By Darrel Richter, Contributing Writer
Do you think college tuition is out of hand and you won’t able to afford it? While state colleges are much more affordable, there are some colleges that cost over six figures for a four-year degree! Well, there is an investment opportunity that will allow you to plan for a child’s college early in his/her life so that the tuition costs aren’t overwhelming when the time comes to pay the institution. This type of investment is called a college annuity.
“The college annuity is one that many parents and grandparents are utilizing now because they retain control of the funds even after the child is eligible for college,” says June Lynn, an insurance investment specialist for All State. “This is a very good investment option.”
There are several advantages from investing in a college annuity. First, you will receive tax benefits from this type of annuity. You will qualify for an income tax deduction immediately upon your donation (similar to a charitable gift annuity). In addition, you will pay no income taxes on the interest earned from the accumulation of funds in the account. So, in essence, the taxes are deferred.
Second, the beneficiaries do not have the same money restrictions that other investment vehicles have. You can contribute up to $11,000 per year. This is considered a gift. You’ll have to pay taxes on any gift, if the gift is more than $11,000. (Advisors say you can always get around this by having more than one person contribute funds, so no taxes will be incurred.)
Third, you will retain control of the funds forever, even after the child is going to college. For someone with a lot of money to contribute, this is very important. Some grandparents may not trust giving such funds to parents with the thought that the parents may use the money elsewhere.
Fourth, the rate of return is better than other funds, especially taking into account that you will probably have more funds in this type of account than a savings account or a certificate of deposit. So, the interest earned will be much higher, and you won’t have to pay taxes on it until you withdraw the funds.
A bank savings account is a safe investment because the bank does not invest the funds, is backed by the FDIC, and has no age requirements for tax purposes. However, the rate of return is not as generous as an annuity and you would suffer taxes on the interest when it is earned. So, the annuity is the better option. A CD allows you to place a premium in an account for a specified period of time, typically less than five years. Also, the funds are only available at maturity. The investment is taxed in the same year it draws interest, similar to a savings account. However, this is not a long-term investment strategy like the college annuity.
“CD’s and savings accounts aren’t even in the same league because the tax is deferred and the annuity will accommodate more funds than its counterparts. For instance, you can only contribute $2,000 per year in an IRA. College annuities are very good for someone with a lot of money and/or someone with money in an estate. You can take your money out of the estate and transfer it to an annuity, thus escaping the estate tax,” says Lynn.
The college annuity is a valuable investment choice because with the interest that accumulates, the rate of return will likely be greater than another investment strategy that is not taxed on a deferred basis, such as a savings account or a CD.
However, as with all investment options, there are drawbacks to the college annuity. But, these drawbacks can be avoided. First, be careful when the funds are withdrawn. The magical age here is 59 ½. If you completely or partially withdraw funds from the account before you reach age 59 ½, you will incur a 10-percent early withdrawal penalty tax. You may not like the outcome when you add the 10 percent early withdrawal charge to the standard income tax imposed for withdrawing the funds. One way around this situation is to put the policy in an older person’s name, such as a grandparent’s name, so that you can guarantee the policyholder will be over 59 ½ when the funds are taken out.
Another way around the age situation is for you to annuitize the contract over your life expectancy. Instead of withdrawing the funds when your child reaches college age, the contract will become a standard annuity where payments will be made to you over your life expectancy. So, the 59½-age obstacle doesn’t apply in this instance.
Is this investment right for you? There are many factors to consider. Consulting an annuity advisor can help you identify your options as you prepare to fund your child’s educational future.
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