How to Ace Saving for College - state-sponsored savings plans for college

Kiplinger's Personal Finance Magazine, Feb, 1999 by Kristin Davis, Margaret Ringer

THE BEST STATE SAVINGS PLANS ARE OPEN TO ALL AND CAN BE USED ANYWHERE.

A few short years ago, state-sponsored college-tuition plans were not serious contenders for your college savings. Only nine states offered them in 1995, mostly to their own residents and mostly on the premise that you could pay tomorrow's tuition at today's prices. But that was before a landmark tax decision converged with wide. spread disappointment over the new education IRA, which puts a measly $500-a-year cap on contributions,

Today, 34 states offer tax-advantaged tuition-savings programs, and the best programs promise to be a popular--and sensible--way for parents in any state to save for their children's education.

Corinna and Arnold Huntrods of Collins, Iowa, pounced on the chance last fall to join their state's brand-new plan. For each of their three daughters--Erin, 12, Kate, 7, and Jenna, 6--the couple contributed $2,000, which earned them a hefty $6,000 deduction on their Iowa income-tax return.

What makes Iowa's plan--our favorite among those operating so far--and many of the other new plans so attractive is the opportunity to earn stock-market returns on college savings you don't need right away. The Huntrods family's money is invested in Vanguard Life-Strategy Portfolios, a group of four funds tailored to the number of years a child has before entering college.

The younger girls' money is in Vanguard Life-Strategy Moderate Growth fund, which invests in a mix of 60% stocks and 40% bonds; it returned an annualized 16.5% over the three years to December 1. (Contributions for children under age 6 are invested in a more aggressive growth fund that returned an annualized 18.6%.) Their older sister's account is in the Life-Strategy Conservative Growth fund (annualized return, 14%), which holds about 40% stocks and 60% bonds. When Erin turns 16, her money will shift into the portfolio's income fund, which holds 80% in bonds (annualized return, 11.6%).

That strategy limits risk while paying significantly more than the U.S. savings bonds the Huntrodses cashed in to fund the accounts. Plus, their savings may get an extra boost: a prorated share of earnings from an endowment fund that Iowa has set up to receive contributions from corporations, foundations and individuals.

An even bigger draw for the Huntrodses is that their savings can be used for tuition, room and board, and other expenses at any accredited college in the U.S. They especially want to keep options open for Erin, who is deaf. "A state school might be fine," Corinna says, "but there are schools for deaf students, and we want the flexibility for her to be able to go there." In fact, while it is widely believed that state-sponsored plans restrict your choices to in-state public schools, most allow you to take your savings to any accredited institution in the U.S., public or private, without penalty.

Then there are the tax benefits. Thanks to a federal law passed in 1996, contributions to state college-savings plans grow tax-deferred until the money is used to pay for college. Then earnings are taxed in the student's bracket. States are free to add their own tax advantages: Iowans, for instance, can earn a state-tax deduction of up to $2,000 per contributor per account each year, and earnings in the plan are free from state income tax.

Most plans allow relatives and friends to open an account for a child or contribute to an existing account. "We've suggested it instead of buying gifts for Christmas or birthdays," says Corinna.

Of course, there is a catch. If you don't use the money for college, you're hit with a penalty, often 10% or 15% of your accumulated earnings or 1% of the account balance. The harshest penalties are levied by Alabama and Florida, which return only your contributions, with no earnings. But even if your child decides not to go to college, you may avoid a penalty by transferring the account to another family member--or by deferring use of the money in case the beneficiary attends college up to ten years later.

GO TO THE HEAD OF THE CLASS

If the states that offer any kind of college-savings plan were a graduating class, Iowa would be the valedictorian and New York the salutatorian (both earn an A on our report card, which begins on the next page). Those states, and nine others, have no residency requirements for contributors or beneficiaries, so if you don't like what your own state offers, you can enroll in one of them (though without the special benefits enjoyed by state residents).

Nineteen states offer prepaid-tuition plans, which essentially limit the growth of your account to the rate of public-college tuition increases in your state. Some art tuition "contracts," in which you agree to prepay a set amount in a lump sum or monthly installments. Others sell "units" or "credits," each worth a percentage of future tuition and fees, which you can buy irregularly or on a schedule.

Prepaid plans were more attractive a decade ago, when tuitions were rising 8% to 9% annually. But tuition hikes have slowed to between 4% and 5%, on average, according to the College Board. Considering the tax benefits, that's a satisfactory return for money you'll need to use in three years or less. But parents of young children should aim for higher returns.