College Cash

Tax-free savings for higher education

Karen Dewolski wants to go to Harvard. She knows she needs top grades, plenty of extracurricular activities, and, of course, the test scores. Her parents, Scott and Rachel, know that she'll need one more thing. And a lot of it.

Harvard's undergraduate admissions office estimates that a year on campus for 2001-2002 costs around $36,650. Most families aren't able (or expected) to pay the full freight without financial aid, but most aid consists of loans--not outright grants--so it's often a matter of paying now or paying later (plus interest). How much help you provide is a personal choice. Some parents are determined not to let their children struggle the way they did, and feel that a child who gets the grades should not have to worry about the money. Others are fond of telling their children (or grandchildren) how they walked from Peabody to Cambridge in their bare feet every day to get to class and wouldn't think of denying later generations the joy of that character-building exercise. Whatever your preference, there are ways to ease the burden of raising all or part of the daunting sums. That way the student can graduate with less debt and the parents don't have to risk retirement funds, or take out a second mortgage, to fulfill their child's dream.

When thinking about how best to save for your child's academic future there are three main questions to ask: What is the best way to hold the investments for tax and control purposes? How aggressively should you invest the savings? How much should you save?

 

The 529 Plan

The tax act that was signed into law on June 7, 2001, has made one college-savings approach stand head-and-shoulders above all the rest: the Qualified Tuition Program (also known as the "529 plan" after the section of the IRS code that made the program possible).

The plans have been established by many states and can make all investment income on qualified college savings free from federal (and in many cases state) taxation as of January 1, 2002.* There is no income limit for participation and no cap on annual contributions (but talk to a professional before putting in more than $10,000 in a calendar year). The plan doesn't have to be set up by an individual (corporations can do it), and the beneficiary needn't be a blood relative of the person who funds the plan. Furthermore, you do not even have to live in the state in whose plan you invest--many of my California clients have funds in Missouri's 529 plan.

Most states allow contributions of up to four years' worth of tuition and living costs at the most expensive private school in that state. However, the money in these plans can be used at any accredited college in the United States. Some states sweeten the deal by giving state residents a tax deduction or credit on their contributions. The Massachusetts legislature recently discussed the possibility of doing just that, which is one reason I recommended the Massachusetts U.Fund College Investing Plan to Scott and Rachel deWolski, who live in Springfield. They opened two Massachusetts U.Fund accounts, one for each of their children, Sean and Karen. The state has chosen Fidelity Investments to manage the U.Fund and Fidelity offers several different investment choices. Because Sean and Karen are already teenagers, I recommended investing 70 percent in the equity option (which invests in more than 10 different Fidelity stock mutual funds covering both the United States and international markets) and placing the other 30 percent in less volatile fixed-income vehicles.

In a different scenario, a California client who has no children of his own wanted to help his nieces and nephew. We opened accounts with the Missouri MOST Plan, which uses TIAA-CREF as its manager and has extremely low expenses that average 0.65 percent per year (versus around 1 percent for the U.Fund) along with a 20 percent international investment component (as opposed to 15 percent in the Fidelity plan), which might make the ride a little smoother in the event the United States slips a bit in performance. The children don't live in Missouri, but because California doesn't give residents any special tax break, we decided to go for the lowest-cost plan with global investments. (Utah has a plan with only 0.31 percent expenses that is administered by Vanguard, but invests only in the United States.) We chose the 100 percent equity option because all the children are preteens.

One item of note: If the designated beneficiary of a 529 plan doesn't end up needing the funds, the money can be transferred to an account for another relative of the beneficiary, not necessarily of the funder. Transfers can also be made from one state plan to another, but they cannot occur more often than once within a 12-month period.

States competing for business have been falling over each other with constant improvements in their 529 plans. Many states that did not automatically adopt the federal law are in the process of making disbursements from their state's fund tax-free. Keeping up with the latest nuances would be a daily chore were it not for the free website, www.savingforcollege.com, maintained by Joseph Hurley, a certified public accountant based in New York. Hurley has become a leading specialist and advocate for the 529 plans, and has written a fine book entitled The Best Way to Save for College. Another website to visit that specializes in 529 plans is www.collegesavings.org.

 

Coverdell Education Savings Accounts

The federal government has also improved another savings plan for college: Education IRAs, which have been renamed Coverdell Education Savings Accounts (in honor of an advocate, the late Senator Paul Coverdell of Georgia). Starting in 2002, non-tax-deductible contributions of up to $2,000 per year can be made to Coverdell ESAs, but only by single taxpayers with income less than $95,000 and married couples with incomes under $190,000. The accumulated earnings are tax-free if used for college. Furthermore, distributions from an ESA can also be used for K-12 tuition and other education expenses of pre-college children (including a home computer that will have some educational use).

ESAs are established with a broker, a bank, or a mutual-fund entity that is willing to offer them; the funds may be invested in any way permitted by the account provider. Unfortunately, the potential build-up in these funds is so small that many mutual funds and brokerage firms refuse to open them. (One provider willing to do so is TIAA-CREF.) Overall, less flexibility in transferring and withdrawing funds and the low limits on contributions make these plans less desirable than 529 plans.

 

Custodial Accounts

Before the 2001 law, a common way to save for college was through UTMA (Uniform Transfers to Minors Act) accounts. The income from these accounts is taxable each year, but at the minor beneficiary's tax rate. Furthermore, the money can be used for any purpose that benefits the minor, not just schooling. This flexibility sounds good, but all the funds come under the control of the beneficiary when he or she reaches 18 or 21 (depending on the state), so the money might end up going for a Harley instead of Harvard. And there is no way to transfer the funds to anyone else, either.

The deWolskis used UTMAs before the new tax law passed. They are planning to liquidate those investments (resulting in some taxation) so that the funds can be transferred into a 529 plan (so there won't be any further taxation). One drawback is that since the UTMA designation of a minor is permanent, the 529 plan that receives these funds must also be designated as an UTMA account with all the restrictions intact (e.g., these funds could not be transferred to a relative later, as other 529 money can be).

 

Take Risks

If $2,000 per year is put into a 529 plan or Coverdell ESA and earns 10 percent a year in interest beginning the day a child is born, when the child turns 18, there will be more than $100,000 available. At 6 percent interest a year, that same pot of money grows only to $65,000. Not taking risk with investments means taking a big risk of not having enough when the tuition bills are due. The best choice is to keep most (and maybe all) of the money in equity investments. Businesses that provide goods and services earn reasonable returns over time, and as long as you start saving when a child is young, the volatility of the market will be an advantage, not a disadvantage. But don't take silly risks: diversify investments by using broad-based mutual funds, and don't forget to include international funds in the mix.

As noted above, the investments offered in 529 plans are limited, and not the same for each state's plan. The Missouri plan I favor has a 100 percent equity option, a 100 percent guaranteed-income option, and an age-based portfolio that automatically gets less aggressive as the child gets older. By choosing a mixture of these three, virtually any level of risk/reward can be selected. As mentioned, I prefer the 100 percent equity option for preteens and around a 70 percent equity mix for parents of high schoolers.

 

How Much Help to Provide

Although it is easy to recommend 529 plans and a focus on equity investments, it is not as easy to answer the question of how much to save. For most people, the best solution is first to make sure you are at no risk of needing your children's financial help in the future before you make sacrifices to send them to college. Financial aid in the form of loans is always available as a last resort, but borrowing for retirement needs is rarely a viable option. You aren't doing your children any favors by helping them graduate free of debt only to spend their working years worrying about how to provide for both their own offspring and their (impoverished) parents. Make sure your retirement funds are secure before providing help.

Be aware that some of the most cost-effective methods of saving for college are essentially irreversible. Both 529 plans and ESAs are tax-free for college costs, but impose major taxes and penalties if not used for the purpose of education. For this reason, it is not necessarily smart to save enough to cover the most expensive possible education. It's better to save tuition costs for four years at the least expensive school you'd consider, and maybe have access to other funds that could be used for college (but could also be spent elsewhere) to provide the balance. Or just save at the rate that makes you comfortable and see how much money it provides.

Scott and Rachel deWolski finally decided they'd try to save enough to finance four years at a private university for one child and four years at a public college for the other. Should both children end up attending private schools, the deWolskis will turn to additional sums they have saved in a separate UTMA account. (There are no tax penalties if that money is not used for education expenses.) They know paying for college won't be easy, but with 529 plans making the income at least partly tax-free and an equity-oriented investment strategy that offers the hope of higher returns, it shouldn't be nearly as hard as it once seemed. The new tax code may have made the road from Springfield to Cambridge a little bit shorter.

Less Antman, C.P.A., a fee-only personal financial adviser, runs a free message board at www.simplyrich.com that discusses financial planning topics.

You might also like

Harvard College Admits Class of 2028

A smaller undergraduate applicant cohort—the first since Supreme Court ended affirmative action 

Studying ChatGPT Like a Psychologist

Cognitive science helps penetrate the AI “black box”

Reparations as Public Health

A Harvard forum on the racial health gap

Most popular

Harvard College Admits Class of 2028

A smaller undergraduate applicant cohort—the first since Supreme Court ended affirmative action 

Diagnosis by Fiction

The “Healing Quartet,” by “Samuel Shem,” probes medicine—and life.

AWOL from Academics

Behind students' increasing pull toward extracurriculars

More to explore

Darker Days

The current disquiets compared to Harvard’s Vietnam-era traumas

Making Space

The natural history of Junko Yamamoto’s art and architecture

Spellbound on Stage

Actor and young adult novelist Aislinn Brophy