Multiple Choice in College Savings


I have no doubt that my daughter, who's almost six months old, will go to college. Yet, even though I have plenty of time to prepare for that day, I already feel a big hole in my pocket knowing the skyrocketing cost of college. After using the college cost calculator from CollegeBoard.com, I'm even more convinced I have to start saving now.

Thankfully, a rash of investment options are available to prepare for this huge expense, including 529 college-savings plans, Coverdell Education Savings Accounts, UTMA and UGMA accounts, and savings bonds. As you can see from the pros and cons listed in the table below , this isn't an easy decision. "There is no best plan," warns Gary Webb, CEO of Webb Financial Group, a registered financial consultant in Bloomington, Minn. "It depends on the savings ability of the parents and grandparents. Every single option gets you down a different road."

Let's start with 529 savings plans, which have become very popular because earnings compound, and eventual distributions to pay for your child's college costs are free from federal taxes. First, look for 529 plans offered in your state, advises education-plan guru Joe Hurley, author of The Best Way to Save for College - A Complete Guide to 529 Plans and a certified public accountant in Pittsford, N.Y., who also runs savingforcollege.com. The reason is some states offer a state income tax deduction for the contribution if you live there (other taxes are deferred in 529 plans). You can enroll in as many plans as you can afford, some of which have lifetime maximum contributions of $200,000 or more.

IT'S ABOUT THE FEES. With 50 states offering more than one plan, it's not easy to figure out which one is best. The most important rule is to select a 529 with the lowest fees. You'll find many costs to add up, including annual account-maintenance fees (typically $10 to $30 per year), management fees (up to 0.75% of asset value), the underlying expense ratio of the mutual funds chosen (actively managed funds usually cost more than index funds), and possibly an enrollment fee. Try to find a plan that keeps the management fee and fund expenses between 0.7% and 1% of assets, Hurley says.

Steer clear of 529s sold through brokers, Webb says, because these generally entail paying upfront sales commissions known as loads, and the continuing annual fees are often larger than those of plans sold directly to investors by the providers. Hurley agrees: "The cheapest option is to enroll yourself." In the end, high costs not only cut into returns but they can also lessen the tax advantages (see BusinessWeek, 8/16/04, "The 529 Ate My Tax Break").

You can't be too careful searching for the best investment options, Hurley says. Many plans have already figured out asset allocations for you. The so-called age-based option shifts money from stocks to more conservative bonds as your child nears college age. But you can change the investments in the plan only once a year.

THE PRICE OF OPTING OUT. If you're not crazy about the mutual funds and options in your state's 529 plans, compare them with other state plans on savingforcollege.com. You can also compare the funds' performance and style on morningstar.com. One more thing: The 529 plan will be in your name, not your child's. This helps if you plan on applying for financial aid. Only 5.6% of the parents' assets are used to compute financial aid, vs. up to 35% of assets owned by the child.

If the child doesn't want to go to college, you can change the beneficiary to your second child, says Webb. If none of your children ever go to college, then you'll pay a 10% penalty plus the capital-gains tax (maximum of 15%) on the investment gains when you withdraw the funds, he says.

The other type of 529 is the 529 prepaid tuition plan. These state-sponsored programs allow you to lock in current tuition rates way before your child enrolls in college. This can save thousands of dollars in college costs. The payments are invested in a portfolio, and tuition is paid directly to the college when the child enrolls.

LIKE ROTH IRAS. Here's the big catch: Most prepaid tuition plans are restrictive when it comes to choosing a college. If your child decides to attend a college outside the plan, the value of the investment may be cut. In the end, you're essentially giving the college money today that it's investing, Webb explains. "They keep the profit that you could have had, had you invested it yourself," he says.

Coverdell Education Savings Accounts (named for the U.S. senator who came up with the idea) are similar to Roth IRAs and can be set up at most mutual-fund companies or brokers. This lets you sock away as much as $2,000 a year tax-free for each child (from all donors).

The account will grow free of federal income taxes, and for the most part, withdrawals will also be tax-free. Given the $2,000 annual contribution limit, Coverdells are typically used in addition to other plans. The nice thing is you can use the funds to pay for the cost of kindergarten through the 12th grade, as well as for college.

LESS CONTROL. Federal rules say your modified adjusted gross income must be $95,000 or less if you're single and $190,000 or less for married couples to make the full $2,000 annual contribution.

Coverdells do have a few drawbacks. The beneficiary has to be younger than 18, and contributions must stop at that age, Hurley says. Your contribution goes into an account that will eventually go to your child if not used for college. You cannot simply refund the account back to yourself like you can with most 529 plans, Hurley says. So you lose some degree of control, he says.

If you withdraw more than the amount of what's called a "qualified higher education expense" -- which includes tuition, books, supplies, room and board, technology equipment, and Internet access -- the excess money will be subject to income tax and an additional 10% penalty, Hurley says.

SOME SWAMPLAND INSTEAD? Another option is for parents and grandparents to set up a custodial account known as UTMA (from the Uniform Trust to Minors Act) and UGMA (from the Uniform Gift to Minors Act). These accounts don't limit how much you can contribute, but they also don't have the tax benefits of a 529 plan or Coverdell. The attraction is the universe of funds offered is typically quite large and includes mostly no-load funds, so expenses are low, Webb says.

The catch: Again, at age 18 or 21, your child takes control of the money. "If your child decides at that age that they want to buy swampland in Florida, too bad, it's their money," warns Webb. Also, since your child owns the account, more of this money will count in the calculation when determining if he or she is eligible for financial aid.

Another way to save for college is with Series EE Savings Bonds. If the bond is used to pay for qualified higher-education expenses (generally tuition and fees) and other requirements are met (including income limitations), you won't have to pay federal income tax on the interest accrued. Even if you don't meet all of the requirements, Webb says, you can still purchase Series EE bonds to save for your child's college education. You'll just have to pay federal tax on the bonds' earnings when you redeem them. The purchase limit for EE-bonds is $15,000 ($30,000 face amount), and the interest accrues every month.

HIGHER RETURNS. When you hold the bond to maturity, you'll get the amount you paid plus interest. You can avoid federal taxes on the interest by using the bond to pay for tuition and fees, but only if you meet certain income limits, Webb says. Typically, Coverdells and 529 savings plans will offer a higher return over time than bonds, he says.

If the array of choices seems a little overwhelming, it can be. Depending on how much you can spare after paying your expenses every month, a combination of these investments may be the best strategy. Webb recommended that I start a Coverdell and choose a low-cost 529 savings plan such as the Utah Education Savings Plan (800 418-2551; www.uesp.org). Utah's plan uses low-fee funds from Vanguard and was recently hailed by Morningstar FundInvestor newsletter as the best plan around.

Other plans that got praise from Morningstar include the Alaska T. Rowe Price College Savings Plan and the Michigan Education Savings Program. States on Morningstar's worst 529 list were Arizona and Wyoming, which charge hefty fees on top of the funds' fees, as well as Alabama, Tennessee, and Maine.

This helps narrow my exhausting search. Like a good education, a smart investment plan is a terrible thing to waste.

College Planning

Plan

Qualified Education Expense

Pros

Cons

Annual Contribution Limit

Income Limit

529 Savings Plan

College tuition, books, supplies, required equipment (laptop), room & board

Tax deferral; possible state tax deduction

Minimal control of investment options

$11,000 to stay within gift tax exclusion (or $55,000 lump sum spread out over 5 years)

Not applicable

Coverdell Education Savings Account

Elementary and high school tuition and other related expenses; college tuition, fees, books, supplies, equipment, room & board

Tax-deferred; wider choice of investments, lower expenses than 529; control of investments

Limited contribution

$2,000

$95,000 or less if single; $190,000 or less if married

UTMA, UGMA

No limits

More control of investment options, lower expenses than 529

Not tax-deferred; becomes child's money at age 18 or 21; can hurt student's financial-aid eligibility

$11,000 to stay within gift tax exclusion

None

Series EE Savings bonds

College tuition & fees

Interest is tax-deferred to maturity, tax free if used for qualified expenses

Typically return less than other options; must be held to maturity for maximum return

$15,000 ($30,000 face amount)

Tax-free redemption phased out at certain income limits

Taxable account in parents' name

No limits

Parents retain control

Not tax-deferred

None

None

By Karyn McCormack in New York


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