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Saving for college.

The cost of college these days is staggering. Attending a public university for four years can cost considerably in excess of $50,000, and possibly twice as much at a private school. These costs are rising on an average of about five percent per year. However, thanks to some generous tax law changes, it is now much easier to save for college. A 529 college savings plan and/or a Coverdell Education Savings Account, if you qualify; are the answers.

Saving in a Child's Name

In the past, a popular way to minimize taxes was to save in a child's name (a custodial account or a Crummey trust) to take advantage of his/her lower tax rates. For children under the age of 14, "kiddie tax" may be a problem. More important, the savings in your child's name is an irrevocable gift. Your child will gain total control of the account at the age of majority for a custodial account or at the age designated in the trust document for a Crummey trust So, he/she can choose to use the money to buy a luxurious yacht instead of furthering his/her education. In addition, as the account is viewed as the beneficiary's asset, it will have a negative impact on your child's ability to receive financial aid (children are expected to contribute 25% to 35% of their assets for college).

Coverdell Education Savings Accounts

Coverdell Education Savings Accounts (CESAs, formerly known as Education IRAs) have been around for awhile. Before the annual contribution limit was increased from $500 to $2,000 in 2002, CESAs were often criticized as not being worth the trouble. Now, if you contribute the maximum of $2,000 each year, it can grow to over $80,000 in 18 years, assuming an 8 percent annual return. However, your ability to make CESA contributions is phased out between an adjusted gross income of $95,000 and $110,000 (if single) or between $190,000 and $220,000 (if married and filing jointly).

CESA earnings build up tax-free and the money can be withdrawn to pay the beneficiary's elementary, secondary and college expenses. If the beneficiary does not incur enough expenses to exhaust the account before the age of 30, the balance can be rolled over tax-free into another family member's CESA. Otherwise, earnings are taxable as ordinary income and subject to a 10 percent penalty.

Compared to a 529 plan, a CESA allows you to have total control over the investment of the account. If you open a CESA at a brokerage house, you can invest in stocks, bonds and mutual funds. If you want to be safe, open the account at a bank and invest in certificates of deposit. A disadvantage of the CESA is that under the federal methodology of determining financial-aid eligibility, a CESA is viewed as the beneficiary's asset. Once you withdraw funds from the account, the earnings will be viewed as the beneficiary's income and can be assessed at up to 50 percent in the following year's financial-aid eligibility review. Unless your child is close to college age, potential effects on financial aid should not deter you from taking advantage of generous tax breaks in saving for college. In addition, a lot of financial aid comes in the form of loans instead of grants.

529 Plans

A 529 plan is so called because this college savings vehicle is governed by Section 529 of the Internal Revenue Code. There are actually two types of 529 plans: p repaid college tuition plans and college savings plans.

A prepaid college tuition plan generally only enables you to prepay the tuition of certain public in-state colleges. Therefore, you will not save enough to pay for other higher education expenses or to attend private colleges. Under the federal methodology, money in a prepaid college tuition plan is viewed as an outside resource, which means that the beneficiary's financial-aid needs can be reduced dollar-for-dollar. Because of these two drawbacks, these older 529 plans have become less popular.

When withdrawals from a 529 college savings plan account became federally tax-free starting in 2002--if used for (and only for) college expenses--the 529 college savings plan became the most popular option to save for college. Many of these state-sponsored plans let you contribute more than $200,000, compared to the $2,000 annual limit for CESAs. Of course, you need to be careful about potential gift-tax implications (though, these plans allow you to spread a large, single lump-sum contribution over five years for gift tax determination). In addition, before you withdraw, assets in these plans are typically viewed as the parents' assets, meaning that they are assessed at a rate of less than six percent for financial-aid eligibility. Similar to CESAs, once the funds are withdrawn from the account, the earnings will be viewed as the beneficiary's income.

You can contribute to a 529 college savings plan regardless of the amount of your income. In contrast, CESAs are phased out for high earners. With a 529 college savings plan, you can generally change the beneficiary of the account to another family member without tax consequences. In case of nonqualified withdrawals, earnings are taxable as ordinary income and subject to a ten percent penalty.

Each state (except Washington) and the District of Columbia has at least one 529 college savings plan, and most of them are open to both residents and non-residents. (Washington plans to roll out its 529 plan by mid 2003.) How do you choose among these plans? Start by checking out your own state's plans. Many states offer tax deductions or other incentives of varying generosity. Sometimes, these benefits can be large enough for you to go with your state plans even if they are not perfect. In addition, there are other issues to consider: investment choices, performance, expenses, and flexibility.

Investment Choices. While CESAs are self-directed, 529 college savings plans work more like 401(k) plans in that you are offered only a small number of investment options. The better ones offer both age-based portfolios (ones that automatically increase the ratio of bonds in the account as the beneficiary gets older) and static portfolios (e.g., stocks, bonds, balanced, guaranteed income). Some plans, in contrast, offer only one investment option. When choosing a plan, consider whether it offers an investment option that matches your risk tolerance and how often you may transfer your money among different options.

Performance. Similar to saving for retirement, the quality of available investment options is as important, if not more important, as the quantity. When you compare different plans, be sure to compare apples with apples. For example, returns in each age band of an age-based portfolio should be compared with returns of portfolios in a similar age band in other plans. For static portfolios, investment options should be compared against others with similar asset allocations, e.g., an all-equity option against other all-equity options.

Expenses. Charges include one-time enrollment fees and broker sales loads, annual maintenance fees and annual management fees. An annual maintenance fee of $30 represents one percent of a $3,000 account but is only one-tenth percent of a $30,000 account. Therefore, the effect of an annual maintenance fee depends on the size of your account. Total annual expenses of less than one percent can be considered as low. Keep in mind that nonresidents typically pay higher fees than residents and that it is desirable to avoid paying sales loads.

Flexibility. Review the plan documents to see (a) whether you are allowed to change the beneficiary, (b) whether there are any limits on the age of the beneficiary, and (c) what sort of penalties are imposed by the plan for nonqualified withdrawals.

Websites maintained by College Savings Plans Network (www.collegesavings.org) and by Joseph Hurley (www.savingforcollege.com) provide you with plenty of basic information that you need to decide which state's plan is best for you.

Finally, don't think of 529 college savings plans and CESAs as mutually exclusive. If you qualify, consider funding both.

Wing W. Poon is Assistant Professor in the Department of Accounting, Law and Taxation, Montclair State University, Upper Montclair, NJ. He can be reached at poonw@mail.montclair.edu.
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Author:Poon, Wing W.
Publication:The National Public Accountant
Date:Jul 1, 2003
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