Once you have estimated the amount that you need to save for college education the next step is determining what kind of saving plan to choose from. There are several Qualified Tuition Plans (QTP) or 529 plans to choose from. It is important to use these plans as they offer some tax advantages. You can decide on the one which is most appropriate for you or you could choose a combination. There are some state specific rules on QTPs.
Broadly speaking, there are two types of savings plans, Prepaid Tuition Plans and Savings Plans.

  • Prepaid Tuition Plan: As the name indicates, these plans allow the payment of future tuition at current prices or 'locks-in' your future tuition cost. It is offered jointly by state and a particular college. The idea is that the child will attend that particular college. But if for some reason child can't get in that college or some other situation demands the child to attend a different college in the state then there is some flexibility. Obviously, this plan is not very popular.
  • Savings Plans: College saving plans are a great way to regularly save for your child's college education. The investment earnings in such accounts grow tax deferred (you don't need to pay taxes on them each year). In fact when your child withdraws the money for college expenses, these earnings are taxed at your child's tax rate. You can contribute up to $15,000 to each child's savings plan in a given year. This amount can be doubled if you and your spouse contribute together. A higher contribution can run into gift tax issues. However, if you have received a lump sum payout from some source e.g. a lottery or gift from someone, you can contribute up to 5 times this amount in a given year provided you don't contribute anything for the next 5 years. For grandparents this is a great way of helping the grandchildren. Each grandparent can use the 5 year payment approach. In fact, if a grandparent is considering to help a grandchild's current tuition bill, a more tax effective way is to mail the check directly to the college (payable to college). That way you don't run into generation skipping transfer taxes .

The money from such plans can only be used for qualified college education expenses. They include tuition, room and board, and books/supplies. If the funds are not utilized by the beneficiary they may be transferred to a new beneficiary within the same generation and within the same family (including first cousins of beneficiary) to avoid penalties and gift taxes. Penalties are waived if the beneficiary dies or becomes disabled or receives a scholarship of an equal amount.

They include -

  • Coverdell Education Savings Account: It is same as Educational IRA (old name). This allows you to save $2,000 per child per year. The contribution for a given year can be made until April 15th of the following year. This is another great way to save for a child's education. In this case too the contribution is with after tax dollars but earnings are tax free if funds are withdrawn for qualified educational expenses. The account must be setup when the child is under the age of 18. Unlike a qualified savings plan, in this case, you can not change the beneficiary. The other restriction is you can not contribute anything to this account if your annual income exceeds a certain amount; Contribution phaseout for Singles: $95,000 - $110,000 and for Married filing jointly: $190,000 - $220,000
  • Uniform Gift to Minor's Act (UGMA): In this program you create a custodial account for the child and you as a custodian. So, effectively your child is the owner of this account and will have the complete authority on this account after turning a major (18 years or 21 years depending on the state). The earnings are taxed at child's income tax rate after the age of 14 and prior to that it is taxed at the custodian's tax rate. Through this parents can contribute cash or securities in a child's name. The money can be used for any purpose. But the balance of this account reduces a student's eligibility for need based financial aid. For a child who has not yet attained age 18 by year-end, the first $850 of investment income (interest/dividend/capital gains) is tax free. The next $850 is taxed at the child's tax rate - usually 10% and over $1,700 is taxed at parent's highest marginal tax rate.
  • Series EE and Seris I Bonds: Parents can also purchase these bonds from the government to pay for their children's education. The maturity value (principal + interest) of these bonds vary from $50 to $10,000 and you buy them at the discounted value. The interest earned is tax free if the bonds are exchanged for cash in the year tuition payments are made.
  • Education Expense Deduction: Taxpayers may deduct upto $2,000 from gross income for qualifying expenses of tuition and fees. This expense deduction has a phaseout. For singles it is $95,000 - $110,000 of AGI and for married it is $190,000 - $220,000.
  • Education Tax Credits: There are two types of education tax credits, Hope Tax Credit and Lifetime Learning Credit.
    • Hope Tax Credit - A Hope tax credit of up to $ per student is available for the first two years of higher education expenses if the student carries at least one-half the normal class load. The credit is equal to 100% of the first $2,000 of eligible expenses (tuition and fees only) and 25% of expenses over $2,000
    • Lifetime Learning Credit - This credit is available per taxpayer for education expenses equal to of the first of eligible education expenses (tuition and fees) for any year of higher education expenses that the Hope Credit is not used. This credit can be claimed in unlimited number of years as long as the student carries one-half of the normal class load.
  • Both Hope and Lifetime Learning Credits have same phase out of these benefits based on AGI of taxpayers. For Single taxpayers the phase out is: $80,000 - $90,000 and for joint taxpayers it is: $160,000 - $180,000.

    • Decide on a college savings plan that suits your needs
    • Setup an appropriate account at a financial institution
    • Contribute to this account
    • Monitor the progress of this account as time goes by and your child approaches college time