A Tax-Smart Way to Save for College

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By Roy Lewis
January 11, 2002

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 (now known as Coverdell Education Savings Accounts) 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 $2,000 per 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," $2,000 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 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 an Education IRA account. That fee could be as much as $35. If you invest $2,000, a $35 administration fee is almost equivalent to a 2% charge. Ouch! That means that you'll have to make at least a 2% 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 (called as such because these plans are discussed in Section 529 of the Internal Revenue Code) allows you to either prepay tuition for qualified universities or save funds in a tax-free account to be used to pay higher education costs. That's right: tax-free. Under the old laws, 529 earnings were only tax deferred. But for any distributions from a 529 plan used to pay for qualified higher education expenses in 2002 and later (until at least 2010), you'll owe not one dime in federal income taxes.

And in some cases, various states allow for a tax deduction for your 529 plan contributions. And it gets better: 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 -- as much as $200,000 in some cases -- versus the annual $2,000 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.

Additionally, unlike a custodial account, the assets in a 529 plan remain in your control. With only a few exceptions, your kids can't grab the money and run off to Europe when they reach the age of majority. Instead, you're in complete control. You decide when distributions are made, and what the funds will be used for.

Tax benefits galore
As we noted above, taxes on the earnings within a 529 plan are not only tax-deferred while they are held in the account, but are tax-free when withdrawn to pay for qualified education expenses. This allows you to build 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. 

And there are some great estate-planning aspects, since making a large contribution to a 529 plan reduces your taxable estate much quicker than the current $10,000 annual gift exclusion. But while the assets leave your estate, they don't leave your control. But note that your contribution to the 529 plan is considered a gift, so you have to be careful of the gift tax reporting rules. But this, the annual gift that you can make to any person increases to $11,000. And you can also make a substantial gift in one year and treat it as if it were made over a five-year period. That means that you could fund your child's 529 plan with $55,000 in 2002 and have no gift tax problems because the gift would be considered to be $11,000 annually made over a five-year period.   

Potential pitfalls
As with most things, you've gotta take the good with the bad, and there are some minor drawbacks to 529 plans. First, if you remove the earnings from the 529 plan and decide not to use them for higher-education expenses, you'll not only pay taxes on those earnings, but you'll get zapped with a 10% penalty on the same earnings. That being the case, many folks are concerned that if the child decides to skip college, there will be a tax and penalty problem. But remember that you are able to change beneficiaries to a 529 plan without penalty. So if your older child decides not to attend college, you can transfer the 529 plan account to your younger child.

Additionally, the funds in the 529 plan account are handled by the 529 plan administrators, and not by you. (Some might say that having the funds managed by professional money managers is actually a benefit, but I'll leave that determination up to you.) One final fly in the ointment is that once the money is in the 529 plan, it must stay there; non-qualified distributions are subject to taxes and penalties. But this doesn't mean that they have to stay in a specific plan. Recent tax law has allowed for a tax- and penalty-free rollover from one 529 plan to another.

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 in my opinion.  

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: Savingforcollege.com. You'll find tons of information along with a frequently asked questions section and plan summaries on a state-by-state basis. 

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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