Your Financial Future:
Education Savings Accounts Vs. 529 College Savings Plans
What is the best way for your family to save for college? Find out here.
Education Savings Accounts
In 2002, Congress recognized the growing challenge of paying for college by giving parents an improved savings tool, Coverdell Education Savings Accounts (ESAs). ESAs have replaced the old underpowered Education IRA. Parents, grandparents or friends can contribute up to a total of $2,000 a year, compared to the old Education IRA’s limit of $500.
While ESA contributions are not tax-deductible, account savings or investments grow tax-free, significantly increasing total returns. Withdrawals are not subject to federal (nor often state) income tax either, unless they are made for a non-educational reason. But Congress also expanded the eligible expenses for withdrawals. In addition to college expenses, many kindergarten-through-high school expenses qualify as well.
And parents can now earn a higher level of income and still be eligible to contribute to an ESA: up to $220,000 for couples and $110,000 for single parents. For the great majority of American families, though, the concern is not fitting within the income guidelines, it is how to find the money to save.
There are however, a few drawbacks with ESAs. First, the child owns the assets, which means that financial aid may be reduced or eliminated. And, if the ESA is invested in a mutual fund there’s usually an annual fee to maintain the account – according to experts, those fees can be as much as $35 a year, which would be 7 percent on a $500 contribution. You can get a Coverdell ESA through any financial institution that normally offers IRAs, such as a bank, credit union, or mutual fund company.
Congress Improves State 529 Plans
Congress has also expanded important provisions for state-based college-based college savings plans, called 529 plans. 529 plans are named after the section of the IRS code that governs them. Each state has its own investment plan designed to help families save for college costs. Today, all states have at least one plan available . There’s a common belief that these plans only have value if you send your child to a state school. But, if you use a 529 savings plan, the value of the account can be used at any accredited college or university, even certain foreign schools.
In general, 529 savings plans allow dramatically higher contributions compared to the Coverdell Education Savings Accounts –the limits are established by the program, and can exceed $300,000 per beneficiary, vs. ESA’s $2,000 a year limit. The 529s do not have an income limit for making contributions and they have estate-planning benefits. Since the account stays in the donor’s name, the beneficiary can be changed within the family, including first cousins, by rolling it into another 529 for someone else. You can also roll a Coverdell ESA into a 529 plan although experts advise that the process can be a complicated hassle.
Federal tax advantages
State 529 plans are showing impressive growth; total assets reached $88.5 billion in 2008, and have increased by over 69 percent since 2004.(1) Contributions are taxed but the earnings grow tax-free and when the plan distributes the money to pay for the college costs, the distribution is free of federal taxes.
So far, 32 states allow a deduction for contributions to a 529 plan.(2) In order to get the deduction you have to live or work in the state and choose its plan, except residents of Pennsylvania, Arizona, Maine, and Kansas, who are offered tax deductions even if the plan is out of state.
Contributions to 529 college savings plans go into one or more investment portfolios offered by the plan. Portfolios are managed either by the state or, increasingly, large money management or investment firms. Investment portfolio options are typically sorted out by type of security held and associated level of risk – for example, portfolios largely made up of stocks, which offer more growth potential but higher risk, or safer fixed-income investments such as bonds, with their lower earnings rate.
Choosing the right investment mix is important for reaching all long-term savings goals, including college plans.
Some state 529 plans make choosing a portfolio easier by offering “age-adjusted” investment options. That is, for families saving for a child who is still some years away from high school graduation, they suggest a higher proportion of stocks or stock mutual funds, with their higher growth potential. Then, as the student gets closer to attending college, the family’s contributions are shifted to a less volatile portfolio make up largely of more conservative investments such as bonds or bond funds. That way, the account’s value is protected from a sharp drop in the stock market just as the money is needed to pay tuition and other costs.
Learn the Basics
Even with advice from the plan’s investment manager (among others, these include TIAA-CREF, Vanguard, and Fidelity), it is still up to you to learn basic investment principles – if you’re not already familiar with them – in order to act according to you own needs and level of risk tolerance. Beyond the “risk-reward” trade-off between stocks and bonds mentioned above, other fundamental concepts include diversification, asset allocation, and what to do (or not do), in a volatile market.
When Choosing a 529 Plan:
If you don’t like your state’s plan, you can choose other states’ plans, but you should watch out for extra fees or missed tax advantages. Some employers offer a 519 plan through a payroll deduction, like a 401(k), but the employee may miss out on tax advantages and other state incentives – like matching grants, or state financial aid preference.
If you use a broker, make sure you understand how the broker is paid, because you may pay a sizable sales fee otherwise. Better yet, see if you can start a plan on your own. For instance, the Wall Street Journal reported that if you buy an account in the Rhode Island plan directly, there is no fee. But if you go through a broker, there is as much as a 4.25% sales fee. Also, watch the annual fees, they vary.
Consider the choice of investments – do they fit your needs? Some states’ plans have only a few choices, while others have many.
529 Prepaid Tuition Plans
There are two kinds of state 529 plans: prepaid tuition plans and the more recently established college savings plans, which are discussed above. Contributions to prepaid tuition plans allow parents to lock in today’s tuition rates; the plan pools contributions and makes long-range investments to cover college tuition increases in the state. While these plans initially could be used to pay tuition only at the state’s public colleges and universities, most states now have more liberal rules that also allow account withdrawals to be used to pay tuition at private and out-of-state institutions.
College Savings Plans Network, an affiliate of the Association of State Treasurers. Call 877-277-6496 to be connected to your state’s 529 plan. Or visit their website at www.collegesavings.org.
The Best Way to Save for College: A Complete Guide to 529 Plans, 2001-2002 Edition. Book. Joseph F. Hurley, CPA. Mr. Hurley also manages a website, www.savingforcollege.com, which contains comparative information on states’ 529 plans, as well as basic introductory information.