College Savings Plans Come of Age

How to sift through the many options states now offer

When states began offering plans to help parents save for college in the late 1980s, the choices were simple: Pay a set amount for tuition in advance, and your child could attend an in-state school years later regardless of what happened to tuition costs. It was sort of like prepaid funeral expenses--and about as tantalizing.

The plans, called 529s after the section in the tax code that authorized them, have come a long way since then. A new savings breed lets you set aside $100,000 or more in a tax-deferred account that can be invested--depending on the state--in anything from boring bonds to risky technology funds. Your child can use the money in any school--not just those on a preselected list. Best yet, you're not restricted to investing in your own state's plan but can go shopping among nearly all of the 41 states that either offer these programs or will soon.

To help you find the plan that meets your needs and investment tastes, BusinessWeek has compiled a comprehensive guide to the new 529s. In the table (page 104), we tell you how many and what types of investment options each savings plan offers, its fees and 2000 investment returns, as well as helpful information such as how to reach the plans by phone.

Edward McCartney, an executive vice-president at Fidelity Investments, which manages the Massachusetts, New Hampshire, and Delaware programs, calls the new plans "one of the best vehicles for saving for college," since they allow for tax-deferred growth. No wonder these plans are sprouting up across the nation. Since 1990, 32 states have launched these go-anywhere plans, creating a vibrant, competitive national market. An additional nine states have approved programs and are expected to get them up and running later this year. Six more, plus the District of Columbia, have legislation pending.

An important factor to weigh when choosing among 529s is the number and type of investment vehicles offered. Keep in mind that it can be difficult--and costly--to move money to a new state plan or even from one option to another within a single state's plan. You may have to shift the account to a new beneficiary or pay a penalty, typically 10% of earnings, for an unqualified withdrawal. A state with several investing options gives you the flexibility of putting new contributions into a different fund if you don't like how your first pick is doing.

While a handful of states still offers only one way to invest, the trend has been toward more choice--and more exposure to the stock market, as well as the opportunity to choose what kind of equities you want. If a large menu of investment options appeals to you, check out the Arizona, Maine, and Nebraska plans. Each offers 10 or more different portfolios. Twenty-four states either have or plan options that let you bet everything on stocks--in some cases, aggressive, growth, or even tech stocks. Thirteen offer bond funds, and 18 feature balanced funds, which are stock-and-bond blends.

There is, of course, a downside to all this choice. Higher potential returns usually mean higher risks. Many states with equity options reported losses last year in at least some of their funds. Investors who bought into Arizona's technology fund, launched Sept. 1, saw 48.2% of their savings disappear by yearend. On the other hand, Louisiana's lone, trusty bond fund reported a steady 6.51% gain.

SAFETY OPTION. Some savings plans come with a guaranteed floor. New Jersey obligates itself to giving back at least your contributions. New York, California, Connecticut, Michigan, and several others offer an option protecting your account principal and a minimum 3% return.

Many people will prefer the simplicity of the age-based portfolios offered or planned by 33 of the 41 states. This type of fund moves your contributions lockstep through a series of investment allocations, gradually shifting from mostly stocks for the preschool set to nearly all bonds for high school upperclassmen.

As investment options have proliferated, states have signed up professional money managers to run them. Many are well-known names. TIAA-CREF, which manages $280 billion for colleges and other educational and research institutions, runs 12 state plans, the most of any one manager. Salomon Smith Barney, T. Rowe Price, and Merrill Lynch also are in the business.

As states have sought Wall Street-style management, some costs have gone up, so our table reports on expenses, too. States with the lowest-cost plans include North Carolina, New Jersey, Vermont, and Utah. Arizona's is on the high side. Still, expenses are generally minimal unless you sign up for a 529 plan through a broker. That's easily avoided with most states, but a few leave you no choice. Nonresidents who want to save with Ohio or Rhode Island must go through a broker or adviser or pay additional fees of from 0.25% to up to 3.5% for Ohio. Arkansas, Maine, and Wyoming tack on a $50 annual account fee.

How much a state will let you squirrel away is another consideration. Maximums vary widely, rising from a low of around $100,000 to more than twice that much. Alaska lets parents save the most--up to $250,000. Idaho, Mississippi, New York, Ohio, and Rhode Island allow funds to grow to well above $200,000 before contributions must cease.

After checking out such variables, the decision may come down to taxes. While most of the new plans are open to out-of-state residents, parents might be better off with their own state's plan if it offers sizable tax benefits--especially if they live in a high-tax state such as New York. In that case, the tax savings could outweigh any advantage from somewhat higher earnings or lower fees. Seventeen states, including Mississippi, Missouri, and Colorado, allow a deduction on state income taxes for all or part of the money contributed. Twenty-six states exempt earnings from taxes. Generally, a deduction today is worth more than an income tax exemption for your child tomorrow. Only New Jersey, Colorado, and Arizona give the state tax exemption to residents who invest in other states' plans. No state allows residents who invest out-of-state to deduct contributions. Other benefits: Louisiana, Michigan, Minnesota, and Pennsylvania match part of the contribution, subject to income and other restrictions. New Jersey offers scholarships for students who attend in-state.

The programs also have much in common. All come with the benefit of tax-deferred growth, with earnings taxed at the child's typically lower rate when he or she pulls the money out. All assess a penalty if the money is used for noneducational purposes--usually 10% of earnings. And all benefit from a special gift-tax rule allowing for a $50,000 lump-sum contribution instead of five of the $10,000 annual tax-free gifts you can give to a child. That makes them attractive estate-planning tools for wealthy grandparents.

When deciding whether a 529 is right for you, think about your loss of investing control: Once you put money into an option, you lose the right to dictate how it's invested. Financial aid is another consideration. While money in an account is treated as an asset of the parents (or whoever opened the account), the earnings portion of anything withdrawn for college becomes income to the child, explains Joseph F. Hurley, a certified public accountant and founder of Web site, which provides information about 529s. That money can have a big impact on financial aid, since under federal guidelines, the child is expected to contribute 50% of his or her income above a minimal level toward college costs. The prepaid plans can be even more devastating. With those, aid may be reduced dollar for dollar.

Still, tax-deferred growth is a powerful lure. As anyone with an IRA or 401(k) retirement account knows, a piggybank grows fatter if Uncle Sam isn't taking his annual slice.

By Carol Marie Cropper & Anne Tergesen

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