Feb. 10, 1998
Contact:
Connie Becker Mitchell
Sr. Information Specialist
(573) 882-9144
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MU EXPERT ADVISES PARENTS HOW TO USE NEW IRA, TAX LAWS FOR COLLEGE SAVINGS PLANS
COLUMBIA, Mo. -- For parents who are saving up to fund their children's college educations, yesterday's savings strategies may not be best in light of new tax laws that went into effect this year, according to an expert from the University of Missouri-Columbia.
Robert Weagley, associate professor of consumer and family economics, says that his previous analysis of the best ways to save for a college education has been altered due to the creation of the Education IRA along with several changes in federal tax rules. "Wise investing requires some flexibility," he says. "When the government changes the way it taxes investments resulting in new investment vehicles, we need to adjust our plans accordingly."
The most notable change involves the new Education IRA, a tax-free account for eligible households that allows deposits of up to $500 per year. While Weagley still counsels families to invest for college through a combination of stock-based mutual funds and bonds, he now suggests taking full advantage of the Education IRA.
"Because families can only contribute $500 a year, the Education IRA alone almost certainly won't be enough to completely fund a four-year college education, so parents should use this as just one facet of their overall college savings strategy," he says. For most families who don't anticipate receiving much need-based financial aid, Weagley recommends investing in the Education IRA from the time the child is born and then using all the IRA's principal and earnings to fund the first one or two years of college.
"The Education IRA is tax-free, which means that the government can not claim any portion of the earnings generated by the account. If parents put $500 each year into the Education IRA for the first 18 years of their child's life, and the account earns an average return of 9 percent, they will be entitled to the full account value of about $22,500 when the child starts college," Weagley explains. "If money were invested in a regular taxable mutual fund, parents would have to pay about $6,000 in taxes on the account's earnings."
Weagley notes that some parents may question this strategy because it conflicts with the use of the new, high-profile Hope Scholarship and Lifetime Learning tax credits, which can not be claimed in any year in which funds are withdrawn from an Education IRA. The Hope Scholarship is a $1,500 tax credit available to eligible households in the first two years of college. The Lifetime Learning tax credit can then be applied to subsequent years and is worth $1,000 through 2002 and $2,000 thereafter.
However, Weagley points out that prudent parents should spend the entire Education IRA in the first years of college, thus forfeiting the first and possibly second year's Hope Scholarship of $1,500 in order to capture the full $6,000 tax benefit from the Education IRA. Then, in subsequent years, the family may be eligible to receive one year of the $1,500 Hope Scholarship and two years of the $2,000 Lifetime Learning tax credit. In this way, the family receives approximately $10,000 to $11,500 in total tax benefits -- more than the $7,000 the family would receive from four years of the Hope Scholarship and Lifetime Learning tax credit.
A final point Weagley makes is that parents should always plan for retirement first and then consider saving for college. "Most financial planners would suggest that adequate retirement funding should supersede college expenses," Weagley says. "Moreover, retirement savings are not counted against the household in determining financial aid eligibility if one does not use the retirement assets to fund college expenses."
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