IT'S ALL ABOUT MONEY
A plan comparison: Section 529 plans, Coverdell ESA,
Series I savings bonds, mutual funds, and savings accounts
By William A. Clemmer and Gary S. Lesser, Esq.
Paying for college education is one of the most significant financial burdens many families will have to bear. Unlike retirement, which can be planned for over the economic life of the wage earner--30 to 40 years--a child's college education can be expected to start 16 to 18 years after the child is born. Retirement can also result in reduced costs to the wage earner, while college costs inexorably increase--year to year.
College tuition increases have averaged two to three percentage points higher than the overall inflation rate over the past 30 years. For the 2001-2002 academic year, the average tuition and fees at four-year public colleges and universities is $3,754, a 7.7% increase from the previous year. For the same period, the average tuition and fees at four-year private colleges and universities is $17,123, a 5.5% increase from a year ago. (College Board, Trends in College Pricing 2001. New York, 2001).
Traditionally, college tuition and expenses have been borne by families through a combination of current income, savings, securities, loans and financial aid. With the increase in costs, families and institutions have been looking to and relying on additional methods of supporting the increasing costs. Over the past few years, tax-advantaged programs--Education IRAs (now the Coverdell Education Savings Account or Coverdell ESA), Series I Savings Bonds, and Section 529 plans are receiving increasing attention. Hope Scholarships and Lifetime Learning Credits are also available. Other plans might include certain qualified Section 72 distributions from a qualified retirement plan.
With the increasing cost and expanded methods of paying for them, planning takes on new significance. It is no longer enough just to "save for college." With fewer students living at home while in college, college expenses are an increasing burden. These major costs in addition to tuition include fees, housing (resulting from a lack of college subsidized housing), textbooks and supplies, transportation ... and the list goes on. It is also increasingly difficult (if not impossible) for the student to "put himself through school." Parents (especially with the increase of single parent families and second families) cannot carry the college expense load without planning and assistance.
Planning requires that families take as much advantage of the students' formative years as possible. And, as is the case in retirement planning, tax-advantaged programs are increasing in importance. While certain types of plans have been available since 1996, the passage of The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) has expanded these plans making them even more viable. Many institutions provide "pre-paid tuition plans." While not truly a "tax-advantaged plan" but a "price-advantage plan," these plans allow a family to pre-pay one or more years of a student's college tuition at a current year's tuition level or the current year plus a predetermined percentage increase. Tufts University, Boston, Massachusetts, had such a program in 1986. The Michigan Education Trust (the first formal trust) was introduced in 1988.
Section 529, added to the Internal Revenue Code in 1996, was a qualified tuition savings program. There are two basic types of Section 529 plans:
- Prepaid plans (allowing prepayment of tuition at current levels)
- Savings plans (investment programs offering a variable rate of return)
Section 529 plans are state-sponsored plans. While originally conceived as a means to pay for in-state tuition, much has changed (especially with the passage of EGTRRA last year) so that 529 plans may well be a prime tool for college savings in the days ahead. Contributions to Section 529 plans are not deductible for federal income tax purposes, but earnings grow tax-free of federal income tax (and in some states, free of local and state taxes) until qualified withdrawal.
The Coverdell ESA (formerly the Education IRA) was another use of the individual retirement arrangements that we discussed in an earlier article ("Thirteen Faces of IRAs," Rough Notes, November 1999). The Education IRA (similar to the Roth IRA) allowed for the tax-deferred growth of earnings and potentially tax-free distributions. The Education IRA could be used only for education expenses and was limited to an annual contribution of $500 (for 2001) per beneficiary. EGTRRA changed this to $2,000 for 2002, as well as increased the scope of qualified withdrawals.
The Series I Savings Bond is a government bond on which earnings are tax free at the state and local level. Earnings are fully or partially excludable from federal income tax for qualified taxpayers, if used for qualified college expenses.
Mutual funds and savings accounts are perhaps the most popular methods of saving and investing for college expenses. Savings accounts are generally federally guaranteed to $100,000 per account. Relative lack of risk and instant liquidity are the advantages of a savings account. Lower returns are the major disadvantage. Mutual funds have no guarantees but do have the advantages of being invested in a portfolio of securities and being professionally managed, as well as featuring reasonable fee levels and liquidity. The potential disadvantage of mutual funds is the volatility of the stock market.
| Section 529 Plans | Coverdell ESA | Series I Savings Bonds | Mutual Funds | Savings Accounts | |
| Tax Benefits on Earnings |
Federal + state income tax deferred + federal income tax free, if withdrawals used for qualified higher education expenses. | Income tax free, if used for qualified education expenses (elementary, secondary + higher). | State + local income tax free, federal income tax deferred. For qualified taxpayers, earnings fully or partially deductible from FIT, if used for qualified higher education expenses. | No special benefits; earnings taxed in year realized - unless municipals or tax-managed funds used. | No special benefits; earnings taxed in year realized. |
| Qualified Higher Education Expenses | Tuition, fees, books, supplies, room + board, + equipment. | Tuition, fees, books, supplies, room + board, + equipment. | Tuition + fees only. | Any expense. | Any expense. |
| Investment Limitations? | Varies by state. Some states allow lifetime account balances up to $265,620. | Up to $2,000/year. | Up to $30,000/year. | No limit. | No limit. |
| Income Restrictions | No. | Yes. | No - on purchases. However, there is income restriction on excluding earnings from FIT. | No. | No. |
| Financial Aid Treatment - treated as: | Savings plans: parents' assets; prepaid plans may reduce aid $ for $. | Student's assets. | Parents' assets if education expenses are for a child. Students' assets if education is for self. | Parents' assets. | Owner's assets. |
| Investment Decisions? | State sponsor with input from program manager. | Owner. | Guaranteed returns. | Owner. | Owner. |
| Withdrawals/ Redemptions |
Earnings on non-qualified withdrawals taxed at distributee's rate plus 10% penalty. | Earnings on non-qualified withdrawals taxed at distributee's rate plus 10% penalty. | Can be redeemed after 6 mos. A 3-mos. earnings penalty if redemption is within 5 years of insurance. | Money can be withdrawn at any time for any purpose. | Money can be withdrawn at any time for any purpose. |
| Impact on Hope of Lifetime Tax Credits | Education expenses used to support tax-free distributions may not be used to claim Hope or LTC. | Education expenses used to support tax-free distributions may not be used to claim Hope or LTC. | Education expenses used to support tax-free distributions may not be used to claim Hope or LTC. | None. | None. |
| Is the value of the account excluded from the owner's taxable estate? | No. | No. | No. | No. | No. |
The College Savings Plans chart provides a brief comparison of these plans. In subsequent articles, we'll cover Section 529, Coverdell ESA and other plans in some detail, as well as relative investment returns based on the tax advantages of each. *
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.
March column correction
Tax filing extension doesn't extend due date for IRA contributions
The "It's All About Money" column in the March issue (page 154) included an incorrect statement concerning the deadline for IRA contributions.
Contributions to an IRA can be made as late as the due date for an individual's federal income tax return-not including extensions. An individual who obtains a federal tax filing extension cannot obtain an extension of the deadline for making IRA contributions.