A Tax-Smart Way to Save for College

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By Roy Lewis
May 25, 2001

Saving for your child's education can be a tricky issue. Most folks want to maximize the savings while minimizing taxes. That's why many folks are using Education IRAs and custodial accounts. These types of college savings vehicles do have tax advantages, but present other problems. 

What Problems?
With an Education IRA, you can save just $500 per year (though the tax bill that just passed Congress will increase this to $2000 a year). That's not a lot of money, given that tuition, room, and board can cost thousands -- and even tens of thousands -- of dollars a year. If you're starting late on your child's education "kitty," $500 per year may not get you past freshman year. 

Since the Education IRA account is in the name of the child, the child owns the assets. The ownership of these assets can cause the reduction or even elimination of the financial aid that your child might otherwise be able to receive. This same problem also applies to custodial or "Uniform Gift to Minors" accounts. If you take distributions from the Education IRA to pay for college, you are barred from also claiming the Hope Credit or the Lifetime Learning Credit for the same student in the same year.

If you invest your Education IRA in stocks or mutual funds, you might be in for a very unpleasant surprise.  Most brokers and mutual fund companies charge an annual fee to maintain a Education IRA account. That fee could be as much as $35. If you invest $500, a $35 administration fee is equivalent to a 7% charge. Ouch! That means that you'll have to make at least a 7% return on your contribution just to break even. 

Depressed yet? Don't be. There's a (relatively) new way of saving for college: the 529 Plan. 

What Is It?
A 529 Plan allows you to either prepay tuition for qualified universities or save funds in a tax-deferred account to be used to pay higher education costs. You can do this any child in your life -- your kid, your grandkid, or the kid next door who mows your lawn. And you don't necessarily have to live in the state of the plan that you choose. Sweet. 

529 Plans allow you to sock away huge sums of money -- more than $100,000 in some states -- versus the annual $500 Education IRA contribution. And most of these plans have no age or income limitations, so higher-bracket taxpayers can participate. Heck, if you're thinking of going back to school, you can even set up a 529 Plan for yourself. Another big advantage is that the person who establishes the account decides when distributions may be made. That differs greatly from a custodial account, which could allow your child to use his or her education money on a brand-new shiny sports car. 

Let's not ignore the tax benefits. Taxes on the earnings within a 529 Plan are deferred until the money is withdrawn. Since none of the earnings or gains are taxed during the life of the plan, you receive all of the tax benefits of deferral, building a big war chest much faster than you ever could if you had to deal with taxes on the investment gains and income every year. When the money is used to pay for qualified college expenses, the earnings are taxed at the student's ordinary income tax rate, which is usually lower than the parent's rate. Finally, making a large contribution to a 529 Plan reduces a taxable estate much quicker than the current $10,000 annual gift exclusion.   

As with most things, you've gotta take the good with the bad, and there are some drawbacks to 529 Plans.  First, if the child decides to skip college, there will be a 10% penalty on the earnings. Additionally, the funds in the 529 Plan account are handled by the 529 Plan administrators, and not by you. One final fly in the ointment is that once the money is in the 529 Plan, it must stay there.

Are these pitfalls enough to dismiss using a 529 Plan altogether? I don't think so. You just have to understand that there is some downside to a 529 Plan. But the good far outweighs the bad. 

Is That All There Is?
Far from it. The information above only scratches the surface. You have a cornucopia of options when dealing with 529 Plans. Would you like to learn more about them? Then go directly to the best site on the Web for understanding 529 Plans: http://www.savingforcollege.com. You'll find tons of information along with a Frequently Asked Questions section and plan summaries on a state-by-state basis. Before too long, you'll certainly be able to see the advantages of a 529 Plan when compared with other college savings options.  

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues. He understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.
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