Miracle Grow - tax breaks on college savings

Kiplinger's Personal Finance Magazine, Sept, 2001 by Kristin Davis

EDUCATION | A powerful new mix of TAX BREAKS can fortify your college savings. By Kristin Davis

THERE ARE 11 college graduations in Tom Grzymala's future--and he'll happily sit through all of them. A generous man, he's invested more than $75,000 in the future diplomas of his grandchildren, who range in age from 8 months to 12 years.

Until now, Grzymala, a financial planner in Alexandria, Va., has parked the money in separate custodial accounts in the children's names. But he's about to change course, thanks to the recently passed tax legislation that heralds a seismic shift in the college-savings landscape.

The legislation, most of which takes effect beginning in 2002, vastly improves state-sponsored college-savings plans, also known as 529 plans, primarily by making their earnings tax-free. And it repairs the lame tax-free education IRA by raising the limit on contributions from a feeble $500 to a reasonable $2,000 per year. By comparison, the tax benefits of saving in a child's name using a custodial account seem anemic.

That's why Grzymala is about to brave a blizzard of paperwork to roll his grandkids' accounts into Virginia's college-savings plan. "All the money that would previously be taxed coming out of a custodial account will now come out tax-free," he says. And he'll get a big state-tax deduction for the rollover, plus up to $2,000 a year for future contributions to the kids' accounts. Considering the powerful benefits, it's no wonder he's advising his clients to consider a similar switch.

The new rules

STATE college-savings plans have always been appealing, with earnings that were tax-deferred and then taxed at the student's rate when used to pay college bills. But freeing the earnings from taxes altogether makes 529 plans almost irresistible. Consider what happens to $100 a month invested over 18 years at 10%. In a taxable account, with taxes shaving 27% from the earnings each year, your savings grow to nearly $45,000. The same amount invested in a 529 plan under the old rules--and taxed at 15% when withdrawn--provides you with a spendable college stash of about $55,000. Now, with tax-free earnings, your college fund reaches about $60,500.

The states are expected to follow suit and exempt earnings from state taxes, too. Even better, about 20 states allow residents to deduct contributions on their state tax returns.

Even with just tax-deferred earnings, 529 savings plans had a lot going for them. You can contribute no matter what your family's income, and the contribution ceilings are high--more than $200,000 in some states. You can open an account with as little as $25 or $50, and anyone can add to the kitty, making the plans a great place for Grandma or Aunt Sue to direct the occasional birthday or holiday gift. The money may be used for qualified higher-education costs (tuition, room, board, books and transportation) at any accredited college in the U.S., and some foreign institutions.

And a reassuring benefit to many parents is that the account owner controls the money until it's used for college--unlike a custodial account, of which the child gains control at age 18 or 21 (or occasionally 25). So if your child snubs the academic life, you could transfer the account to another family member with anticipated college expenses--yourself included. The new law also lets you transfer accounts between cousins, which is a boon for grandparents who might want to shift funds among their grandchildren. You could even take the money back for another purpose, although the earnings would then be taxable and you'd pay a penalty equal to 10% of earnings.

Better investments

THE FLEXIBILITY and tax benefits make 529 plans almost perfect havens for college savers. The spoiler is that the state controls your investment options, and once you choose one you can't change your mind. But even that flaw is less of a limitation than it used to be because states are expanding their investment choices, and the new law gives you an easy out.

Most 529 plans rely on "age-based" portfolios of mutual funds that invest mostly in stocks when a beneficiary is young and gradually shift to bonds and money-market funds as the child ages. That's exactly how a parent should invest for a child's college expenses, gradually tamping down risk as the tuition bills near--so these self-adjusting portfolios can be blessedly simple buy-and-forget investments. But experienced investors in many states have found the one-size-fits-all choices too conservative. In New York, for instance, the original managed portfolio was 25% in bonds for a newborn, and reached a 50-50 split between stocks and bonds by the time a child reached age 8. That's just too conservative for many investors' tastes.

So now states are adding more choices, such as multiple age-based portfolios with conservative, moderate and aggressive asset allocations, as well as 100% stock and fixed-income funds that can be used alongside an age-based portfolio to fine-tune the overall allocations to suit you. Nebraska's plan, managed by Union Bank & Trust, offers investors a generous ten choices: four age-based portfolios and six other mutual funds, including an S&P 500 index fund. Like savings plans in 29 other states, Nebraska's plan is open to any U.S. resident.