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College Savings Plans Make the Grade

Although the birth of a child may give you joy and excitement, it also raises the inevitable question of the best way to save for Junior’s education.

A relatively new investment vehicle, known as a Section 529 plan, addresses the college savings burden. There are two types of Section 529 plans. A "prepaid tuition plan" primarily covers in-state tuition at public institutions. Basically, you purchase tuition credits or certificates on behalf of a designated beneficiary to be used at a future time. The "college savings plan" is a potentially tax-exempt account to which contributions are made on behalf of a designated beneficiary for the purpose of paying for college.

The law that created Section 529 plans in 1996 allowed each state to establish its own plan. Under the 2001 tax law, private educational institutions now are allowed to set up their own plans as well. Not surprisingly, there are many differences among the plans being offered. Among state-sponsored programs, Colorado, Florida, Nevada, Texas and Virginia offer prepaid tuition plans, while New York, Connecticut, California and New Jersey are among the states that have set up college savings plans.

Prepaid tuition plans offer good protection against continuing inflation in education costs, provided your child actually ends up attending the school whose tuition is being pre-paid. If your child goes to a different institution, the prepaid tuition generally will be worth a weighted average of the cost of tuition at in-state public schools. In contrast, the savings plan approach is more flexible. It can be readily used with any public or private institution, in your home state or elsewhere, but there is no guarantee that your Section 529 savings account will actually grow at a rate that matches the growth of education costs.

Either type of Section 529 college savings plan offers some important benefits compared to other ways of funding Junior’s education: control, tax advantages and flexibility.

Control. If you use Uniform Gift to Minors Act accounts to save for your child, you relinquish control of the money when the child reaches age 18 or 21, depending on your state. Although you may have intended that the money you socked away be used to pay for college, Junior may have a different idea. If he decides that he would rather withdraw all of the money and buy a Porsche, you cannot stop him. If you use a Section 529 plan, you stay in control. If the money is not used to pay qualified higher education expenses for Junior, you can withdraw the money or transfer it to another Section 529 account for a different beneficiary. Junior does not get his Porsche.

Tax advantages. Thanks to last year’s tax law, earnings on investments in Section 529 now can be federal tax-free rather than merely tax-deferred. Some states also grant tax exemption for withdrawals that are spent on qualified higher education expenses. Qualified expenses generally include college, vocational and graduate school tuition; room and board; and supplies. Also, you are still eligible to claim the Lifetime Learning or Hope tax credits if the higher education expenses you claim for the credit are not the same as those paid with the tax-free distribution from the Section 529 plan.

Flexibility. You are not locked into the beneficiary you designate when you initiate a college savings plan. You can roll over the assets of a Section 529 plan at any time to the account of another beneficiary tax free, provided that the new beneficiary is a family member of the previous beneficiary. In addition, you are allowed to cancel the plan or use the money for other than qualified expenses. However, you will pay income tax on the earnings, at your tax rate, plus a 10% federal penalty on the earnings. Compared with the value of long-term tax-deferred growth and the benefits of the savings plan, this may not be a terrible price to pay. Exceptions to the 10% penalty include death of the beneficiary, disability of the beneficiary or if the beneficiary receives a scholarship.

The amount you can contribute to a college savings plan varies by state. Most plans have account balance limits rather than yearly contribution limits. Currently, more than half of the plans have account balance limits between $175,000 and $250,000. These limits are not the end, though, because multiple Section 529 plans can be set up for any beneficiary. While there are no "contribution police," it would probably still not be wise to invest significantly more than you expect Junior to need when he goes to school, because earnings on the excess are likely to be subject to the 10% penalty.

One of the long-standing criticisms of Section 529 plans was their limitations on the ability to select the investment strategy and vehicle you want. Plans are gradually becoming more flexible, however, by offering more investment options and more opportunities to change among them. Each sponsor chooses its own fund managers. The plans in New York, Connecticut and California all are managed by TIAA-CREF, while that in New Jersey is managed by the state Treasury Department. Additional fund managers for other states include T. Rowe Price, Salomon Smith Barney, Vanguard and Fidelity.

Some Section 529 plans are age based, requiring you to follow a particular investment strategy depending upon the beneficiary’s age (generally reducing your allocation to stocks as the beneficiary approaches college). Self-directed plans allow you to choose a strategy regardless of the beneficiary’s age.

Contributions made to Section 529 plans are considered gifts. If you are wealthy enough to have potential exposure to gift and estate taxes, you typically would want to keep your Section 529 plan contributions below the annual gift tax exclusion limit of $11,000 per beneficiary ($22,000 for married couples). However, you can make a special election to treat an upfront contribution of $55,000 for an individual, or $110,000 per married couple, as a gift made over five calendar years. This can be a great estate-planning tool, because it takes money out of your estate while still leaving it in your control. If you change the beneficiary to someone in the original beneficiary’s generation, there is no additional gift tax. If the new beneficiary is a member of a younger generation, such as a son or daughter of the original beneficiary, the transfer is deemed a gift from the old beneficiary to the new beneficiary, thus eliminating exposure to the generation- skipping transfer tax.

The college savings plans allow you to put large sums of money away for your children. The amount that you can contribute is not limited by yearly income, whereas if you were to invest in a Coverdell Savings Account (previously known as an education IRA) you would be able to put only $2,000 away each year and you would face certain income limitations.

You can invest in any state’s Section 529 plan as long as that state accepts nonresidents. That said, it is still worth your time to investigate your own state plan first because it may offer some extra benefits to residents, such as a state income tax deduction. New York, for example, allows a deduction of up to $5,000 a year for singles and up to $10,000 a year for married couples.

You can find more information on Section 529 plans in general and the specifics of plans in your state on the Internet. One useful site is www.savingforcollege.com.

Senior Client Service Manager Rebecca Pavese, based out of Atlanta, contributed several chapters to our firm’s recently updated book, The High Achiever’s Guide To Wealth, including Chapter 3, “Being Smart About Budgets And Credit,” and Chapter 9, “Medical And Disability Insurance.” She was also among the authors of the firm’s book Looking Ahead: Life, Family, Wealth and Business After 55.
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