qualified higher education expenses. Distributions used otherwise are taxable to the extent of the portion which represents earnings.

A distribution may be tax-free even though the student is claiming an American Opportunity Credit (formerly the Hope Credit) or Lifetime Learning Credit, or tax-free treatment for a Coverdell ESA distribution, provided the programs aren’t covering the same specific expenses.

Distribution for a purpose other than qualified education is taxable to the one getting the distribution. In addition, a 10% penalty must be imposed on the taxable portion of the distribution, which is comparable to the 10% penalty in Coverdell ESAs.

The account owner may change beneficiary designation from one to another in the same family. Funds in the account roll over tax-free for the benefit of the new beneficiary.

Tip: In 2009, the American Recovery and Reinvestment Act (ARRA) added expenses for computer technology/equipment or Internet access to the list of qualifying expenses. Software designed for sports, games, or hobbies does not qualify, unless it is predominantly educational in nature. In general, however, expenses for computer technology are not considered qualified expenses.

Gift Tax. For gift tax purposes, contributions are treated as completed gifts even though the account owner has the right to withdraw them. Thus they qualify for the up-to-$13,000 annual gift tax exclusion in 2012 (no change from 2011). One contributing more than $13,000 may elect to treat the gift as made in equal installments over the year of gift and the following four years, so that up to $65,000 can be given tax-free in the first year.

However, a rollover from one beneficiary to another in a younger generation is treated as a gift from the first beneficiary, an odd result for an act the “giver” may have had nothing to do with.

Estate Tax. Funds in the account at the designated beneficiary’s death are included in the beneficiary’s estate, another odd result, since those funds may not be available to pay the tax.

Funds in the account at the account owner’s death are not included in the owner’s estate, except for a portion thereof where the gift tax exclusion installment election is made for gifts over $13,000. For example, if the account owner made the election for a gift of $65,000 in 2012, a part of that gift is included in the estate if he or she dies within five years.

Tip: A Qualified Tuition Program can be an especially attractive estate-planning move for grandparents. There are no income limits, and the account owner giving up to $65,000 avoids gift tax and estate tax by living five years after the gift, yet has the power to change the beneficiary.

State Tax. State tax rules are all over the map. Some reflect the federal rules, some reflect quite different rules. For specifics of each state’s program, see College Savings Plans Network (CSPN). If you need assistance with this, please contact us.

Saving with Coverdell Education Savings Accounts (ESAs)

You can contribute up to $2,000 in 2012 to a Coverdell Education Savings account (a Section 530 program formerly known as an Education IRA) for a child under 18. These contributions are not tax deductible, but grow tax-free until withdrawn. Contributions for any year, for example 2012 can be made through the (unextended) due date for the return for that year (April 15, 2013). There is no adjustment for inflation, therefore the $2,000 contribution limit is expected to remain at $2,000 for 2012 and beyond.

Only cash can be contributed to a Coverdell ESA and you cannot contribute to the account after the child reaches his or her 18th birthday.

The beneficiary will not owe tax on the distributions if they are less than a beneficiary’s qualified education expenses at an eligible institution. This benefit applies to higher education expenses as well as to elementary and secondary education expenses.

Anyone can establish and contribute to a Coverdell ESA, including the child and an account may be established for as many children as you wish; however, the amount contributed during the year to each account cannot exceed $2,000. The child need not be a dependent, and in fact does not even need to be related to you. The maximum contribution amount in 2012 for each child is subject to a phase out limitation with a modified AGI between $190,000 and $220,000 for joint filers and $95,000 and $110,000 for single filers.

A 6% excise tax (to be paid by the beneficiary) applies to excess contributions. These are amounts in excess of the applicable contribution limit ($2,000 or phase out amount) and contributions for a year that amounts are contributed to a Qualified Tuition Program for the same child. The 6% tax continues for each year the excess contribution stays in the Coverdell ESA.

Exceptions. The excise tax does not apply if excess contributions made during 2011 (and any earnings on them) are distributed before the first day of the sixth month of the following tax year (June 1, 2012, for a calendar year taxpayer). However, you must include the distributed earnings in gross income for the year in which the excess contribution was made. The excise tax does not apply to any rollover contribution.

The child must be named (designated as beneficiary) in the Coverdell document, but the beneficiary can be changed to another family member, for example, to a sibling where the first beneficiary gets a scholarship or drops out. Funds can also be rolled over tax-free from one child’s account to another child’s account. Funds must be distributed not later than 30 days after the beneficiary’s 30th birthday (or 20 days after the beneficiary’s death if earlier). For “special needs” beneficiaries the age limits (no contributions after age 18, distribution by age 30) don’t apply.

Withdrawals are taxable to the person who gets the money, with these major exceptions: Only the earnings portion is taxable (the contributions come back tax-free). Also, even that part isn’t taxable income, as long as the amount withdrawn doesn’t exceed a child’s “qualified higher education expenses” for that year.

The definition of “qualified higher education expenses” includes room and board and books, as well as tuition. In figuring whether withdrawals exceed qualified expenses, expenses are reduced by certain scholarships and by amounts for which tax credits are allowed. If the amount withdrawn for the year exceeds the education expenses for the year, the excess is partly taxable under a complex formula. A different formula is used if the sum of withdrawals from a Coverdell ESA and from the Qualified Tuition Program exceed education expenses.

As the person who sets up the Coverdell ESA, you may change the beneficiary (the child who will get the funds) or roll the funds over to the account of a new beneficiary, tax-free, if the new beneficiary is a member of your family. But funds you take back (for example, withdrawal in a year when there are no qualified higher education expenses, because the child is not enrolled in higher education) are taxable to you, to the extent of earnings on your contributions, and you will generally have to pay an additional 10% tax on the taxable amount. However, you won’t owe tax on earnings on amounts contributed that are returned to you by June 1 of the year following contribution.

Professional Guidance

Considering the wide differences among state plans, federal and state tax issues, and the dollar amounts at stake, please call us before getting started with any type of college savings plan.