With the cost of higher education continually rising, it’s more important than ever to get an early start saving for a child’s college education. For parents or grandparents considering the possibilities, state-sponsored Section 529 College Savings Plans may be the way to go.
College Savings Plans allow you to invest significant sums of money that can grow tax-free. You can set up an account for anyone — your child, grandchild, niece, nephew, or even yourself. These accounts grow larger than an identical taxable account where earnings are taxed every year. The reason? Dividends and realized capital gains are not taxed annually and continue to grow within the account. Additionally, when the money withdrawn is used to pay for qualified education expenses, including tuition, fees, certain room and board expenses, supplies and equipment, it’s free from federal income tax. Many states also extend favorable tax deductions and tax-free withdrawals to state residents. New York and Connecticut currently offer state residents a $5,000 (individual) and $10,000 (married couple) tax deduction per year; New Jersey presently does not offer a deduction for state residents. Check with your tax advisor on this point.
Contributions to College Savings Plans are usually invested in one or more predetermined structured portfolios. Typically, plans include age-based or years-to-enrollment portfolios that become more conservative as the child nears college attendance. Early on, the portfolio will usually hold more stocks; as college approaches, the portfolio will automatically include more fixed income investments in order to reduce the risk of stock market volatility on money needed to pay for college in the near future. Other options include static portfolios that do not alter their investment allocations over time, and individual fund portfolios that allow for a greater degree of customization. OF course, the performance of the portfolios depends on market conditions and there is no guarantee that there will be enough money in the account to cover all education expenses.
Do the Math
To fully understand the benefits of 529 plans, compare how they stack up against more traditional plans. If you’ve started to explore education-funding possibilities, you have probably found that most traditional savings plans come with limitations. For example, with an Education Savings Account (ESA, formerly an Education IRA), you can only save $2,000 a year — not much given that tuition, room and board can sometimes cost tens of thousands of dollars for a four-year education. And while these accounts do provide tax-free distributions, parents with relatively high incomes may not be allowed to contribute.
Custodial accounts present other dilemmas. The child owns the assets since the account is in his or her name, but the latest changes in the taxation of unearned income by minors has been extended all the way through age 18, and up to age 24 for college students! That means you can only hope that your college-bound teen decides to use the money for college, but no matter how the money is spent, much of the investment income will be taxed to you at your highest marginal tax bracket.
U.S. Savings Bonds are also a popular savings vehicle. However, these bonds carry modest interest rates.
Do Your Homework
There are a couple of things you’ll want to consider when evaluating 529 plans.
First, find out about your state’s College Savings Plan. Keep in mind that where you live may or may not be the best place to invest. Most states allow accounts to be opened by and for non-residents. If your state has a College Savings Plan, you should weigh any local tax benefits against the benefits and conditions of plans offered by other states.
New York’s plan is administered by Columbia Management, Connecticut’s by TIAA-CREF, and New Jersey’s by Franklin Templeton. But this is not enough information to make an informed decision on choosing a plan. In addition to state of residency, it is also important to consider the tax bracket of the investor and how much they want to contribute. Columbia Management was recently rated by Barron's (a respected financial publication) as the best overall fund manager over the last five years. Based on that information, an investor in New Jersey, where there is no tax deduction, might consider using the New York plan to gain access to Columbia. However, the New York plan also has a higher initial minimum of $1,000, compared to the New Jersey plan’s $250 minimum.
If you are already saving within a custodial account, an ESA, or with U.S. Savings Bonds, you may want to explore the tax-free transfer of these savings to a College Savings Plan.
Finally, keep in mind that if the funds aren’t used for educational purposes, you’ll face a 10 percent penalty tax on earnings upon withdrawal.
Still, many families find the benefits of the plans greatly outweigh any potential disadvantages. Last year alone they invested around $5.5 billion.
NICHOLAS J VERTUCCI is a financial advisor and wealth advisory specialist at Citi Smith Barney. For more information: 212-603-6248; [email protected].