Save for College with 529 Plans, Aug 05 | Be Financially Prepared for Your Kids’ Higher Education


My two grandnieces start college this fall. I hope they haveas wonderful a time earning an undergraduate education as my four childrendid from 1984 through 1993. The only problem is that, even with scholarships,I estimate their expenses will be two-and-a-half times more than we had toendure.

Fortunately, my grandnieces and their parents are financially prepared—mostly,so long as the children get jobs and are prepared to pay for unforeseen expensesout of their own pockets.

Lord knows, their tasks haven’t been easy. When the market averageswere climbing ever higher during most of the 1990s, it looked like smooth sailing.However, the recession of 2001-03 made it tough going.

While past performance is no guarantee of future performance, records showthat over time, the stock market performs at an average annual rate of 7 percentand the bond market at an average annual rate of 4 percent. The important thingis to get started early and to make regular contributions to a solid program.

When I was saving for college, my tools were uniform gift to minors accounts(UGMA) and uniform transfer to minors accounts (UTMA). These accounts weresubject to taxes. The Tax Reform Act of 1987 made them taxable at the parents’ ratesif the children were under the age of 14, so they lost their attractiveness.

529 plans, which were invented to allow parents to overcome tax problems,also have drawbacks. Nevertheless, I still think they are a reasonable wayto save for college. The major advantage is that investors do not have to paytaxes on the earnings when withdrawn—if the money is used to pay forsuch qualified expenses as tuition, fees, books, and room and board. I shouldpoint out that it most definitely cannot be used to repay student loans. Thenit would be taxed at the student’s rate.

However, the provision in the tax code that allows for tax-free withdrawalsis due to expire in 2011. In tax parlance, it’s known as the “sunset” provision.Unless Congress agrees to extend the provision, earnings will be taxed at thebeneficiary’s rate.

Given the increasing calls for fiscal restraint in Washington, it does notseem likely that tax breaks for 529 plans could expire in 2011. I find it hardto imagine that politicians would decide that tax breaks for 529 plans, whichhave gained wide acceptance among middle-class voters, should be on the choppingblock.

Christine Benz of Morningstar, the company that tracks and rates annuitiesand mutual funds, notes that assets in 529 plans in 2004 jumped 50 percent,so politicians may well extend the current tax treatment of 529s to avoid offendingimportant constituents.

Benz also points out that even if Congress does not renew the current taxtreatment for these plans, it would not be a complete disaster for 529 holders.They would still enjoy tax-deferred compounding, and withdrawal of investmentearnings would be at the student’s own, presumably lower, income taxrate, not that of their parents.

Under the current framework, each state is responsible for setting up itsown plan, and some have clearly been asleep at the switch. They have chosenfund groups with high fees, limited choices, and substandard performances.However, investors are free to choose plans from other states.

For example, the Utah plan, which Morningstar cites as one of the best, useseffective funds. However, it tacks on a 0.25 percent administrative fee inaddition to the fees that the funds charge, and also charges an annual maintenancefee. Nevertheless, its overall plan expenses are far lower than the expenseratio of most mutual funds. Morningstar lists Alaska, Kansas, Colorado, andVirginia as offering solid, reasonably priced 529 plans.

Another concern investors express is: What happens to 529 assets if the studentdoes not go to college? They pay a 10 percent penalty on assets that are notwithdrawn for qualified college expenses.

That penalty can be avoided if the assets are transferred to another beneficiaryin the family. Moreover, some 529 plans do not require making withdrawals ata certain age. That means the student has the option of tapping 529 assetslater in life.

Investors also have expressed concerns about 529s limiting a student’sability to gain financial aid. Most financial aid calculations look more favorablyon assets held in the parents’ name—as is the case with 529 plans—thanthey are with UTMA/UGMA accounts, which are held in the student’s name.

So, relative to some other tax-advantaged savings vehicles, 529 plans maybe a better choice when it comes to financial aid. However, don’t takemy word for it. See your friendly neighborhood financial advisor. And remember:If you think education is expensive, try ignorance.