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SAVING FOR COLLEGE
HAS NEVER BEEN EASIER.
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By Peter Downs
With the cost of a college education rising faster than the rate
of inflation, saving for a child’s tuition can be a bit of a challenge.
Changes in federal and state tax laws in recent years, however,
give parents more and better tools for saving than they have ever
had before.
Phil Behnen, manager of the financial planning group at A.G. Edwards,
groups the many choices parents or grandparents have for saving
for college into three main options: 529 savings plans, Coverdell
Education Savings Accounts (ESAs), and traditional custodial plans.
By far the most popular of those are 529 savings plans, which have
supplanted the prepaid college tuition plans state’s used to offer.
Most 529 plans are set-up by state governments, although last Fall
a consortium of over 200 private colleges set-up an independent
529 plan to save against tuition at any of its participating schools.
In general, a 529 plan works like a Roth IRA: the money you put
into the plan has already been taxed, but any income your investment
makes is not taxed, as long as you use the money for qualified educational
expenses, which include tuition, room and board, books, or fees.
The tax-free status of that income only applies until 2011, however,
Behnen said, although Congress could certainly extend it.
Every state now offers a 529 plan, and each one is open to investors
from across the country. How does a parent decide which of the 50
plans is best for his or her child? One way is to look at the web
site www.savingforcollege.com,
which evaluates all of the plans and ranks them. Both Missouri’s
and Illinois’ 529 savings plans are highly rated, getting 4.5 out
of a possible 5 “caps.”
Both Missouri and Illinois offer a powerful incentive to their own
residents to invest in their respective state’s own plan. Missouri
lets Missouri taxpayers deduct their contributions to Missouri’s
plan from their taxable Missouri income, up to $8,000 a year, per
taxpayer, $16,000 for a married couple. Illinois lets Illinois taxpayers
deduct their contributions to Illinois’ plan from their state taxable
income, without limit. Those incentives make the Missouri plan most
attractive for Missouri residents, and the Illinois plan most attractive
for Illinois residents, said Behnen.
TIAA-CREF manages Missouri’s 529 plan, called the Missouri Saving
for Tuition plan (MO$T). Chris Drazen, the program manager, said
he advises people to use three questions to evaluate state 529 savings
plans:
1) Will you get state tax benefits for investing in your own
state’s plan?
For both Missouri and Illinois residents the answer is “yes.”
2) What is the cost?
Missouri has one of the lowest cost plans in the nation, charging
only 65 basis points a year (0.65 percent of the account amount).
3) Does it have investment options that meet your needs?
MO$T has three options: an aggressive option that puts all contributions
into stocks, an aged-based option, and a conservative option that
pays a guaranteed rate of return.
Drazen said the option that “makes the most sense for the most people”
is the age-based option in which investments are made in traditional
mutual funds based on the age of the child. “The younger the child,
the more aggressive the investment strategy, as the child ages and
approaches college age, the investment is moved to less risky instruments,
because you don’t want to lose what you have saved.”
On the most conservative option of the three, the guaranteed rate
of return is adjusted every July 1, but it can never go below three
percent.
Money in state 529 savings plans can be used for any type of post-high
school education, from vocational school to a graduate or professional
degree, at any accredited school in the U.S. and over 400 affiliated
schools abroad. That’s an advantage the savings plans have over
prepaid plans, which are good only for colleges in the system covered
by the plan. Illinois’ prepaid plan, for example, covers only state
colleges in Illinois.
While prepaid tuition plans usually have a time limit in which tuition
vouchers must be used, “There is no time frame for using the money”
in a 529 savings plan, Drazen said. “If the beneficiary doesn’t
use up the money, you can transfer it to another beneficiary, as
long as they are somehow related. You can use it yourself to go
back to school; save it for the beneficiary, who might go back to
school when he’s 35; or save it for a future grandchild.”
The minimum investment in MO$T is $25. The maximum contribution
is $235,000 for one beneficiary, Drazen said. Once that upper level
has been reached, MO$T will not allow any additional contributions.
There are a couple of other maximums to keep in mind, however. Contributions
to 529 savings plans are considered gifts, so the maximum contribution
one can make to MO$T for one beneficiary, without having to pay
gift taxes, is $11,000. State 529 plans are able to take a $55,000
gift and average it over five years to avoid taxes, however. But
the maximum contribution that one can claim for a Missouri tax deduction
is $8,000.
In addition to the flexibility outlined above, 529 savings plans
are very popular because “it is the only investment you can make
where the money is outside your estate, but you retain full control,”
Behnen said. “The combination of tax benefits, flexibility, and
estate benefits make 529 savings plans the number one choice for
college savings.”
PHIL BEHNEN
manager,
financial planning group
A.G. Edwards
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The second choice for college savings, Behnen added, is a Coverdell
Education Savings Account. ESAs also function much like a Roth IRA—income
earned on the account is not subject to federal taxes. The limitations
of ESAs, however, are such that they don’t cover the full cost of
education and they aren’t available to higher income clients.
To take full advantage of an ESA, a parent’s adjusted gross income
must be less than $95,000 (twice that for a married couple). ESAs
can only be set-up for children under the age of 18, and the maximum
contribution per child is $2,000 a year.
What are the benefits? There is no expiration of the tax-free status
of account income, as there is with 529 accounts, and they can be
used for any level of education, including private grade school
or high school, Behnen explained.
The third major alternative is the standard custodial account, which
is making a comeback Behnen said. “From a tax standpoint, the first
$800 in unearned income is tax-free, the next $800 is taxed at the
child’s rate, and, if the child is under the age of 14, anything
over $1,600 is taxed at the higher of the parent’s or the child’s
rate. That is usually not a problem,” Behnen said, “because you
usually don’t have more than $800 in unearned income. The advantage
is that you can use the money on anything, such as travel to and
from school, miscellaneous food expenses, etc.”
Given all the choices, what does Behnen recommend? “They aren’t
mutually exclusive,” he said. “If you have the money, we recommend
doing both a 529 savings account and an ESA.”
Peter Downs is a St. Louis-based free-lance writer.
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