College Bound - state college-savings plans

Kiplinger's Personal Finance Magazine, August, 2000 by Kristin Davis

EDUCATION | State-run SAVINGS PLANS are making great strides. Which one is best for you?

WITH TWO MEDICAL DEGREES in the family--and lots of education debt--Paul and Heidi Gels know how expensive college can be. No wonder their 18-month-old, Aiden, already has a college fund. But what may be surprising is that his tuition kitty resides 2,000 miles away from the Geises' home in Pittsburgh--in Utah's college-savings plan. "We hope to have a large family and would like them all to be able to go to whatever school they can get into," says Paul Geis, who does cancer research at Allegheny General Hospital. It will take "a staggering amount of money, and I thought we would have the best chance for good returns in the Utah plan."

Utah is among several states that have dramatically improved their college-savings plans in the past year. The chief upgrade is a menu of four investment options, including the one the Geises chose--a portfolio that will invest exclusively in a Vanguard S&P 500 index fund until Aiden turns 9. Then the plan will begin trimming risk, but it will still be 75% in stocks when he is 16. The Geises could also have chosen to keep their money entirely in stocks, entirely in bonds, or, by opening two accounts, in any combination of the two.

Until now, most state-run plans have tended toward a single investment track with more timid asset allocations. Geis, for instance, says he decided against the Fidelity-run plan in New Hampshire and the Merrill Lynch plan in Maine because they retreated from stocks too quickly. But now Maine--along with California, Illinois, Indiana, Kansas and Wyoming--offers a range of investment choices, so you can determine how aggressive you want to be. More states are certain to follow the trend.

In addition, 14 states have added new plans, and some existing plans have waived fees, reduced penalties and expanded tax breaks. But while a good bet for college savings is getting even more exciting, some states' plans are still clearly better than others. Luckily, you're not limited to your own state's offering--24 state-run savings plans are now open to any U.S. resident, and all allow you to use your money to pay expenses at any accredited college in the U.S.

Savings plans 101

YOUR COLLEGE SAVINGS get a potent kick when you use state-sponsored college-savings plans (also known as 529 plans, after the section of the tax code that governs them) because your money grows tax-deferred until it's used for college. Then, the earnings are taxed in the student's tax bracket (usually 15%). Some states also allow residents to deduct contributions on their state-tax returns; others make earnings tax-free for residents. Some states give citizens both breaks.

To see the power of the federal tax break, consider what could happen to a single $1,000 investment over 18 years, assuming a 10% annual return. In a taxable account, with the IRS claiming 28% of the earnings each year, the account would grow to $3,495. In a college-savings plan, it would grow to $5,560 and, after paying tax on the earnings in the 15 % bracket, you'd have $4,876. That gives you nearly 40% more money to pay college bills simply by keeping the IRS away from annual earnings. (There's a good chance that within the next few years, Congress will make college-savings-plan earnings completely tax-free.)

Tax deferral works for you whether you choose a savings plan, which invests your money in mutual funds or similar accounts, or a prepaid-tuition plan, which promises that your payments today will cover tuition tomorrow no matter how much costs rise. If you're saving over the long haul, savings plans let you reach for stock-market returns, which are likely to outpace tuition inflation. There's a risk, of course, that you'll lose money in a prolonged bear market, but you're not necessarily insulated from losses in a prepaid plan, either (see "Failing Grades".)

Savings plans have other benefits, too. You can participate no matter what your household income and can contribute far more than the $500 a year that's allowed in an education IRA. (The maximum is as high as $160,000 in some states.) And because the account owner--usually a parent--controls the money until it is used for college, there's no way Junior could empty the account at the nearest car dealership.

However, you pay a price for the privilege of watching your savings grow tax-deferred: Once you choose an investment path in a college-savings plan, you cannot change it. So it may be wise to hedge your bets by investing monthly or annually, rather than committing a large lump sum. That way, if you're not happy with the performance of your current plan--or if better choices open up later--you can direct new investments elsewhere. You can also spread your investments among several state plans--as Geis intends to do for Aiden's future siblings. And though it involves some pretzel twists, it is possible to move money from one state plan to another, and to change your investment choice in the process. To switch, you'd have to name a new beneficiary, make the rollover, then change back to the original beneficiary.