Personal Business: College Planning
Grading the New College Savings Plans
With their older daughter two years away from high school, Diane and Bill McIver are getting serious about saving for college. Although the Schenectady (N.Y.) couple has put aside some money in savings bonds, they have less than 10% of the $370,925 it could cost if both Jessica, 12, and Lindsey, 10, opt for private colleges. "It's scary," says Diane McIver, an elementary school principal. "What we've saved is not nearly enough."
To try to catch up, the McIvers are enrolling in one of a slew of new state-sponsored college-savings plans. Since Congress clarified the plans' tax status in 1996, about 19 states have launched them, with eight more, including California, expected to follow shortly.
These plans differ from past efforts by states to encourage college saving. Most older plans guarantee your returns, ensuring that a set payment today will cover tuition at certain schools when your child enrolls. Although attractive to the risk-averse, these funds cap your annual returns at the rate of inflation in college tuition. Because college costs are rising by only 6% to 7 1/2% annually--down from two times that rate in the late 1980s--returns on the guaranteed plans have lagged the historic 10% average annual return on stocks. The new plans, meanwhile, put more money into stocks in hopes of boosting their returns, but they offer no guarantees. If the market tanks, so will your fund.FLEXIBLE. Like all state-sponsored college savings plans, the newcomers offer generous tax breaks to parents, grandparents, and anyone else who wants to save for a child's education. They are also more flexible than older plans, allowing benefactors to save more and to use funds without penalty at private and out-of-state schools. If you're looking for a state-by-state rundown on these programs, a good place to start would be the College Savings Plans Network (www.collegesavings.org).
Generally, the new plans resemble "lifestyle" mutual funds that tailor their asset allocation to an investor's age or risk tolerance. Sponsoring states usually turn parents' contributions over to professional managers, who will invest more aggressively for an infant than for a high school student. Under New York's plan, 55% of a newborn's nest egg would go into stocks. But as your kid gets closer to college, the portfolio's asset allocation shifts toward bonds, and the risk level declines. For Jessica McIver and other 12-year-olds, the equity portion of the plan is only 25%. In Iowa, meanwhile, 80% of a baby's portfolio would go into stocks, but by the time a child is 16, the same proportion would be invested in bonds.
Over the years, the plans have become less rigid. Most new ones allow parents to save for room, board, and even books. The most generous of the new crop, Massachusetts' College Investing Plan, is expected to cap total contributions at $158,752 per student when it makes its debut in March. (To avoid triggering the federal gift tax, benefactors should limit contributions to $10,000 a year or up to a lump sum of $50,000, prorated over five years on their tax returns.) Managed by Fidelity Investments, the new vehicle will co-exist with the state's older program, the U.Plan.
The newest plans allow funds to be transferred to siblings or other relatives and used at any college. Although older plans no longer limit students to home-state schools, some give those attending private or out-of-state institutions less generous payouts. Students opting for schools other than the 83 in the U.Plan only get back contributions adjusted for inflation, currently 1.5%. But when participants cash out of the new plans, they get the market value of their accounts.
The best feature of all the plans is their tax treatment. While giving parents control over the money, they allow investment gains to be taxed only when used, and at the child's rate, usually 15%. That's a saving for parents who would otherwise pay a 20% capital gains tax on profits. A measure before Congress would scrap federal taxes on earnings. Many states already exempt such gains from state tax. Some go further by allowing benefactors to deduct contributions on state returns. New York lets a couple write off up to $10,000 a year. (If you give more, the deduction will not rise or carry forward to future years.) When Minnesota launches its plan this summer, the state will even match some contributions.
If you're thinking of getting into a new college plan, watch the expense ratio. Iowa's plan charges just 29 cents for every $100 invested. But Indiana's plan pockets $1.75 of every $100--20% more than the average mutual fund. Also ask what the plan's expected returns are. Some states play it so safe they may have a hard time outpacing the college inflation rate. New York aims for an average annual return, minus fees, of 8% or so for a newborn--a target that drops to about 7% for a newly enrolled 10-year-old, says Tim Lane, vice-president at the plan's investment manager, TIAA-CREF. At that level, though, the growth rate of the 10-year-old's account might fall behind the 6% to 7 1/2% college inflation rate. Lane says New York may up the portion of its investments devoted to stocks next year, boosting the share for infants to 65% and for 10-year-olds to about 40%.CROSSING BORDERS. If you don't like your state's offering, you can invest in a plan that accepts out-of-state residents. But that may not make sense because you won't get a break on your state's taxes. That's not a concern if you live in Florida, Texas, or any state with no income tax.
Be aware that the plans might compromise eligibility for financial aid. "Since this is such a new investment vehicle, it is unclear" how the savings will be treated in aid calculations, says Scott Prince, director of external relations for the Massachusetts Educational Financing Authority, which oversees the state's two college plans. The question is no minor detail: If considered a student's property, the savings would reduce every dollar of financial aid by at least 35 cents. But if the money is counted as a parent's asset, aid is cut by only 6 cents. Until a decision is made, Raymond Loewe, president of College Money, a financial consultant to parents in Marlton, N.J., is advising all but wealthy clients to steer clear of state plans. "If I'm in the 40% tax bracket, I know I'm probably not going to get financial aid," he says.
You can't yank funds from a poorly performing plan without being hit with penalties. If money is used for any reason aside from college--even for an emergency--the Internal Revenue Service requires states to levy a penalty of at least 10% on gains. You also lose state and federal tax breaks.
Couples who make less than $150,000 a year and are interested in a federal tax-free Education IRA should be careful. You can't invest in both a state plan and the IRA in the same year. But because contributions to the IRA are capped at $500 a year, you're better off with a state plan.
If key issues such as financial-aid treatment are resolved favorably, state plans will be hard to beat. A simple comparison furnished by Loewe shows why: If someone in the 31% tax bracket contributes $2,400 a year to a mutual fund that gains an average of 10% annually, the account would hold $33,000 a decade later, after taxes are paid at a parent's rate. In a state-sponsored college savings account, the same investment would be worth $36,112 after the student's 15% tax rate is applied. With the price tag for a single year of private college expected to top $40,000 by 2009, every little bit helps.By Anne TergesenReturn to top