For parents struggling to save for their children's college expenses, tax breaks have been few and frustrating. The restrictions on many college savings plans make them less than attractive. For instance:
IT'S ALL ABOUT MONEY
Agents can help clients avoid sticker shock
through Section 529 plans
By William A. Clemmer and Gary S. Lesser, Esq.
For parents struggling to save for their children's college expenses, tax breaks have been few and frustrating. The restrictions on many college savings plans make them less than attractive. For instance:
Education IRAs. The advantages are that the $500 contribution limit has been increased to $2000. Also, one can now use these funds for qualified elementary and secondary school expenses. Tax-free withdrawals can be used for certain room and board, uniforms, computers and extended day program costs. However, not everyone is eligible to contribute. There are strict income limits.
Custodial accounts. Tax savings are minimal and control of the asset is ceded to the child. Assets cannot be moved from one child to another.
State-run prepaid tuition plans. Low inflation-level returns are the norm. Funds must be used in the state of origin. Non-qualified withdrawals are disadvantageous.
Thus, many parents use taxable accounts, sacrificing a portion of their profits to taxes, or tap their retirement accounts for college expenses.
In 1996, the Section 529 plan was introduced, and substantially expanded by EGTRRA as an outgrowth of earlier prepaid tuition plans. This plan is an investment plan operated by a state to help families save for future college expenses. Although contributions to the plan are not deductible, they accumulate on a tax-deferred basis. Qualified expenses (college related) can be withdrawn or redeemed without tax or penalty. As a state-sponsored plan, most states offer additional income tax benefits. Assets typically can cross state lines. Multiple plans can be set up (even in more than one state) for a single beneficiary. Grandparents can change beneficiaries among grandchildren. The donor controls asset use. Non-qualified withdrawals are subject to a small tax penalty. The only ones who could possibly object are tax collectors without children.
Funds may be used for that state's schools (all) or in many cases, in any accredited institution. Recent changes allow institutions to offer their own Section 529 prepaid plans. Most states have arrangements with investment companies to operate their plans for them, using either existing investment products or funds specifically geared to the plan including age-based funds which change investment strategies as the child gets older.
The EGTRRA changes allowed Section 529 plan assets to be used for most college expenses including room and board as well as tuition, effectively doubling the amount of money that families can save through them. While total contributions vary from state to state, as much as $265,000 could be accumulated in some plans. All 50 states and the District of Columbia have qualified tuition programs either in operation or development. Section 529 plans have received, as reported in mid-2001, over $2.5 billion in investments (a number that is expected to grow to $10 billion by the end of 2002, according to Joseph Hurley inwww.savingforcollege.com, a Web site that tracks college savings plans). "People are starting to realize that 529s are the best college savings plans to come along," says Hurley. Like any program, tax advantaged or otherwise, there are pros and cons. Let's take a look.
Note that EGTRRA created some substantial advantages to Section 529 plans, some of which are:
* Earnings from state-sponsored plans were made exempt from federal income tax.
* Earnings on contributions grow tax-free until withdrawn.
* Transfers or rollovers are allowed from one Section 529 plan to another without changing the beneficiary.
* Transfers between cousins were made possible.
Those changes generally took effect on January 1, 2001. It should be noted, however, that all provisions of EGTRRA are scheduled to expire on December 31, 2010. Were this to occur (and given no other changes in the interim), the federal tax treatment would revert to its status prior to January 1, 2001. On the other hand, since the applicable provisions of EGTRRA were specifically designed to facilitate long-term savings for college, it is possible that the enhanced federal tax status will continue after 2010. While we make the assumption of continuation, the potential risk should be noted.
Types of plans:
* Prepaid Plan: This type of plan provides the opportunity to prepay tuition based on the current cost of tuition along with a guarantee which will keep pace with tuition inflation.
* Savings Plan: This type of plan offers a dedicated qualified college savings plan with a variable rate of return, based on the underlying investment(s) managed either by the state treasurer or the treasurer's designee (investment manager). This plan is not guaranteed to keep pace with tuition inflation.
Income and contributions:
* Anyone, regardless of income, can contribute.
* A contributor need not be a parent or relative.
* Contributions can be made to any living beneficiary.
* Contribution limited to a one-time $50,000 contribution per donor per beneficiary.
* Maximum total contribution limits are set by each state (Rhode Island allows $265,620).
* Adults who plan to attend
law or medical school can contribute their own savings to a Section 529 plan.
* Funds can be used by a future generation.
Tax advantages:
* The investment grows tax-free as long as the funds stay in the plan.
* Distributions used for qualified expenses are free of federal income tax (and state and local income taxes in many states).
* Some states offer an upfront deduction for contributions or income tax exemptions on withdrawals.
Control and flexibility:
* The donor generally retains control over the funds until distributed. The named beneficiary (with a few exceptions) has no control over the funds.
* Plan may be set up and investments generally may be made in multiple states for the same beneficiary (most states do not have residency requirements).
* Maximum amounts (per state) may be invested in multiple states (there is no requirement that a state count investment in another state against their own limits). However, use of a Section 529 plan as an unrestricted tax shelter may draw attention. There are some restrictions and penalties.
* Funds can be used for college expenses at any accredited institution in any state.
* Funds can be transferred to a sibling, cousin, niece or nephew; grandparents may switch funds between grandchildren. (This is an annual "rollover.")
* Most plans allow recapture of funds at any time (a non-qualified withdrawal) without question and subject only to income taxes and a 10% penalty on earnings.
Financial aid advantages:
* Section 529 funds are not considered a student asset in the formula for aid calculations
(FAFSA form).
* Section 529 withdrawals are tax-free and do not trigger a 1099; therefore, there is no effect on income.
* Section 529 funds which are in a plan established by a grandparent need not appear as a parental asset on the FAFSA form.
Negatives:
* Changing plans, beneficiaries, or investment options is difficult and cumbersome, and generally annual.
* Unused Section 529 funds can be withdrawn but become subject to federal income tax and possibly a 10% penalty tax and, in some cases, state income tax.
* Using both a Section 529 and Education IRA in the same year for the same beneficiary is not allowed.
Picking the right plan:
The key word is "shop." Plans differ from state to state--in costs, investment choices, and tax advantages. Typically, a state with high taxes will also have matching grants and/or scholarships. Sixteen states allow a tax deduction on Section 529 contributions and most states exempt earnings from state income taxes.
We recommend three guidelines for 529 plan shopping: management, costs, and the right investment choices.
Management. Because 529 plans are relatively new, there is only a short reviewable record, especially in the new "age-based" options. Investment companies with successful records managing retail mutual funds and retirement plans are a good start. State pension plan results are posted on many state Web sites (www.state.org). State-sponsored 529 plans are generally under the auspices of the state treasurer, who either manages them or contracts with an investment company to do so.
Costs. Expense ratios vary considerably (from 0.31% in Utah to 2.24 % in Oregon). Some states' plans are sold by brokers, which add additional costs. (For instance, this may range from 3.5% - 5% in Arizona, Ohio, Rhode Island and Wisconsin.) However, these sales charges can be avoided by buying directly from the state or fund. Watch for other fees (e.g., new account and annual fees).
"Right" investment choices. Since account transfers are annual and slow, a plan with a host of investment choices is not as advantageous as a plan with the right choices. Many plans offer "age-based," "years-to-enrollment" and "risk-based" portfolios, which gradually shift the asset allocation as the beneficiary moves toward college age. Early on, plans were criticized for their conservative portfolios. But a conservative strategy is often the most sensible. "People forget that they have fewer years to save for college than for retirement--more often 10 years or less, since they tend to start late," notes TIAA-CREF Vice President Timothy Lane. "If you lost a lot in the early years, it's very hard to make up."
(See accompanying chart on page xx.)
Multiple accounts for each child, one for each asset class, can create a personal portfolio mix. Asset allocation can then be accomplished by investing different amounts in different accounts in different years.
Information:
Most states list their Section 529 programs under the state treasurer's office. Written material is available from all operational plans (over 44). The National Association of State Treasurers sponsors The College Savings Plan Network (www.collegesavings.org).
Many fund groups provide specific links on their Web sites relating to Section 529 plans. Some investment companies manage plans in more than one state (Merrill Lynch, Fidelity, AIM, TIAA-CREF). Some states have several managers. In addition, the number of partnerships is increasing as 529 plans catch on and more investment managers are trying to get into the market and state sponsorships are taken.
There are also a number of information and commercial sites:
--BabyMint(TM)
www.babymint.com*
--Microsoft
www.moneycentral.msn.com
--Upromise
www.upromise.com
* BabyMint is a new approach that allows a parent to receive "cash-back contributions" from everyday "normal" purchases from a host of retail partners. These contributions are automatically deposited in a Section 529 plan account. BabyMint estimates that a typical educational savings account could reach $50,000 by the time a child is ready for college. It is of interest because it is another indication of how quickly the Section 529 plan idea has caught on.
In our next column, we'll discuss the Coverdell Education Savings Account and other college savings plans. The chart in the May 2002 issue of Rough Notes (p. 60) will be a handy reference. *
The authors
William A. Clemmer and Gary S. Lesser, JD, head up Financial Services Agency Consulting (FSAC), a division of The Rough Notes Company. Clemmer has more than 25 years of financial services industry experience on Wall Street. Lesser writes and lectures widely on retirement planning and taxation issues. He is a member of the board of advisors for the Journal of Taxation of Employee Benefits.
Effect of Early Losses and Subsequent Gains of 10%/year
| Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
| Loss/Gain | -3% | -3% | -3% | 10% | 10% | 10% | 10% | 10% | 10% | 10% |
| Investment $100 | $97 | $94 | $91 | $100 | $110 | $121 | $134 | $147 | $162 | $178 |
| Loss/Gain | 10% | 10% | 10% | 10% | 10% | 10% | 10% | 10% | 10% | 10% |
| Investment $100 | $110 | $121 | $133 | $146 | $161 | $177 | $195 | $214 | $236 | $259 |
*All deposits made at beginning of year.
Effect of Early Losses and Subsequent Gains of 8%/year
| Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
| Loss/Gain | -3% | -3% | -3% | 8% | 8% | 8% | 8% | 8% | 8% | 8% |
| Investment $100 | $97 | $94 | $91 | $99 | $106 | $115 | $124 | $134 | $145 | $156 |
| Loss/Gain | 8% | 8% | 8% | 8% | 8% | 8% | 8% | 8% | 8% | 8% |
| Investment $100 | $108 | $117 | $126 | $136 | $147 | $159 | $171 | $185 | $200 | $216 |
* All deposits made at beginning of year.
Effects of an Early Loss (3%) and Subsequent Gains (8%)
| Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | Loss/Gain | -3% | 8% | 8% | 8% | 8% | 8% | 8% | 8% | 8% | 8% |
| Investment $100 | $97 | $105 | $113 | $122 | $132 | $143 | $154 | $166 | $180 | $194 |
| Loss/Gain | 8% | 8% | 8% | 8% | 8% | 8% | 8% | 8% | 8% | 8% |
| Investment $100 | $108 | $117 | $126 | $136 | $147 | $159 | $171 | $185 | $200 | $216 |
*All deposits made at beginning of year.