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Federal education loan rates are on the rise; could it affect you?

If you currently take advantage of federal loan programs to borrow money for college -- or intend to do so in the future -- take notice. Rates on popular loan programs have been moving up in line with three-month Treasury bills, lifting the repayment rate on Stafford loans for student borrowers to 5.3 percent for the 2005-2006 fiscal year, while the rate on PLUS loans made to parents rose to 6.1 percent. Now, under legislation passed earlier this year, rates will increase even further starting July 1, when new Stafford and PLUS loans will be switched to fixed rates of 6.8 percent and 8.5 percent, respectively.

Meanwhile, higher education expenses have kept increasing at a faster pace than inflation. According to The College Board, a year at a four-year public college now costs an average of $12,127 for tuition, room and board, and fees. The average bill at a private school has gone up to $29,026. With costs likely to continue their upward trend, families with children or grandchildren headed to college will have to save diligently, adopt sound investment strategies and take advantage of tax incentives in order to minimize the need for loans.

Tax-advantaged options

If college planning is a priority for you or a loved one, it will be beneficial to learn about tax-advantaged investment vehicles that can be used, as well as family gifting opportunities that may help meet your savings goal. You might start by considering Coverdell Education Savings Accounts and Section 529 plans.

Parents and others can contribute up to $2,000 (in after-tax dollars) annually per child to a Coverdell Education Savings Account (formerly an Education IRA). Earnings accumulate tax-free, and withdrawals for qualified education expenses are tax-free. With similar tax advantages, Section 529 plans may be especially appealing if your goal is quite large. Total plan contribution limits often exceed $200,000 per beneficiary. In addition to tax-deferred growth of earnings, qualified withdrawals from 529 plans are currently tax-free -- a provision that will expire at the end of 2010 unless extended by Congress.

Section 529 plans come in two versions:

ï Prepaid tuition plans let participants pay for tuition at today's rates, essentially taking inflation out of the equation. These plans are generally available only to residents of the sponsoring state and may be intended for in-state tuition (participants may be able to use the money at out-of-state schools, but only a percentage of the balance in some cases).

ï College savings plans let participants invest their contributions in mutual funds or similar managed financial instruments. Money in such a plan can be used for qualified undergraduate and graduate expenses at any accredited college or university, and many plans are open to residents of any state.

With both prepaid tuition and savings plans, the account owner generally maintains complete control over the account and may also change the beneficiary to another family member. Assets in both types of plans are treated as assets of the account owner, not the beneficiary, when computing federal financial aid eligibility. This is an advantage compared to assets held in custodial accounts, where the beneficiary is considered the owner.

If you decide that a 529 plan deserves further consideration, keep in mind that there are often important differences among plans. For example, lifetime contribution limits can vary widely from state to state. Also, some 529 college savings plans offer relatively few investment options, while others may provide a wide range of professionally managed investment choices. You will want to evaluate the performance of the investment options offered in specific plans, as well as their fees and expenses. Also keep in mind that some states offer in-state residents a tax deduction when they make a 529 plan contribution.

If you decide to invest in a 529 plan outside of the state in which you pay taxes, you may lose any tax benefits offered by the state's plan. Withdrawals used for qualified expenses are federally tax-free. Federal income tax-free withdrawals from state-sponsored 529 plans are for the years 2002-2010 unless Congress extends this law. Tax treatment at the state level may vary.

Gift-giving opportunities

Thanks to IRS rules, 529 plans can accommodate substantial gifts to college-bound children. Parents, grandparents and anyone for that matter can donate up to $12,000 per year per beneficiary free of federal gift taxes, and couples filing jointly may give as much as $24,000. Donors may also adopt an accelerated gift schedule by electing to make a lump-sum contribution of $60,000 ($120,000 for a couple) in the first year of a five-year period. In such a case, they would not be able to make additional gifts to the same beneficiary during the five-year period.

If you are enlisting family and friends for help with college costs or are considering ways that you can help finance a child's higher education, there are other avenues you may want to explore. For example, an individual can make annual gifts of up to $12,000 free of gift tax to a minor under the Uniform Gifts/Transfers to Minors Acts. And family and friends can pay any amount of a student's tuition and fees directly to an educational institution with no gift tax consequences. As with any tax-related moves, be sure to consult a tax professional before making a decision.

Finally, don't rule out the possibility of obtaining financial aid. As The Wall Street Journal reported in April, many of the nation's pricey private colleges recognize that putting a child through college can strap even high earners, and are offering financial assistance to families with six-figure incomes.

Wilsey is a registered principal with Linsco/Private Ledger, a member of the SIPC. Hear him on KFMB AM 760 Saturdays at 8 a.m., and see him on Channel 8 News and CNBC. Contact him at brent.wilsey@sddt.com. Comments may be published as Letters to the Editor.

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