Piling Up Those Bucks For College

How to pick from an array of state-sponsored plans

Saving for college is getting a lot easier. A new breed of state-sponsored savings plans offers parents and grandparents big tax breaks while they build up assets to meet future education bills. Unlike the states' earlier prepaid tuition schemes, these savings programs, called Section 529 plans after the tax code section authorizing them, provide cash for any college. And nearly every state's plan is open to residents of other states, so savers have a wide range of choices.

Indeed, the major problem facing savers these days may be variety. Each state wants to tweak its version. Investment options, fees, and sweeteners for in-state savers create a range of choices. So parents and grandparents still face some tough challenges in deciding whether to invest in a 529 plan and, if so, which one to buy.

States first started helping parents panicked by the cost of college by offering prepaid tuition plans in the mid-1980s. But the newer savings plans are rapidly pushing prepaid tuition schemes aside. "With a strong stock market and slower tuition increases, the investment plans provide a better return," notes Joseph Hurley, a Pittsford (N.Y.) accountant whose Web site, www.savingforcollege.com, tracks and evaluates both types of plans. They're also more straightforward: Savers set up an account for a child, or beneficiary, and fund the account with aftertax dollars. Earnings aren't assessed for federal tax until the beneficiary withdraws funds. If the funds are spent on tuition or other college expenses, the earnings are taxed at the child's federal tax rate--zero to 15%, most likely, vs. 28% to 39.6% for the parent or grandparent.

To boost the plans' appeal, many states offer enticements to their own residents. New York taxpayers can deduct from their state income up to $5,000 in contributions ($10,000 for a couple) to New York's plan, run by the insurance and mutual-fund giant TIAA-CREF. Louisiana and Minnesota will match up to 15% of a resident's contributions, based on the saver's income. Connecticut's plan, also run by TIAA, promises to exempt withdrawals from state tax. New Jersey's state-administered plan exempts earnings from state tax and gives beneficiaries who attend in-state colleges a $500 freshman scholarship.

But some big states, such as California and Massachusetts, don't offer residents any special rewards. And almost every state limits its sweeteners to its own plan. For instance, a New Yorker who signs up for Massachusetts' plan, run by Fidelity Investments, cannot deduct contributions against New York's taxes.

Besides taxes, the 529 plans' big appeal is control: The account belongs to the donor, not the beneficiary. If the savers' daughter runs off with a motorcycle gang instead of enrolling at State, Mom and Dad can shift the account to little brother. Indeed, most states allow a change of beneficiary to any family member (even a parent), although a quirk in federal law bars transfers to cousins. If Grandma needs to reclaim her funds, she can even cash out the account herself, although the state must assess a penalty--usually 10%--on the earnings.

Grandparents get another kicker: A saver can make a single contribution of up to $50,000 to a plan without paying any gift tax. The contribution is counted against the donor's $10,000 annual gift exclusion over five years. That moves $50,000--and five years' earnings--out of the donor's estate, with no gift or estate taxes.

Are these plans for everyone? Almost. If you're saving for a preschooler or elementary-school child, 8 to 18 years of tax-free compounding is hard to beat. "For an upper-income family that won't get financial aid, the 529 is a good deal," says Raymond Loewe, president of College Money, a Marlton (N.J.) financial planning firm.

For a teenager or preteen, the choice is tougher. Once a child turns 14, he or she pays taxes at low rates--with the first $700 in investment earnings exempted from tax, and the next $26,250 taxed at 15%. Long-term, a Uniform Gift to Minors Account (UGMA) might result in less tax than a 529 plan. But you have to answer two questions: Is this child reliable? A child takes control of his or her UGMA at age 18 or 21--and many a UGMA intended for college has bought a sports car or cruise instead. Also, is your family likely to qualify for student aid?

If so, stick with Section 529. For purposes of federal financial aid, 529 plans owned by a parent are counted as the parents' assets. Parents are expected to contribute no more than 5.6% of their assets to college costs--far less than the 35% slice taken from student-owned assets. (Payments from prepaid tuition plans reduce financial aid dollar-for-dollar.) Private financial aid--scholarships and grants offered by colleges themselves--is trickier. Some private colleges have decided that 529 plans are student-owned assets.

Some investors might find that 529 plans are too conservative. Federal tax law specifies that the donor can't manage the account's investments. Plans responded by offering managed portfolios that start out aggressive--up to 80% stock when the beneficiary is a preschooler--but grow conservative, to ensure cash is available, as the student approaches college age.

It's a textbook strategy. But for parents starting late on saving, the mix offered for a 12-year-old by, say, the Maine plan run by Merrill Lynch--50% stocks, 40% bonds, and 10% money market--doesn't promise the big score needed to meet looming tuition. States and investment firms have responded by offering more choices: Merrill now offers all-stock and all-fixed-income accounts. The donor can't move funds from one account to another--but she could set up multiple accounts and direct later contributions to achieve the asset mix she prefers.

To choose among 529 plans, look first at your own state's plan to see what sweeteners it offers. Most states' tax rates are so low, however, that any breaks can be swamped by better investment returns. So you've got to compare managers (which, in some cases, are state agencies), asset allocation choices, specific mutual funds offered, and management fees--which range from 0.6% to 2%, on top of fund fees--from one state to the next.

Fans of 529 say the future is bright. States are offering accounts with smaller minimum contributions and are urging employers to set up payroll deduction plans. "We almost need to take a United Way approach to this and campaign for people to sign up," says Tim Lane, TIAA's vice-president for tuition financing. Congress is likely to lift investment restrictions and make it easier to transfer between accounts. Republicans have twice passed tax-cut bills, vetoed by President Clinton, that would have made 529 earnings totally tax-exempt--potentially a huge boon. College will always be a major financial hurdle for most families. But these new plans are moving the bar lower and lower.

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