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How to Maximize Your College Savings Program, Part II

  • Mark Biller Sound Mind Investing
  • 2007 4 Apr
  • COMMENTS
How to Maximize Your College Savings Program, Part II

Editor's Note: Read Part I here.

Choosing the Right Account

The college savings landscape is dramatically different today than a decade ago. Back then, the most popular vehicles were EE savings bonds, UGMA custodial accounts, and state-sponsored prepaid tuition plans. The savings bonds offered tax advantages but were an inferior investment product. The UGMA accounts offered the opposite—better investing options but potential tax drawbacks. Changes to the tax laws in 1997 and 2001 have eliminated those tradeoffs for most college savers, allowing them to now invest on a tax-free basis without having to settle for either inferior investment products or giving up control of the money invested. As a result, EE bonds and UGMA accounts have fallen dramatically out of favor, and it's the rare family that should even consider using them at this point.

State-sponsored prepaid tuition plans promise that your investment in the plan today will cover tuition at any school in the state no matter what the cost at the time your child enrolls. Consider this recent example from Florida's College Prepaid Program: For the enrollment period that just ended, a lump sum payment of $16,808 for a child in the third grade would cover all of the child's future tuition and fees for four years at a state university—guaranteed. The price is locked in regardless of future increases in state tuition.

Due to the rapid rise of college costs in recent years, some states have either stopped accepting new participants in their prepaid tuition plans, or have made the pricing options less attractive. As a result, fewer parents have access to a compelling prepaid tuition plan. Still, they offer a no-risk alternative to paying for a college education. However, as with most no-risk investments, the internal rate of return typically isn't that great. In addition, there are some limits on how flexible these plans are, so be sure to find out ahead of time what the implications are if Junior decides to break a five generation tradition and forsake Home State U. (gasp!) in favor of its arch rival in the next state.

Unless the guarantee aspect of the prepaid plans is very important to you, we suggest that you instead look to the newer college planning options—Coverdell Education Savings Accounts, Roth IRAs (surprise!) and Section 529 plans. They provide superior tax advantages and planning flexibility. Let's take a quick look at the pros and cons of each of these kinds of accounts.

Coverdell Education Savings Account (ESA). Created in 1997 as Education IRAs, and improved dramatically in 2001, Coverdell ESAs are a compelling savings vehicle for parents who meet the contribution limits. Parents filing jointly with adjusted gross income below $220,000 may contribute up to $2,000 per child, per year, to a Coverdell ESA. The contribution is not deductible, but all earnings grow tax-deferred, to be distributed tax-free if used to pay the beneficiary's college expenses. $2,000 per year may not seem like much, but it adds up if you start early. Contributing $2,000 per year for 18 years with an earnings rate of 10% would accumulate to just over $100,000.

While Coverdell ESAs and Section 529 plans both offer the prospect of potentially tax-free earnings, only Coverdell's and Roth IRAs offer the flexibility to choose the specific investments you desire. Section 529 plans don't, as we'll see shortly. This is a big advantage to using a Coverdell or Roth IRA for those who want to direct their own investment program, as many Sound Mind Investment readers like to do. (Most fund companies or brokerages can set up a Coverdell ESA and/or a Roth IRA for you, allowing you access to their full range of investment products.) In addition, the favored tax treatment of Coverdell earnings extends, for now, to cover elementary and secondary school expenses. The list of qualified expenses is lengthy, and includes both obvious items like tuition and books, as well as non-obvious items like uniforms, transportation, even computers and Internet access for the family during the years the beneficiary is in school.

However, there is a noteworthy fly in the ointment here. The Pension Protection Act of 2006, which permanently made withdrawals of earnings from 529 plans free of federal taxes if used for qualified college expenses, failed to similarly extend some key provisions pertaining to Coverdells. The tax treatment of Coverdell earnings is not in jeopardy; however, as it stands now, the contribution limit to Coverdells will decrease from $2,000 to $500 after 2010. In addition, Coverdell withdrawals for elementary or secondary school expenses would no longer be allowed. But even if these provisions aren't extended, the worst-case scenario is that Coverdell owners would end up rolling their accounts into 529 plans. So at this point, the combination of tax-free savings and the ability to choose your own investments still make Coverdells a solid choice, as long as you realize you may have to switch courses in a few years.

Roth IRAs. Although Roth IRAs are designed for retirement, they can be surprisingly useful for college planning as well. While you won't get tax-free treatment on earnings saved in a Roth (if used for college), you can withdraw your contributions for college expenses without tax or penalty. Ideally, you'll leave any earnings in the Roth for your retirement while withdrawing the principal to pay college bills. In addition, if junior doesn't go to college, gets a scholarship, or whatever, there's no need to move your savings around to a different type of account if it's already in a Roth IRA. It's already in the most tax-advantaged spot for your retirement savings to be. This can be a big benefit, since the annual Roth contribution limits would likely keep you from being able to transfer large sums from a college-specific account into a Roth down the road. And if you're fortunate enough to be making big bucks by the time the kids go to college, you can pay some college bills out of current income and keep more of your Roth IRA intact (since you may no longer be eligible to make new contributions to a Roth due to your high income).

With the 2007 annual limit for Roth IRAs at $4,000 and increasing to $5,000 in 2008, a married couple will be able to save a full $8,000-$10,000 per year in Roth IRAs. Many families with kids aren't going to be able to save more than that anyway, and if they can, Coverdell accounts and 529 plans are still available.

Unfortunately, there is a potential downside to using a Roth IRA to save for college, and that has to do with how IRAs are treated in the financial aid formulas. These formulas consider family income as well as assets. A parent's IRA isn't counted as an asset in the formulas, but withdrawals from IRAs often are counted as income. In other words, withdrawals from a Roth to pay college expenses are likely to bump up current income in the formulas, potentially decreasing your aid eligibility. Coverdell ESAs and Section 529 plans get the opposite treatment—they count relatively lightly against you as parental assets, but withdrawals normally don't count against you as income. As a result, if you think you're likely to qualify for financial aid, saving for college via a Coverdell ESA or Section 529 plan may be a better choice than doing so via a Roth.

The tradeoff is that a primary reason to consider a Roth for college savings in the first place is that bumps in the financial road do happen sometimes. If it comes down to an either/or situation, it's more important that you have a reasonable level of retirement savings than a large college savings fund. Remember, no one will lend you money for retirement; however, they will lend your child money for college.

Section 529 plans. These plans have become the savings vehicle of choice for many parents and grandparents. A 529 plan offers the same potential tax-free savings for college as a Coverdell ESA. Most 529 plans are run by individual states, the majority of which make their plans available to any U.S. resident (rather than just residents of their state). This means a great variety of plans are available to today's college saver. Students are not required to attend college in the state where their 529 plan money is invested either; they can use the assets at any accredited post-secondary institution in the U.S.

Unlike Coverdell accounts and Roth IRAs, there are no annual income limitations for 529 plan contributors, making 529s the natural choice for high-income college savers. In addition, while Coverdell ESAs limit contributions to $2,000 and Roth IRAs to $4,000 per beneficiary per year, with a 529 plan an individual can contribute up to $12,000 per year to a single beneficiary (that limit being the maximum annual gift tax exclusion). There's even a way to boost this already high limit: a contribution of up to $60,000 can be made up front, then treated as five consecutive annual contributions for gift tax purposes. Given that these limits are per contributor, a couple could effectively give double these amounts to a single beneficiary. For most people, this means 529 plans offer them the ability to save as much as they can without worrying about any restrictions.

Don't be dissuaded if you don't happen to have $12,000 laying around to fund a 529 plan with. Even small amounts invested regularly over an extended period of time can grow surprisingly large. For example, if you can save $100 per month for 18 years and the plan averages returns of 10% per year, you'll end up with $60,557. That may not cover all of Junior's college expenses, but it'll sure put a big dent in them.

A final advantage of 529 plans is that the contributor retains control and ownership of the account. This is important on several levels. For starters, it means that the contributor can pull money out of the account at any time and for any purpose, although taxes and a 10% penalty will result from unqualified distributions. It also allows for a great deal of flexibility in changing the beneficiary from one child (or grandchild) to another. And perhaps most importantly, it ensures that a child who decides not to go to college doesn't wind up with an unintended financial windfall. A 529 plan may not only be a valuable vehicle to help you provide for the costs of a college education, but also to protect your children from receiving a large sum of money that they aren't spiritually and socially equipped to handle yet.

While there are many benefits of 529 plans, there are also some flaws. Savers using 529 plans are limited to a relatively small range of investment options selected by the state—a significant downside for those who want to manage their own portfolios. Also, many 529 plans are broker-sold which results in paying a sales load that greatly reduces the 529 plan advantages. While overall expenses continue to fall, there are still some plans with outrageously high expenses (1.5% and up). High expenses in a 529 plan—where you don't have the advantage of being able to upgrade between funds —are the kiss of death.

Choosing the Right Section 529 Plan

With over eighty 529 plans to choose from, it's crucial to know what factors are important when comparing plans. Obviously, one key component is the rate of return you can expect. Understanding how 529 plans invest can give you some idea of what to expect from each type of plan.

Most 529 plans are managed by mutual fund companies and offer a range of investment options. Usually, one or more age-based portfolios are available that invest mostly in stock funds when the child is young, and automatically shift to safer, interest-earning investments like bonds and money market funds as the child gets closer to college age. In that respect, they're an easy auto-pilot way to save for many investors. But there's a huge variation in how aggressive various states are in their allocations. For example, even in the aggressive track, an 11-year old in New York's plan is still only 50% in stocks. Many would argue that isn't enough.

Thankfully, many plans are adding features that allow some fine-tuning. In addition to age-based portfolios, "static" portfolio options are now quite common. These allow the investor to select a certain mutual fund or mix of mutual funds that will remain constant unless the investor initiates a change. It's not unusual to find states offering multiple static choices, such as Nebraska's 529 plan, which offers six static portfolios in addition to their four age-based options. These static portfolios range from 100% in stocks to a very conservative 50% bond/50% money market split.

So, while you forfeit the right to pick and choose the exact investments you want in a 529 plan, you can still exercise a significant amount of control over how the assets are invested by utilizing the ever-expanding array of choices within these plans. For example, the New York plan offers five different Vanguard stock index funds, plus a bond index fund, among its twelve individual portfolio choices. Account holders can own up to five of these options in one account and can specify what percentage they want allocated to each fund. When you consider that you can change investment options as often as once every twelve months within most plans, and can redirect new contributions at any time, you can see there's quite a bit of flexibility allowed. You also have the ability to roll your account from one state's plan to a different one with better investment choices. This can only be done once in any 12-month period, but aside from that it's a simple process.

Congress initially put the states in charge, and each one is doing its own thing—creating different rules for who can participate, how much can be put in, how the money will be invested, and so on. The fact that there are so many plans to choose from creates a lot of confusion for parents. Here, then, are my suggestions as to which factors are most important.

Shop around, but check your own state's plan first. Look beyond your state's borders. Most plans offer state tax deductions for contributions made by their residents, and this often convinces parents to look no further. After all, a 5%-9% state tax deduction on every dollar you contribute ought to get your attention. But be aware that other factors, such as the quality of the investment managers, number and type of asset allocation choices, and the level of management fees, can outweigh the value of a state tax deduction. Check SavingForCollege.com for an overview of your plan as well as ratings of other plans open to non-residents.

Look closely at your asset allocation options. Your most important decision is the allocation between stocks and bonds in the account. Many of the age-based portfolios are quite conservative, moving into bonds in large doses at an early age. At the opposite end of the risk spectrum, you can take a more aggressive posture by using the static portfolio options to stay 100% in stocks from birth to graduation. The right balance is somewhere between those extremes. While you don't want to be in bonds too early, it is appropriate for the allocation to get more conservative as college age approaches. This helps assure that the account won't suffer a significant loss just as your student enters college. Make sure the allocation options fit with your desires as to how aggressive you wish to be. One simple approach for those using static portfolios is to invest 100% in stocks until college is five years away, then shift 20% of the account into bonds each year until college arrives.

Consider the fees. Just as with a mutual fund, there are ongoing operating expenses charged to your account. These fees can vary by more than 1% annually, making a big difference over many years.

Favor plans with low-cost index fund choices. At Sound Mind Investing, we firmly believe that it's possible to beat the market's returns if you're able to rotate between top-performing funds as we do in our Fund Upgrading strategy. Helping our readers outperform the stock market for eight straight years speaks for itself. However, in a 529 plan, you don't have the flexibility to Upgrade like that. The next best thing, then, is to use index funds. Study after study has shown that index funds will typically beat the majority of actively-managed funds over time, in large part due to their lower expenses. As a result, our advice in picking a 529 plan is to find one with good index fund choices. More and more states are catching on to the virtues of having low-cost index funds in their plans, so it's increasingly likely your state will offer index funds among their investment options.

Conclusion

At this point, Section 529 plans offer the "cleanest" and simplest path to saving for college. They were designed specifically for this goal, and Congress has now removed the uncertainty regarding their future tax status. Assuming you pick one that features a solid lineup of low-cost index fund investment choices, their only significant drawback is that you're "settling" for an indexing strategy, as opposed to being able to follow a potentially more profitable Upgrading path within a Roth or Coverdell.

For those who do want to chart their own investment course, I still believe in fully funding a Roth IRA every year as a joint retirement/college savings account. However, as college costs continue to escalate, the financial aid implications make it reasonable to question if the average family is going to come out ahead Upgrading in a Roth vs. indexing in a 529 plan. Unfortunately, there's no easy answer to that as future returns are unknown and many schools use their own financial aid formulas anyway.

Coverdells would fill in this gap nicely if their already low $2,000 annual contribution limit wasn't slated to be cut to an insufficient $500 in a few years. Still, Coverdells are a good option for now; just realize you may need to reevaluate in 2010. Of course, you can hedge your bets somewhat by contributing some to a Roth each year while also funding a Coverdell or 529 account. That path may leave you with the most flexibility as your future financial situation becomes more clear.

As we have seen, Roth IRAs, Coverdell ESAs and 529 plans all offer pros and cons. Don't get so caught up trying to figure out the very best option that you postpone making a decision. Any combination of these three choices is better than waiting. Review the options, pray for wisdom and discernment, and get started! Contributing early and often is the best way to win the college savings race.  

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