College savings vehicles.

Today, it can cost over $35,000 per year to send a child to private college. Even in-state public universities can run over $10,000 per year. With these hefty costs staring parents in the face, it is no wonder they seek advice on how to reduce the burden. For years, tax advisers and financial planners have been formulating college-funding strategies designed to save taxes; yet the task continues to get more difficult and complicated. Federal tax roles have not changed much since the enactment of the Taxpayer Relief Act of 1997 (TRA '97), but the addition of new qualified tuition plans and the modification of already existing plans, state tax rules and changes in the economy continually affect funding strategies.

The TRA '97 provided much-needed aid to parents planning for their children's college education. It not only provided help in the form of the Hope Scholarship and Lifetime Learning Credits, but also created new planning investment vehicles, such as the Education IRA and college savings programs (CSPs). While the Education IRA disappointed parents and planners alike, (because of adjusted gross income (AGI) and maximum contribution limits), CSPs are gaining popularity as states improve their offerings. The changes raise the question of the "best" college funding strategy, which is more difficult to answer today than ever before.

Pre-TRA '97

Before the TRA '97, tax advisers focused on the income tax and estate tax benefits of transferring assets to a child using custodial accounts under the Uniform Transfers to Minors Acts (UTMAs) and the Uniform Gifts to Minors Acts (UGMAs) (see Exhibit 1) and irrevocable trusts (see Exhibit 2). This analysis centered on whether tax benefits were sufficiently large to outweigh the costs associated with masts, as well as the lack-of-control issues pertaining to custodial accounts (and, to a lesser extent, to trusts).

Exhibit 1: Custodial accounts (UTMA/UGMA)

* A custodian controls funds for a minor until he reaches the age of majority, which varies by state. Generally the age is 18, but it can be as high as 21.

* A custodian may not withdraw money, except for expenses that benefit the child. It is an irrevocable gift to the child.

* If a donor acts as an account's custodian, the value of the account will be included in the donor's gross estate. To avoid this, often one spouse makes a gift and the other spouse acts as the account's custodian.

* Generally, each individual can transfer up to $10,000 per year ($20,000 if a joint election is made) to an account without incurring Federal gift tax.

* The annual income is subject to kiddie tax for a child under age 14. For 2000, the first $700 of the child's income is tax-flee and the next $700 of income is taxed at the child's rate (presumably, 15%); any additional income is taxed at the parent's Federal marginal tax rate.

Exhibit 2: Irrevocable trusts

* A trustee makes all investment and distribution decisions, pursuant to the trust's terms.

* The provisions of a trust document cannot be changed. They dictate what funds can be used for, as well as how often and at whose discretion they can be withdrawn.

* Assuming a mast is properly drafted, generally, a donor will not include the funds in his gross estate:

* The annual gift tax exclusion of $10,000 ($20,000 if a joint election is made) applies.

* Generally, a trust not required to fully distribute its income annually pays no Federal income tax on its first $100 of taxable income. If it has to fully distribute its income annually, it is allowed a $300 annual exemption.

* Any income and capital gains not distributed by the trust are generally taxed at the mast's income tax bracket. The top Federal marginal bracket is reached at a relatively low income level (only $8,650 in 2000).

Sometimes a simpler solution better meets a client's needs. Simply saving for a child's costs in an investment account may be a viable alternative, because there are no incremental cost or control issues. In these cases, U.S. Series EE Savings Bonds (see Exhibit 3) may be appropriate, because they can provide Federal and state tax savings. While EE bonds are not expected to produce relatively high rates of return, they are insulated from losing value during a stock or bond market downturn. As a matter of fact, unlike other bonds, they actually benefit when interest rates increase.

Exhibit 3: U.S. Series EE Savings Bonds

* Interest earned on EE bonds is tax-deferred until withdrawn.

* Subject to an AGI limit, the interest earned may be excluded from income to the extent that bonds are used for college costs and the following requirements are met:

1. Bonds must have been purchased after 1989.

2. Bond owner must be at least 24 years old before the bond's issue date.

3. Bonds must be in the bond owner's name.

4. Bond proceeds must be used for tuition and fees for a dependent, spouse or the bond owner, at a qualifying educational institution. Qualified expenses include contributions to a qualified state tuition program or an Education IRA.

* The EE bond interest exclusion is phased out by a modified AGI limit. The phase-out occurs between $81,100-$111,100 for married filing jointly, and from $54,100-$69,100 for single or head of household filers. Those who file married filing separately are not eligible for the interest exclusion.

Even after the passage of the TRA '97, advisers must still continue to consider these three strategies when determining how to best meet their clients' college-savings goals.

The TRA '97

The TRA '97 introduced several new options. It created a new tax-advantaged savings vehicle, the Education IRA (see Exhibit 4), the Hope and Lifetime Learning Credits (see Exhibit 5) and Sec. 529.

Exhibit 4: Education IRA

* A contributor is the owner and, consequently, makes investment decisions for an account.

* A taxpayer cannot contribute to both an Education IRA and a qualified state tuition program in the same tax year.

* Subject to AGI limits, each taxpayer may make nondeductible contributions of up to $500 per year for each designated beneficiary under age 18.

* The $500 contribution amount is phased out for single filers with AGI between $95,000-$110,000, and for joint filers with AGI between $150,000-$160,000.

* Distributions are exempt from Federal income tax if used for qualified higher education expenses by the time a beneficiary reaches age 30.

* To the extent distributions are not used for qualified higher education expenses, earnings are taxed as ordinary income to the contributor and subject to a 10% penalty

* Education IRAs are not included in a donor's gross estate; rather, they are included in the beneficiary's gross estate.

Exhibit 5: Hope Scholarship and Lifetime Learning Credits

* Subject to AGI limits, the Hope Credit provides a nonrefundable Federal income tax credit equal to 100% of the first $1,000 and 50% of the second $1,000 spent on postsecondary tuition and fees. This credit is only available for the first two years of postsecondary education.

* The $1,500 Hope Credit maximum applies on a per-student basis. Thus, it is possible to take advantage of this credit more than once in the same tax year if two or more children are enrolled in college.

* The Hope Credit maximum will be indexed for inflation starting in 2002.

* The Lifetime Learning Credit provides a nonrefundable credit of 20% of up to $5,000 of qualified tuition and fees paid during the tax year, subject to AGI limits.

* There is no limit on the number of years for which a taxpayer can claim the Lifetime Learning Credit for each student.

* The Hope and Lifetime Learning Credits are phased out for modified AGI levels between $80,000-$100,000 if married filing jointly, and $40,000-$50,000, if single, head of household or a qualified widow(er).

* Tuition payments made from a qualified tuition program account or an Education IRA will be eligible for the Hope or Lifetime Learning Credits.

College Savings Options

Qualified tuition programs are the most complex college savings options. There are two types: prepaid tuition programs (see Exhibit 6) and CSPs. These programs were granted beneficial tax treatment by the TRA '97, which added Sec. 529 to the Code.

Exhibit 6: Prepaid tuition programs

* Generally, prepaid tuition programs only cover tuition and mandatory fees.

* Participation in a prepaid tuition program is generally restricted to residents of a particular state.

* Generally, a limited state tax deduction is available for contributions made.

* The earnings on prepaid tuition programs are tax-deferred until withdrawn.

* The difference between the purchase price and the amount paid for qualifying tuition and fees will be taxed to the student as ordinary income over the number of years the benefits are used.

* If the prepaid tuition proceeds are not used to pay qualifying higher education expenses, they will be subject to a penalty, the amount of which varies by state.

* Funds can be used at any university approved by the Department of Education. This list includes some foreign universities.

* Contributions are eligible for the $10,000 ($20,000 joint) annual gift tax exclusion. Moreover, each taxpayer can accelerate up to five years' annual exclusions to minimize the gift tax on contributions.

* Funds invested in prepaid tuition programs are excluded from both the donor's and the beneficiary's estates. There is an exception if the donor dies during the special five-year period granted for the annual gift tax exclusion.

Prepaid tuition programs. Prepaid tuition programs often come up a little short on two counts. First, states generally restrict the prepaid tuition programs to state residents. This can be quite burdensome if a child decides to go to an out-of-state school, and the total value of the plan does not fully cover actual costs. Second, by definition, the money contributed to a program will earn a rate of return equal to the inflation rate of the applicable state's average tuition. According to the 1998-1999 College Board Annual Survey, last year, the average inflation rate for tuition charged by public four-year colleges and universities was approximately 4%. This is significantly less than the return most investors earned during that same period and much less than the annual 7-9% tuition inflation rates experienced when prepaid tuition programs were first conceived.

CSPs. The big news in college funding is CSPs. The number of such programs continues to grow and their features have been changing dramatically in an effort to offer greater benefits as states compete with each other for applicants' college funds.

The benefits of CSPs include:

1. All investment earnings are tax-free until withdrawn.

2. When withdrawn, investment earnings are taxed at the beneficiary's tax rate for Federal income tax purposes, as long as he uses the funds for qualified education expenses.

3. For state tax purposes, such withdrawals may also be tax-free, depending on the state of residence and the state program used

4. Some states (such as New York) provide a limited deduction for contributions made by state residents to their programs.

5. Contributions are eligible for the $10,000 ($20,000 joint) annual gift tax exclusion. Moreover, each taxpayer can accelerate up to five years' annual exclusions to minimize the gift tax on contributions. Therefore, if a joint election is made, $100,000 per child can be contributed gift tax-free in a single tax year.

6. Funds invested in CSPs are excluded from both the donor's and the beneficiary's estates. There is an exception if the donor dies during the special five-year period granted for the annual gift tax exclusion.

7. Funds can be used, Without penalty, for all qualified education expenses, including housing costs and student supplies (e.g., books, computers, etc.).

8. Funds can be used at any university approved by the Department of Education, including some foreign universities.

9. Under most circumstances, any individual can use CSPs, regardless of his or a beneficiary's state of residence.

10. Any individual is eligible to be selected as a beneficiary. Once a beneficiary has been chosen, a contributor can change the beneficiary by selecting another member of the original beneficiary's family.

The disadvantages of CSPs include:

1. Similar to other transfer strategies, the contribution is not eligible for the additional gift tax exclusion for tuition payments.

2. Each state limits the amount that can be contributed to its plan on behalf of any one beneficiary. This amount currently ranges from $100,000-$168,000.

3. To the extent withdrawals are used for something other than qualified education expenses, the state will charge a penalty when withdrawn. Currently, states will keep 10%-15% of any amounts withdrawn and used for an ineligible purpose.

4. Most states' plans charge annual management fees, which can be as high as 1.86% per year.

5. Some states charge an enrollment fee. Frequently, the fees charged to nonresidents exceed those charged to residents of the state sponsoring the plan. Sometimes these fees can be waived if a minimum account balance is met.

6. Neither the contributor nor the beneficiary controls the investment decisions.

7. Investment performance has varied dramatically among state plans, due to risk preference and manager success.

8. Because CSPs are relatively new, no long-term investment performance information is yet available.

Investment performance. One of the greatest differentiating factors between programs offered by various states is expected investment return. The differences in the expected returns and risks of these tax-advantaged vehicles can be so great that it is often appropriate to forgo special state tax savings of a resident's state's plan and instead invest in another state's plan to achieve the desired investment risk and return.

Most states use a professional investment firm (such as TIAA-CREF, Merrill Lynch, Salomon Smith Barney or Fidelity,) to manage their CSP investments. While the security selection decisions made by the particular investment manager contribute to the difference in the investment performance of these plans, the major differences in the expected investment returns and risks of the various states' CSPs come from their asset allocation requirements.

Studies have shown that, by far, the greatest contributor to the return and risk of a long-term portfolio is the asset allocation decision. As noted, neither a contributor nor a beneficiary of a CSP may make investment decisions; the plan determines the asset allocation for all assets contributed to the program.

Currently, most states offer an asset allocation based on a beneficiary's age. In the child's younger years, the age-based option exposes the portfolio to more risk, by allocating more of the funds to equity investments. As the child grows older, more and more of the funds are allocated to bonds and cash, which decreases the amount of risk in the portfolio as the date the first tuition check needs to be written nears. This strategy makes good sense, because most parents do not want to see their child's college funds decline in value by more than 10% (as has occurred more than once this year already) ,just before "Junior" is about to go to Stanford.

Even though most states offer age-based options, they vary greatly from state to state. For example, New York's CSP is run by TIAA-CREF and provides an average equity exposure of 38.6%. In contrast, New Hampshire, Massachusetts and Delaware use Fidelity's CSP, which provides an average equity exposure of 58.8%. This can have a huge impact on the projected savings needed to fund college costs, as well as the probability of having sufficient assets in that fund to pay these costs.

In an answer to some taxpayers' desire for a larger amount of equity exposure (or in some cases, smaller), some states now offer fixed options. Maine and Wyoming, for example, currently offer options that invest 100% of the funds in equities (or 75% of the funds in equities) for the life of the account. Arkansas and Missouri, on the other hand, have created a 100% bond option. Many states are looking to offer one or a combination of these fixed portfolios in the near future.

These fixed options provide investors with as many benefits as they do disadvantages. The greatest benefit of fixed options is the ability to select an asset allocation that meets a client's specific investment objectives. However, the greatest disadvantage is that the asset allocation will be fixed. For example, an investment entirely in stocks will be in stocks until withdrawn. While an all-equity allocation may be appropriate for funding a baby's college costs, it is probably too risky to use a year before the child goes to college.

A fund's desired long-term investment strategy must be determined up front; the investment may be in existence for a long time and, once the money is invested in the CSP, control over its asset allocation ceases. It is critical to make sure the asset allocation requirements of the selected CSPs are appropriate to meet investment objectives today--as well as in the future.

Plan evaluation. When evaluating CSPs, it is important to keep in mind not only that they are not all the same, but also that their availability and features change frequently. Eighteen months ago, only 15 states had plans available. Soon 40 states will offer them.

The following is a three-step process for evaluating which CSP is best suited to a client's needs:

* Step 1: Determine which programs are available for consideration, based on state residency requirements. (For example, New Jersey's plan is currently available only to resident contributors or beneficiaries of New Jersey.)

* Step 2: Eliminate from consideration programs that do not offer an asset allocation strategy consistent with a fund's long-term investment objectives. At times, it may be necessary to use two different states' CSPs to achieve a desired result.

* Step 3: Rank the remaining plans based on investment performance expectations. Unfortunately, the history of investment risk and returns for CSPs is short. However, two known variables may affect the rate of return expectation for various state plans. Based on the current terms of the CSPs under consideration (as well as a contributor's and a beneficiary's residence), there may be (1) special state tax deductions or credits available that would increase the expected overall return of a particular state's plan and/or (2) an annual state maintenance and/or management fee(s) imposed on plan assets, which would result in a negative adjustment to an expected return computation.

Advisers should also compare the pros and cons of the selected plan with all the other alternatives--Education IRAs, custodial accounts, irrevocable trusts and U.S. Series EE Savings Bonds. When formulating an appropriate college savings strategy, it is critical to evaluate both the tax and the financial aspects of all the possible alternatives.

Barbara J. Raasch,
CPA, CFA
Partner-in-Charge of Investment
Advisory Services

Anthony Amitrano,
M.S., Tax
Senior Tax Consultant
Ernst & Young, LLP
New York, NY