Saving for College Expenses 
Avoid paying too much tax on the money set aside for your offspring to get their education.
The new tax law passed in 2002 year offers some new benefits for families interested in saving for their children’s college education. The best deal coming out of this legislation seems to be the provision that allows tax-free withdrawals from Section 529 college savings plans.
Until President Bush signed his tax cut measure into law, parents had several tax-advantage options for sheltering college savings. But those accounts—including Section 529 plans, sponsored by state governments—either had salary and contribution restrictions or required that taxes be paid on investment income when the funds were withdrawn. The new tax law eliminates those taxes for Section 529 plans (most of which have no salary restrictions) starting in 2002.
Section 529 plans have been around since 1997 and are operated by individual states. Until the new tax law was passed, money deposited into such plans enjoyed tax-free compounding, but withdrawals were fully taxable. No more. Withdrawals are now tax-free, as long as they are used for higher education expenses. This provision makes Section 529 plans a very attractive proposition and superior to various saving schemes that have fully taxable accounts. 
States Offer Plans
Section 529 of the tax code actually covers two different kinds of college savings programs. The first is commonly referred to as a prepaid tuition plan, which is not affected by the new tax law. Several states have been offering these plans for years. Such plans typically guarantee to pay a child’s tuition at a public college in that state that participates in the plan or an equivalent amount if the child goes to a private college or a school out of state. Most prepaid plans are limited to state residents. In some states, prepaid tuition plans are quite popular. In states with only a small number of colleges or few highly regarded schools, prepaid tuition plans have not caught on. 
Section 529 of the tax code also provides for the creation by individual states of investment-based college savings plans. These second types of programs are commonly referred to as “Section 529 plans” (all future references to such plans refer to the investment-based programs), and will be affected by the new tax law. Typically, participation in a Section 529 plan is not limited to residents of that state, and the money can be used for various higher education expenses, not just tuition. In addition, some states offer state tax deductions for contributions to the state’s Section 529 plan, and a few exempt distributions from state taxes. Dennis M. Filangeri, a certified financial planner licensee in San Diego (www.myfrontdoor.com/ffs) adds that “under the new law, Section 529 plans are even more flexible because you can select a variety of mutual funds and managed investments to include within your plan.”
The best way to find a Section 529 plan that meets your needs is by shopping around. Step one is to see what’s offered in your state. While the prepaid plans offer security that Section 529 plans cannot offer, 529 plans offer greater flexibility. Investing in a 529 plan can sometimes compromise other financial aid. College savings plans are typically viewed as a parent’s—rather than a child’s—asset. And that means that a financial aid officer would count a maximum of 5.6% of those assets toward financial aid eligibility, says Filangeri. So if you think that when your child is ready to go to college you’ll be applying for financial aid because you won’t have saved enough, you should consult a financial planner. “Although,” Filangeri adds, “if you start early enough, you probably won’t need financial aid anyway.”
Possible Penalties
Another thing to keep in mind is that if you ever decide to withdraw your funds for something other than college-related expenses, you’ll have to pay taxes plus a 10% penalty on the earnings in your Section 529 plan. It’s also important to note that there are good plans and bad plans, which complicates the process of choosing one. If your state’s plan attracts you, compare it with plans offered by other states. To research what various states offer, go to www.collegesavings.org or call 877-277-6496. The CollegeSavings Plans Network, an affiliate of the National Association of State Treasurers, runs the service. According to the network, about 1.5million accounts are currently open across the county and $9.5 billion in assets are under management.
Education IRAs were also improved by the new tax law (the amount that can be contributed was increased from $500 to $2000 a year), and withdrawals are also tax-free. Withdrawals can be used for elementary and secondary school tuition costs, including uniforms, transportation, room and board, books, and computers. Withdrawn money can be used at public, private, and parochial schools. The downside to these accounts is that they’re limited to elementary and secondary school costs, so their value is diminished if they’re opened when a child is already attending school because there are fewer years for the investment to grow. It’s best to open an education IRA when your child is born and use it when your child enters high school. Using it sooner won’t allow the account to build up much value.
If your state’s Section 529 plan offers a tax deduction and/or doesn’t tax distributions, that’s a great advantage. You should also check fees, which can vary substantially and make a significant difference in your overall return over the years. The new tax law allows you to transfer from one state Section 529 plan to another, but only once a year. That’s useful if you’re not satisfied with the performance of the plan you’ve chosen. Under the old rules, account rollovers were only permitted if you changed beneficiaries. 
Under the new rules, Section 529 plans are now more attractive to grandparents who want to help with a grandchild’s college expenses. Now, a grandparent can transfer an account between grandchildren and even to a cousin if the original beneficiary decides not to go to college. 
Plans Are Flexible
Finally, unlike a custodial account set up for minors, Section 529 plans are not irrevocable gifts, explains Filangeri. In other words, should your child decide not to attend college, you can simply change beneficiaries to someone else in your family. Money in custodial accounts, however, becomes the property of the child once they are legally recognized as an adult, so they can use the money as they’d like. 
The law requires each state to establish a trust that houses your investment. Many states have chosen outside investment management firms such as Fidelity and T. Rowe Price to manage their plan. The investment manager decides how to invest the money you contributed to the Section 529 plan. You have no control over the actual investment decisions. In many states, the investment manager uses more aggressive investment techniques (investing in stocks) while your child is young and shifts toward less aggressive techniques (investing in bonds) as your child nears college age. 
Some view the lack of control over investment decisions in a Section 529 plan as a disadvantage. In contrast, an education IRA offers the donor full control over investment decisions. Is that good or bad? That depends. With a Section 529 plan, you get professional management of your investment. You’re on your own with an education IRA. If you’re comfortable with that arrangement, then an education IRA may be right for you. 
Contributions to Section 529 plans are considered gifts to the beneficiary, but gifts up to $10,000 a year are exempt from gift taxes, and twice that amount is exempt if the gift is made jointly by both parents. The Section 529 plan rules also allow five years’ worth of gifts to be contributed all at once. That means two parents can contribute $100,000 all at once, enabling them to jump-start their college savings program. In addition, some states permit even larger contributions at one time. Wisconsin’s Tomorrow’s Scholar Fund allows a maximum contribution of $250,000 that can then grow tax-free. 
The longer you have to save before your child goes to college, the better chance you have to “grow” your contributions. For example, if a family begins contributing $5000 a year to a Section 529 plan when their child is born and the plan returns 10% per year, the family will have in excess of $275,000 after 18 years, which can be used to pay for tuition, room and board, books, transportation, and other expenses. This return is approximately $25,000 better than a custodial account and $50,000 better than a taxable account in the parents’ name. Using the same expected rate of return, an investment of $2000 per year into an education IRA would yield $110,000 compared with $103,000 for a custodial account and $90,000 for a taxable account in the parents’ name. 

Milton Zall is a freelance writer who specializes in taxes, investments, and HR/business issues. Send your comments or questions regarding this article to tcaw@acs.org or the Editorial Office, 1155 16th St N.W., Washington, DC 20036.