SAVING FOR COLLEGE Tax Breaks for College Savers by Kristin W. Davis
State-sponsored college-savings plans, also known as 529 plans, have vastly improved since the 2002 tax law made their earnings tax-free. The law also repaired the lame tax-free education IRA -- now called a Coverdell education savings account -- 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.
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 The same amount invested in a 529 plan under the old rules -- and taxed at 15% when withdrawn -- provides you with a spendable college stash of about $55,000.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 $250,000 in some states. You can open an account with as little as $25 or $50, and anyone can add to the kitty. 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, 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. 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. 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.
What if you're unhappy with the performance of the portfolio you've chosen? You can shift to another investment track inside the state plan or roll your money into another state's plan (as often as once a year).
One warning for parents of younger children: A strange quirk of Congress' recent handiwork is that the entire tax bill "sunsets" in 2011. Unless lawmakers act between now and then, earnings on 529 plans will revert to being merely tax-deferred. We think Congress will eventually make the change permanent, but if your children will be in college after 2010, you should be aware of the possible reversal.
Improved Coverdells
You now can contribute up to $2,000 a year, a more reasonable cap than the original $500 ceiling. Like retirement-flavored IRAs, Coverdell education savings accounts are offered by banks, mutual funds and brokerage companies -- and you have full discretion to buy and sell what you want. Like Roth IRAs, you get no tax deduction when money goes into the account.
If you contribute the maximum for a newborn from his first year in 2002 to his 18th and you earn 10% a year, the account will grow to just about $100,000 -- probably enough to pay for four years at a public college starting in 2020. If you want to save more, you now can supplement your savings with contributions to a 529 plan. Congress has eliminated the ban on making contributions to both kinds of plans in the same year.
The new tax law remedies another serious shortcoming. You can take a Hope or Lifetime Learning tax credit in the same year you make a withdrawal from a Coverdell ESA.
Another plus is that you can use tax-free withdrawals from Coverdells to pay for private elementary and high school expenses. However, there are income limits for contributing to Coverdell ESAs. You can contribute fully only if your adjusted gross income is less than $95,000 on a single return or $190,000 on a joint return. But this has little real-world impact since parents who make more than the limit could, for example, give $2,000 a year to a grandparent, who could then contribute to a Coverdell for the child. (The $2,000 limit is the most that can be set aside for any child during the year, regardless of how many donors chip in.)
The demise of UGMA
Now that there are two good, tax-free options, traditional custodial accounts (also known as UTMA or UGMA accounts, after the Uniform Transfers/Gifts to Minors Act) may be headed for the dustbin of history -- at least for college savings. Yes, they're tax advantaged: For children under age 14, the first $750 in earnings in a custodial account is tax-free, and the next $750 is taxed at the child's tax rate; for older children, all the earnings are taxed in the child's bracket. But that doesn't compete with zero taxes in a 529 plan or Coverdell ESA.
Plus, saving for college in a custodial account could mean your child gets control of tens of thousands of dollars at age 18 or 21 (depending on the age at which custodial accounts must end in your state), and you're left hoping the money is used for tuition.
Also, savings in a custodial account could cause you to qualify for less financial aid. Custodial accounts are considered a student asset and are therefore assessed more harshly under financial-aid formulas than 529 savings plans and Coverdell ESAs, which are parental assets.
Making the switch
The first catch is that money you've given to your child in a custodial account forever belongs to your child. So if you move the money into a 529 plan, you may not transfer the money later on to another beneficiary, and your child still gains control of the money at the age of majority in your state -- and thus could withdraw the money, pay the taxes and penalties, and blow the dough. You'll gain tax benefits, but not control.
Most, but not all, states will open 529-plan accounts with UTMA/UGMA designations, but if you make further contributions, the state may also consider that money to be subject to custodial-account rules. Thus, it's probably worth the trouble to set up two accounts: one for the custodial-account money and another for subsequent college savings.
Another caveat is that you must cash out of whatever investments you're holding in the custodial account and pay taxes on any gains before redirecting the cash into a 529 plan.
GETTING STARTED
