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Investing for College
The information set forth below is intended only as a brief, general overview of certain federal tax provisions. It should not be considered tax advice. Domini Social Investments LLC, DSIL Investment Services LLC, and their affiliates and agents are not tax advisors, and do not provide tax advice.
Each person’s financial situation is unique. All information and examples provided here are for general illustrative purposes only, and are addressed in general to a hypothetical reader, not to you specifically. Tax law is complex, and has many general rules, details, and exceptions, and state and local tax law varies from federal tax law. To learn about federal tax law and rules, details and exceptions concerning IRAs, you should read IRS Publication 590 “Individual Retirement Arrangements (IRAs)” available at www.irs.gov or by calling the IRS at 1-800-TAX-FORM (1-800-582-6757). If you have questions and for tax advice, you should consult a financial or tax advisor before acting.
A number of different savings programs are available to help you fund your children’s education: Coverdell Education Savings Accounts (ESAs), UGMA/UTMA accounts, and the Section 529 plans offered by individual states.
Coverdell Education Savings Accounts (ESAs)
Many families choose the Coverdell ESA for at least part of their college investing program. Earnings accumulate free of federal income tax, and withdrawals are federally tax-free if they do not exceed the beneficiary’s qualified education expenses at an eligible educational institution for that year. Contributions to a Coverdell ESA are not deductible.
If your income falls below certain limits, you can contribute up to $2,000 per year for each designated beneficiary you choose. However, no beneficiary can receive more than a total of $2,000 per year from you and any other contributors. A beneficiary may be anyone who has not yet turned 18 — whether your own child, a grandchild, or a friend or other relative.
If your modified adjusted gross income (AGI) for the year is less than $95,000 (or $190,000 for a joint tax return), you can contribute up to $2,000 per year to any Coverdell ESA for a designated beneficiary. Your contribution limit is gradually reduced to zero if your modified AGI is between $95,000 and $110,000 (or $190,000 and $220,000 for a joint tax return).
To set up a Coverdell ESA, just fill out our application and return it by mail.
In addition to higher education expenses such as tuition, fees, books, supplies, and equipment — and in some cases, room and board — withdrawals may be used for elementary and secondary school expenses. They may also be used to cover computer technology and Internet access while your beneficiary is in school.
You may contribute to both a Coverdell ESA and a Section 529 plan for the same beneficiary. You may wish to consider saving for elementary and secondary school in a Coverdell ESA and for higher education expenses in a Section 529 plan.
For more details on Coverdell ESAs, including distribution rules and the potential for taxes on distributions, please review IRS Publication 970, “Tax Benefits for Education.” To get a printed copy of this publication, call the IRS at 1-800-TAX-FORM (1-800-829-3676).
Under the Uniform Gift to Minors Act (UGMA) and the Uniform Transfer to Minors Act (UTMA), an adult can invest money for a child in a custodial account. Because a portion of the investment income is taxed at the child's lower rate, this can help offset the cost of saving for education.
To set up an UGMA/UTMA account, fill out an application for a regular investment account and in part 1 of the application fill out section B.
There are two potential drawbacks to investing with an UGMA/UTMA. Once the child reaches a specified age (between 18 and 25, depending on the state), the money legally belongs to the child and might not be spent on higher education. In addition, financial aid offices will generally expect a family to use a greater percentage of a child's assets than the parents' assets to pay for college. By investing in your child's name, you may reduce the amount of financial aid you are eligible to receive.
Other Sources of Education Funding
You may choose to finance your children’s education through other methods, including applying for financial aid, taking out student loans, or making a withdrawal from an IRA.
Generally, if you make a withdrawal from your IRA before age 59½, you must pay a 10% tax penalty (in addition to income tax on earnings and money that was contributed on a tax-deductible basis). The 10% tax penalty is waived if this money is used for higher educational expenses (but the withdrawal is still taxed as ordinary income). Before withdrawing funds from your IRA, you should consider the impact such a withdrawal will have on your retirement savings.
Managing Your College Savings Portfolio
College costs are daunting for most families. The single most important factor for getting a handle on college costs is to start an investment plan as early as possible in your child’s life.
Creating an optimal investment plan for your child's education will depend on several factors:
- Whether you are saving for a private or a public education
- The number of years before your child will begin college
- The amount you can invest now
- The amount you can add periodically to your investment
- Your personal risk tolerance
For a longer time horizon, you may want to be more aggressive with your investment portfolio. For example, a family beginning to save for a newborn's college education might invest heavily in stocks or stock mutual funds in an effort to outpace inflation and maximize the growth of their investment. Stocks expose investors to greater risk than bonds or money market accounts.
As your child gets older and your time horizon decreases, you may want to adjust your asset allocation in order to conserve your principal. This means shifting the focus of your portfolio toward more conservative investments such as bonds and cash equivalents, which tend to offer greater stability but lower returns than stocks.
When you invest in a Coverdell ESA or UGMA/UTMA account through Domini, both you and your children can have the satisfaction of knowing that as your college fund grows, your money is helping build a world of peace and justice.