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The total cost of providing quality education for a child continues to rise faster than the general inflation rate. Planning for education expenses becomes more important each year as most parents realize that it is impossible to cover college expenses out of discretionary income or with meager sources of financial aid. Failure to plan can mean that a child misses a key educational opportunity or is saddled with crushing debts after graduation.

The U.S. government has recognized the difficulties and importance of providing quality education and has established programs to help parents plan for education expenses. Unfortunately, the patchwork of programs established and modified over the years has become extremely complex. Few people have time to learn enough about these programs to make optimal use of them.

There are three basic financial opportunities to consider when planning for a child's education: savings programs, financial aid, and the federal subsidies provided through tax credits and tax-free income.

Savings Programs

Savings programs allow parents (and grandparents) to put money into an investment account that will be used later for a child's education. The program that provides the greatest saving opportunities to the greatest number of families is based on Internal Revenue Code Section 529. Here are some of the characteristics of this program:

• available regardless of owner's income level
• high contribution limits (parents and grandparents can fully fund a private college education)
• no federal income tax on withdrawals for tuition, room & board, books, and supplies
• separate plans sponsored by each state
• state income-tax benefits possible with plan sponsored by owner's state of residence (none currently offered for residents in the state of California)

The characteristics listed above are advantages that section 529 plans have in comparison to other savings programs. There are two disadvantages of section 529 plans to be aware of: contributors to a plan are limited in the number of times a year they can make changes to their already invested assets and contributors have no control of the individual investments within the plan.

In California, the Sec. 529 plan is called Golden State ScholarShare College Savings Trust. Investments are managed by Fidelity Investments, which has developed a strong reputation in the discount brokerage arena. Owners of ScholarShare accounts have a variety of indexed and actively-managed investment options.

Education IRAs are a second type of savings program which allows for a far broader range of investment options than a 529 plan. These IRAs are usually self-directed and allow for added flexibility in a college savings plan, as the assets can be used for expenses prior to college. As with 529 plans, there is no federal income tax on withdrawals made for qualified expenses. However, the contribution limits are capped at a low $2,000 per child per year.

A third program avoids the restrictions of the government programs but incurs taxes that can be minimized by good planning. Parents purchase tax-efficient investments and make gifts to students when college expenses must be paid. Taxes on gains are low because the students typically have low income.

Financial Aid

The possibility that a student may qualify for need-based financial aid complicates the design of an optimal education-funding plan, because some assets and income sources reduce the amount of aid more than others. A financial-aid consultant as well as an investment advisor can be quite helpful to the parents of those students.

Tax Credits and Tax-Free Income

Two tax credits may provide modest help in reducing the amounts that families need to save.

The Hope Scholarship, despite its name, is a tax credit not a scholarship. For the 2007 tax year, it can offset up to $1,650 of expenses per student during each of the first two years of college. The Lifetime Learning Credit can offset up to $2,000 of college expenses per family for each year beyond the first two. Both of these credits are not to parents or students with high income.

A student who is not a dependent can take advantage of his or her own personal exemption and standard deduction. Together, the exemption and deduction allow the first $8,950 of a student's income to be free of federal income tax. The next $8,024 is subject to a rate of only 10% (in some cases, 8%). These amounts apply to tax year 2008 and are expected to increase with the Consumer Price Index.

Conclusion

Pleasanton Financial Advisors assists clients with the design of an education-funding plan that fits their particular situation. The children's ages, the types of college education desired, and the amounts of money earmarked already for college determine the annual savings required to meet education goals. The income level of the parents, and possibly grandparents, determines which savings programs are available and which are the most tax-efficient. Section 529 plans are much more attractive now because withdrawals are tax-free, but the investment restrictions of those plans may make it difficult to create an appropriately diversified portfolio. For that reason, a combination of the available savings programs is sometimes best.

While planning for education can be complex, it can be extremely rewarding both for parents and their advisors.