Weighing Pros and Cons of College-Saving Strategies

College costs are skyrocketing.

The tuition component of the Consumer Price Index jumped 6.4% over the 12 months ending with February 2002, compared to the 6.1% increase in the year ending December 2001, and the 4.5% uptick in 2000.

It's not surprising, then, that parents and grandparents are concerned about how to fund their children's and grandchildren's college education. UTMA/UGMA accounts, education IRAs (recently renamed as Coverdell Education Saving Accounts), Plan 529 accounts or customized trusts? Which is the best option -- particularly if your goal is to transfer assets to descendants while still maintaining control over how those assets are used?

First, remember the power of compounding: $10,000 deposited on behalf of a newborn grows to $39,000 by age 18, assuming 8% return and ignoring taxes for the moment. In 2002, individuals may make gifts of up to $11,000 per child.

So two parents and four grandparents could fund four years at a private school with one initial combined gift of $66,000, which would grow to $264,000 in 18 years at 8%. Alternatively, gifts totaling $5,340 each year grow to $200,000, compounding at 8% annually over 18 years.

More Ways to Save

Until a few years ago, options were limited. Parents could set up a UTMA (Uniform Transfer to Minors Act) or UGMA (Uniform Gift to Minors Act) account depending on the state they lived in. UTMA/UGMA accounts had the advantage of being standardized, and thus inexpensive to set up: all brokerages offer them. They're easy to administer, too -- generally a parent is the custodian.

But such accounts have two disadvantages. Investment income over $1,400 was taxed according to the parents' tax schedules until the child reached age 14, at which point the child starts filing his or her own taxes. At age 18, the child receives control over the assets in the account, but doesn't have to spend the money on education. In fact, the child could spend the money on anything.

Alternatively, guardians could establish specific trusts for the benefit of minors. The trust deed includes the following details:

• Beneficiary. Preferably a single individual.

• Assets to be contributed. Gift taxes generally apply to gifts over $11,000 as of 2002, but donors can get around this by using part or all of the estate exclusion amount: $650,000 per individual in 2002. After the trust is established, more than one person can contribute assets over multiple years. Grandparents can divert up to $1 million ($2 million per couple) to grandchildren through a special trust called a Generation Skipping Transfer Trust.

• Distribution policy. This specifies the circumstances in which funds will be distributed. For example, funds may be distributed only for education expenses, or as a fixed percentage of total assets, or for whatever purpose the trustee deems legitimate -- starting a company, for example. The trust can also terminate at a specific event, such as a specific birthday or a marriage.

• Revocable/irrevocable. Grantors of assets to revocable trusts have the right to call back the assets. Assets donated to irrevocable trusts exit the estate of the grantor, which could reduce their future estate taxes.

• Naming of trustee(s). There are provisions for succession and removal of trustees. Trustees can be professional trust officers, relatives or family friends. Professional trustees can be too rigid in applying the distribution policy, but relatives or family friends may lack the skills to do the best possible job over decades of commitment.

• Investment policy. These should generally follow "Prudent Investor" guidelines. Older trusts often specified that only income could be distributed, which caused great hardship when bond and dividend yields fell sharply through the '80s and '90s. Prudent Investor rules allow for greater discretion in asset allocation.

• Tax ID. This is generally different from the Social Security Number of the beneficiary.

  Such specific trusts typically cost $800 to $2,000 to establish and incur additional annual fees for investment management, trustee and accountant expenses. You shouldn't go this route unless you expect a contribution of at least $100,000.

  Congress established educational IRAs a few years ago when constituents began to worry about higher education costs. Until recently, contributions were limited to $500 per year -- the limit has been raised to $2,000. Further, the ability to make contributions is reduced once adjusted gross income (AGI) exceeds $190,000 per year for a couple, and is eliminated once AGI exceeds $220,000.

  In other words, the families most likely to contribute to an educational IRA probably couldn't. Contributions are not deductible against current income, but the funds grow tax-free and qualified withdrawals are not taxable. All funds must be dispersed by the time the beneficiary turns age 30.

  Because of low contribution limits and limitations based on income, it's not surprising that educational IRAs aren't popular.

  529 to the Rescue

  About the same time, a number of state legislatures established new kinds of savings plans called 529 plans. Two types of 529 plans exist: prepaid tuition plans and college savings plans. Prepaid tuition plans allow donors to lock in current tuition rates by paying now for future education costs. The more popular option is the college savings plans, which are managed by investment firms.

  Tax deductibility on these plans varies by state. The SavingForCollege Web site can help you find plans in your state, and the larger brokerages now sponsor national plans. A recent TSC article documents tax law changes that make the 529 plans more attractive. These are the best features:

  • The donor has full control of the account, not the beneficiary.

  • The account is transferable to another beneficiary.

  • Everyone is eligible. There are no income or age restrictions.

  • The funds may be used at any accredited college or university in the country.

  • Large amounts of money can be contributed -- this year $11,000 per individual.

  • Multiyear contributions can be accelerated (that is, you can contribute up to $55,000 this year provided you make no further gifts to the same beneficiary for the next five years).

  • The assets grow tax-free.

  • Qualified withdrawals are free of federal taxes.

  • Contributions, but not appreciation, are revocable.

  • You don't make investment decisions. The funds are generally invested in index funds, and some plans automatically decrease the equity exposure the closer your child gets to college.

    So are 529 plans the best option? They have clear advantages. If your only interest is to save for a child's education, liquidate your UTMA/UGMA accounts and roll the proceeds into 529 accounts. Remember, though, a child owns anything deposited in the UTMA account; therefore, the child has the right to "revoke" that contribution at the age of 18.

    But you might establish a UGMA/UTMA account for your child for purposes other than education -- for example, to hold your child's after-school earnings.

    If you're in a situation to make substantial (greater than $100,000) intergenerational transfers, you may need to establish specific trusts anyway. There's a limit on how much can be contributed to 529 accounts. It ranges from $100,000 in New York to $268,000 in North Carolina. This rule prevents plans from becoming overfunded, in which case the beneficiary would owe penalties on money they withdraw beyond that spent on education.

    With 18 years of compounding, $100,000 could grow to over $400,000, in which case having a trustee supervise the distribution of funds might be a good idea.