Saving for the College Years
The trick is figuring out which strategy is right for you.
By Bob Barry, CFP

College tuition could be one of the biggest expenses a family will face. Fortunately, recent events, such as the Tax Relief Act of 2001, have expanded your college-savings options. The trick is to find the right strategy for you.

529 savings plans. These plans (named after a section in the U.S. Tax Code) are state-sponsored investment programs offering a variable rate of return. Nearly every state either offers such a plan or has a plan in development. You can invest in any state’s plan, no matter where you live, and the money can go toward both private and public schools.

Investors select either the program or a specific investment option within the program that meets their needs, such as an all-stock or all-fixed-income option. Some state plans gradually shift away from stocks to bonds and money markets as the plans’ beneficiaries draw closer to starting college.

One drawback to these plans is that investors are restricted in their ability to transfer plan assets and thus change investment options. However, the new tax act allows investors to move funds from one plan or option to another, but only once a year. Investors always can direct new contributions to new plans or plan options.

These plans also have income restrictions; generally a married couple can invest and earn as much as $100,000 to no more than $250,000 a beneficiary depending on the state’s plan. Investments must be made in federal, after-tax dollars (some states also give a tax deduction), but the earnings grow tax-free. And in a major change, the 2001 tax act allows tax-free withdrawals as long as the money is used to pay for qualified education expenses, such as tuition, books, and room and board.

Education savings accounts. The 2001 tax act quadrupled from $500 to $2,000 a beneficiary the maximum annual contribution you can make to what is now called the Coverdell Education Savings Account (ESA). As with a 529 plan, ESA earnings and withdrawals are tax-free if used for qualified education costs. In addition, ESA expenses can include those for public and private elementary and secondary schools, including tuition, tutoring, and computers. Another advantage is that you can control investments as you do in an individual retirement account (IRA).

Drawbacks do exist. The beneficiary must be under age 18, unlike the 529 plan where the beneficiary can be an adult of any age. There are income restrictions, though they are high, with phaseout thresholds starting at $190,000 for joint filers. Savings in ESAs also may reduce financial aid more than those in 529 plans do.

Prepaid tuition plans. These plans, which follow the same tax rules as 529 savings plans, allow you to lock in tomorrow’s tuition costs at today’s prices. The plan guarantees that the money you pay now will keep up with college tuition inflation, which has been running 3 percent or more annually above the Consumer Price Index.

Because of the high stock returns of the 1990s, these plans were overshadowed by hot-performing 529 plans. Now with the cooling of the market they look more attractive to some investors. A recent article in the Journal of Financial Planning calculated that the average annual after-tax return of prepaid tuition plans since 1991-92 has been 6.3 percent, with less volatility than college savings plans. With college expenses climbing — tuition increases at four-year public universities jumped 7.7 percent for the 2001-02 school year — the lower-risk, inflation-guaranteed returns of prepaid plans may be appealing. One drawback is that only 19 states currently offer prepaid plans, and usually the plans are open only to residents.

Finding the right strategy can be confusing. Some conflict with financial aid and various education tax credits. Become familiar with them and talk to your financial planner.