If you want your child to attend college, remember this number: 529. Thanks to the recent tax legislation, state-sponsored college savings plans--known as 529 plans for the section of the tax code that created them--are, for most people, the best way to save for college.
The reason is simple: no federal taxes. Starting in January, the U.S. government will allow you to tap the money accumulated in a 529 plan tax-free. This is a big change from the past when earnings were taxed at the student's income-tax rate upon withdrawal. Several states have waived their own taxes on these accounts, and more--though not all---are expected to follow. One hitch: The money must be used for higher education or you will pay taxes and a penalty, typically 10% of earnings.
With a 529, you should be able to save enough to cover four years at a private college. The states don't manage your money. Instead, each has selected a professional to offer a handful of stock and bond funds. New Hampshire, for example, picked Fidelity Investments, while New York went with TIAA-CREF.
FREE TO ROAM. The best way to approach 529 investing is to start with your own state's program. This is important because your state may allow you to deduct contributions to its plan from state income taxes. Generally, deductions are hard to pass up, so calculate your tax savings before opting for an out-of-state plan.
If your state's plan has high fees--1% of assets or more--or unappealing investment options, shop around. Already, 43 states offer 529 plans, with all 50 expected to have one by this time next year. Going with an out-of-state plan is getting easier. In the past, some states levied taxes on withdrawals from out-of-state plans while exempting money in their own. But now many states are likely to give tax-free treatment to all 529s, says Joseph Hurley, whose Web site, Savingforcollege.com, compares the plans and gives contact information (as does www.businessweek.com/magazine/content/01_11/b3723116.htm).
Tax-free status makes a big difference. According to T.Rowe Price Associates, if you invest $5,000 a year in a 529 equity fund that earns an average annual return of 10%, you'll have $287,704 after 18 years. In contrast, a taxpayer in the 28% bracket would have $224,527 after taxes in a regular brokerage account and $250,157 in a custodial account, which exempts only the first $750 in gains per year from taxes.
LOST SCHOLARSHIPS. Some other college savings options--the education Individual Retirement Account and state-sponsored plans that let you prepay tuition--are free from federal and possibly state income taxes, too. But neither allows you to save as much as the $200,000 permitted by many 529s. With a prepaid plan, you can save only as much as it costs to attend a state school. And education IRA contributions are capped at $2,000 a year starting in 2002--not enough to pay for State U 18 years hence, never mind Harvard. So open an education IRA if you are eligible--income limits in 2002 are $220,000 for couples and $110,000 for singles. But establish a 529 account, as well.
The 529 plans do have drawbacks. Whereas education IRAs give you unlimited investment options, 529s offer only a few. And once you select an investment course, you can change it only by designating a new beneficiary or transferring the account into another state's plan. A year later, you can move the funds back to the original beneficiary or state plan. One way to ensure appropriate asset allocation over the years is to select an option that automatically shifts money from stocks to bonds as a child ages.
A successful 529 plan may reduce your child's ability to qualify for financial aid. If you save for seven or more years, though, the tax benefits on a 529 are likely to make up for any loss of aid, says K.C. Dempster, program development director at College Money, a financial-planning firm in Marlton, N.J.
The 529 savings plans aren't perfect. However, if you start putting money into one of them early on and then invest regularly, there's no better deal around.
By Anne Tergesen
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