Not since 007 has a three-digit integer sounded so sexy.
Now it's 529, the number of the federal tax code section that spawned state-sponsored college savings plans, that's grabbing the attention. Thanks to last year's Tax Relief Act, which stripped away the tax on plan distributions, 529 plans are increasingly becoming the vehicle of choice for paying for college.
That's a marked change from the previous situation. Under past law, to be sure, parents could sock away money for college costs in state-sponsored plans and see it grow tax-free. But once those funds were tapped to pay for tuition, room and board, computers, and the like, the earnings were taxed at the student's rate. Today, however, as long as funds are used to pay for eligible college costs, no tax needs to be paid to the feds.
Parents can also move money around among different state plans more easily. In the past, transferring funds to another plan without incurring tax consequences generally required parents to make another family member the account beneficiary. But now individuals can switch from state to state using the same beneficiary, rolling the funds over once every year. And parents can also diversify a 529 plan among multiple states.
Still, even someone with a CFO's acumen needs to scale a steep learning curve to master how to make the best use of the plans. For starters, there are nearly 50 state-sponsored educational savings plans to educate yourself about, as well as the investment strategies available within each state. And a number of different investment managers run the plans. Putnam, for instance, offers its own stable of funds within the state plans it manages, while Manulife's menu includes choices from T. Rowe Price and OppenheimerFunds. In the currently volatile stock market, striking the right balance between growth and security can be a more than academic challenge.
While each fund has different management strategies and past performance to consider, however, many states have similar products. Besides traditional stock and bond funds, many managers offer an age-based portfolio, which lowers the asset allocation risk the closer the child gets to 18.
Then there's the issue of how to time your contributions to the savings plans. One particularly attractive provision is that each parent can contribute up to $11,000 per year per beneficiary (up from the prior $10,000 limit) and not owe any gift tax in the year.
On the other hand, each parent could choose to load five years of tax-free gifting at the front end with a $55,000 deposit. Grandparents take note: That's a real advantage to those interested in getting money out of their estates as quickly as possible.
If you've got the cash, five-year, front-end loading seems like a great strategy, providing that much more time for tax-free growth as well as the gift tax advantage. But there's a downside: Contributors might get only one year of the state income tax deduction they could get for a number of years were they to spread the payments. New York, for instance, allows each parent to deduct up to $10,000 a year for contributions to the state's 529 plan. With a 10 percent tax rate, that's $1,000 tax savings each year.
A more obvious advantage to making yearly 529 contributions is that you get more cash on hand to use for other purposes. Lesley Weiner, president and owner of Heritage Financial Advisors in Montville, N.J., says most of her wealthy corporate clients haven't opted to deposit upfront. Instead, she advises clients to put some of the cash into life insurance or a trust and "keep some money for yourself."
Load and Lock
Besides the decisions about what state plans to use and how much and when to contribute to them, parents also need to decide whether to contribute to educational savings plans or to another kind of account: prepaid tuition plans. Unlike the more widespread educational savings plans, which often involve stock market risk, the prepaid plans enable parents to lock in their tuition costs at current rates without having to play in the market.
In Florida's pre-paid plan, for example, parents can fix what they will pay for tuition (after a fee) by agreeing to pay for up to four years worth of education at a Florida state college in a lump sum or in monthly installments. What's more, the person opening the account doesn't have to live in Florida or even be related to the child.
Still, like the 529 educational savings accounts, the pre-paid plans represent something of a crazy quilt in terms of their uses. Offered in some 21 states, the prepaid plans differ on what will happen to the money if the child goes to a non-state school or private college within the state.
Starting in 2004, private schools will be able to offer pre-paid programs that are exempt from federal tax. Currently, some twenty schools, including Vanderbilt, Emory, and Trinity, reportedly belong to national consortium offering a prepaid program. Under the plan, parents can buy certificates guaranteed to pay a fixed percentage of tuition at consortium schools.
Ferrari Factor
Despite their tax advantages and growing flexibility, 529 plans, whether market-based or pre-paid, aren't for everyone. Parents who want to retain control over how their college savings are invested might be among those who shun them. Each 529 plan, after all, is run by a fund manager and usually consists of only a handful of fund alternatives.
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