Applying to College Is an Expense in Itself

Title: Plotting your savings strategy

Author(s): Paul J. Lim

Citation: September 6, 2004 p 50, 54-56, 58 Section: Money & Business , Paying for college, News You Can Use

Subjects: COLLEGES & UNIVERSITIES; TUITION; PARENTING & PARENTS; EDUCATIONAL FINANCE; STUDENT FINANCIAL AID; SAVINGS

Word Count: 2637

Abstract: Summaries of college savings plans including 529s, brokerage accounts, IRAs, Coverdell education savings accounts, UGMAs, savings bonds, and prepaid plans with advice on how to choose among them

Article Text: Pamela and Peter Gonzalez are probably better equipped than most parents to make sense of the alphabet soup of ESAs, UGMAs, IRAs, and the like that make up the nation's college savings system. For starters, Pam, 45, and Peter, 38, are air traffic controllers. So the Plantation, Fla., couple knows a little something about making complicated decisions under pressure. Moreover, Pam is interning at a financial planner's office because she's thinking about working in that field after she retires from her current job. Still, she says, "the sheer number of options is overwhelming. For each one, you have to figure out 'what does it all mean to me?' "Parents saving for college today have more options--and better options--than ever before. But the creation and evolution of new savings vehicles in recent years, coupled with changes to the federal tax code, have made the array of savings plans more difficult to digest than ever before. In fact, saving for college has become a bit like participating in an Iron Chef competition. Without much prep time, you're given some mystery ingredients to work with, some of which you may never have heard of. And while the clock is ticking, you're somehow expected to whip up a sophisticated financial plan that keeps pace with ever growing college costs. Last year, for example, average tuition at private colleges rose 6 percent to $19,710, according to the College Board, while the average cost at public institutions jumped 14.1 percent to $4,694.The Gonzalezes recently began setting aside $1,000 a month for their daughter, Rachel, 11, and son, John, 9. But the funds are sitting in a money market account earning around 2 percent a year as they weigh their choices. Pam wants a plan that offers maximum flexibility, since she's unsure where her kids will go to school or whether they'll earn scholarships. The family could try a 529 savings plan, a 401(k)-like account that allows for federal tax-free withdrawals for qualified educational expenses. With more than $43 billion invested nationwide, these plans are fast becoming the most popular tax-advantaged savings plan for college. The Gonzalezes are also thinking of investing in a regular brokerage account, which is taxable, where they can have more control over investment decisions and fees (box, Page 56). Or, they can opt to save in an individual retirement account like a Roth."It may be a case where more than one is appropriate," says Geordie Crossan, president of NBS Financial Services, a financial planning firm in Westlake Village, Calif. Indeed, there is ample evidence that most parents are starting to use more than one type of account; 13 percent are using three or more different types.Special blend. Some are relying on a mix of brokerage accounts--an option that has improved in recent years, thanks to lowered rates on long-term capital gains and qualified dividend income--alongside tax-advantaged college savings plans like 529 savings accounts, offered by virtually all 50 states, or Coverdell education savings accounts (Coverdell ESA s). Others are stirring together brokerage accounts and traditional custodial accounts like Uniform Gifts to Minors Act accounts (UGMA s), where assets are put in the child's name and are taxed at the child's lower rate to shield money from Uncle Sam. But these plans have become less popular in recent years with the rise of 529s.Nearly a third of parents are saving in a brokerage account while simultaneously using good old-fashioned savings bonds. Of all the options, this may prove to be the most conservative--perhaps too conservative. "If you're saving in a bank account or in savings bonds, you're not going to keep pace with the goal you're saving for," says Bob Corcoran, vice president of college planning for Fidelity, the nation's largest mutual fund company. While savings bonds have a built-in tax advantage--married couples earning less than $119,750 this year can get a federal tax break on interest used for school--the interest they are now generating is less than the long-term rate of inflation and far below the recent pace of tuition increases. Even so-called I bonds, which are savings bonds whose value rises with inflation, are yielding only 3.39 percent. At that rate, a $10,000 savings account won't even double in 18 years.So what should you be doing? Though it sounds counterintuitive, you actually should start by focusing on you and not your child in this process. No parents really know what school their kids will be attending (or if they'll attend at all). Will they win partial or full scholarships? Be eligible for financial aid? The only things parents know for certain, in fact, are their own preferences and priorities.Raymond Loewe, president of College Money, a financial planning firm in New Jersey that specializes in college costs, suggests parents sit down and figure out what their top priorities are and find a mix of plans that suits those needs. That's what Chris Richardson, 35, an Air Force major stationed in Texas, did. He and his wife, Sara, came to the conclusion that whatever money they put away for their two boys, Jack, 6, and Zack, 3, they wanted to minimize taxes and maximize returns. The Richardsons began saving a little more than three years ago, putting a small amount of money into a low-cost S&P 500 index fund in a brokerage account. But the couple is now convinced that a tax-sheltered 529 would be a better choice, even with the 2003 tax cuts.By lowering rates on long-term capital gains and qualified dividend income to 15 percent, the 2003 tax cuts made investing in brokerage accounts a lot more attractive for college savers than it used to be. But "tax free is almost always better than low taxes," says Whitney Dow, director of education savings research at Financial Research Corp. And that's why 529 college savings plans (named after the section of the tax code that gave birth to them) are considered a good building block for most parents.Just look at the numbers. T. Rowe Price, the Baltimore-based mutual fund company, studied the after-tax returns of an investment in a blue-chip fund earning 8 percent a year inside a brokerage account versus the same investment in a 529 savings plan. The firm discovered that if you were to invest $5,000 a year in a brokerage account for 18 years, that money would grow to $189,869. In a 529, that same money would grow to $217,631. And if it were invested in a 529 plan that offers residents a state tax deduction (as about 25 state plans do), it would reach $223,086.Many perks. The 529 plans are also attractive because they allow parents of all income levels to save around $250,000. Better still, gains withdrawn from 529s are free from federal and usually from state taxes as long as the money is used for qualified educational expenses such as tuition, room and board, and mandatory fees. Though states operate 529 savings plans, you don't have to be a resident to participate. However, because of state tax deductions, you may want to consider your in-state plan first.There are other tax-deferred options, like an IRA. As long as the money is withdrawn for educational purposes, it isn't subject to the 10 percent penalty for early withdrawal. But depending on your age, the type of IRA, and how long you've held the account, you may have to pay taxes on the gains at withdrawal. Many planners warn against using IRA s, since parents shouldn't shortchange their own retirement. But IRA s do give parents a choice to use the money for school or retirement. Moreover, parental assets held in retirement accounts aren't figured into college financial aid formulas (box, Page 58).The Richardsons considered yet another tax-advantaged plan, a Coverdell ESA. Married taxpayers with adjusted gross incomes as high as $220,000 and single taxpayers with incomes as high as $110,000 can participate. But the couple opted for the 529 because a Coverdell permits only up to $2,000 to be contributed a year per beneficiary. Yet this doesn't have to be an either-or situation. Bruce Harrington, director of 529 plans for mutual fund company MFS, says it may actually make sense for parents who are eligible to consider putting their first $2,000 of college savings each year in a Coverdell. Then, you can put your remaining college assets into a 529. Why? Because Coverdell accounts have many advantages. They are tax sheltered, and the gains withdrawn are tax free as long as the funds are used for qualified educational purposes. But unlike a 529, money withdrawn from a Coverdell can also be used to pay for qualified expenses for K-12 education, including tuition costs at a private school, tutoring expenses, and required equipment such as computers.If you contribute to a Coverdell and discover later on that you won't be sending Junior to private high school, don't worry. You can keep the money in the plan and use it for college. Or you can roll over your Coverdell assets into a 529. Money in a 529, on the other hand, can't be transferred into a Coverdell, so it may make sense to fund a Coverdell now, if only to keep your options open.Like the Richardsons, Manuel Sousa's No. 1 concern is reducing his taxes. This is why the 54-year-old Manhattan Beach, Calif., resident began putting away around $100 a month in an UGMA custodial account for his daughter, Karina, when she was born 17 years ago. Later, he started a similar account for his son, Devon, now 12. In an UGMA, the first $750 in investment income is considered tax free. The remainder is taxed at the child's rate if he or she is 14 or older. If the child is under 14, the next $750 in income is taxed at the child's rate, but anything beyond $1,500 is taxed at the parent's rate.But when Sousa, who runs his own court-reporting business, recently learned about 529s, he shifted the money in his children's UGMA s into these savings plans. "The tax advantage makes them a better account than what I had before," he says.Here's why: Based on current tax laws, T. Rowe Price figures $5,000 annual investments in a blue-chip growth stock fund in an UGMA, based on an 8 percent return, would grow to $207,885 in 18 years. That's better than what you'd get in a brokerage account, but it's still $10,000 to $15,000 less than you would have earned in a 529. Another advantage of 529s over UGMA s is that in a 529, the person who funds the account always controls the assets. In an UGMA, the child takes control of the money once he or she turns 18 or 21, depending on the state.Safe haven. Still, there are reasons that some parents may want to use UGMAs. For starters, parents who want to shield assets from would-be creditors--for instance, physicians or small-business owners seeking to safeguard holdings against potential lawsuits--might want to consider using UGMAs. Once in an UGMA, the money legally belongs to the child. Moreover, UGMA s can be funded with appreciated stock. You may want to consider gifting such stock to your child in an UGMA, while using your cash to fund a separate 529.For Kathleen and Bob Piwko Jr., it was peace of mind--and Notre Dame--that topped their list of priorities. So the northern New Jersey couple's recipe involves using a prepaid college tuition plan (also referred to as a 529, making matters even more confusing) in conjunction with a 529 savings plan. The Piwkos started stashing away about $300 a month even before the eldest of their four kids, Kimberly, 10, was born. That money had been going into a brokerage account and, later, UGMA s. But earlier this year, the couple shifted to a new type of prepaid college tuition plan called the Independent 529. Unlike traditional prepaid plans, this one is not run by a state; it's operated by a nonprofit organization. And instead of buying credits at a public college, the Independent 529 allows parents to buy discounted tuition credits at nearly 250 private colleges and universities across the country including Stanford, Princeton, and Notre Dame.So far, the Notre Dame alums have opened two accounts: one for their daughter Kimberly and another for son Matthew, 7. Eventually, they'd like to buy credits for twins Margaret and Michael, 3. The couple would love to see all four kids go to Notre Dame, says Bob, who works as a general manager of a software-services company. But one of the nice features of a prepaid is that it can be transferred to a sibling. So if their elder kids bypass Notre Dame--gasp!--or enroll in a college that does not participate in the Independent 529 plan, those credits can be transferred to their younger kids.Sticking points. Still, there are drawbacks to prepaid plans. Several state-run prepaid plans closed their doors temporarily last year to new money because of short-term fiscal concerns (the Independent 529, because it is backed by private colleges, has not run into these problems). Also, prepaid plans really cover only tuition and mandatory fees. To pay for room and board, the Piwkos aim to start 529 savings plans for their kids next year.So what if you want to be even more flexible? Of all the options, saving in a brokerage account offers the most choices since the money can be used for any purpose. It can be invested in any manner, and it can be withdrawn at any time. And because the money is held in the parent's and not the student's name, saving in a brokerage account can be a decent move from a financial aid standpoint. Among tax-deferred college savings plans, though, 529s are probably the most flexible. For example, once money is in a 529, it can stay there, it can be rolled over into another state's 529, or it can be moved into a prepaid plan.That's why Cathie Marcolesco, the wife of an Air Force flight instructor at Edwards Air Force Base in California and mother of five, likes 529s. Again, she can pick from among all of the state plans, so it doesn't matter where she lives. Moreover, parents can either invest on their own through a limited number of fund offerings like a 401(k) or put their money into a so-called age-based asset allocation fund, which manages the portfolio for them based on the age of the child. "For me, actively managing five separate accounts would be just too much work," says Marcolesco.In this sense, Marcolesco isn't really conjuring up her own college savings recipe as much as she is buying a ready-made meal. But that's OK, too. With today's hectic lifestyles, there's no shame in relying on a few premade concoctions when it comes to something as complicated and time-consuming as college savings. Just make sure the flavor is to your liking.