States Take Lead in Offering College Savings Plans

The Education IRA, passed by Congress, is small potatoes compared with what some states offer.
Author:
Publish date:

The

Education IRA

, created by Congress, allows you to put away up to $500 a year in a tax-deferred account.

Big deal.

Massachusetts' new U-Fund program allows you to invest up to $150,000 per account in a savings program run by

Fidelity Investments

. And there are no income limits on participation, like there are with the Education IRA. Your money grows tax-deferred -- that is, you pay no state or federal taxes on the earnings until you're ready to withdraw them. And your child doesn't have to go to a Massachusetts college to use it.

In fact, you don't even have to be a Massachusetts resident to participate in the program.

The U-Fund program is just one of 10 new state college tuition and savings plans that have cropped up this year, bringing the total number of states offering such plans to 34. Another six plans will be offered next year.

A key feature of many of these programs is a willingness to accept out-of-state dollars. So it pays to shop around.

"We've started seeing the states' marketing getting very competitive," says Kathy Tisson, spokeswoman for the

College Savings Plans Network

, a clearinghouse for information about state college savings programs. "But the bottom line is to give families choice and chance to save."

A big bonus: When you put money into a state tuition plan, it comes out of your estate. That means no federal estate tax will be owed on that money when you die.

So while Congress tinkers with halfway measures like the Education IRA and the

Hope Scholarship

and

Lifetime Learning

credits (which can be used toward tuition expenses, but max out between $1,000 and $1,500 per year), the states are competing with each other to save you real money.

"I recommend these plans to everyone I know," says Martin Nissenbaum, national director of personal income tax planning at

Ernst & Young

. They're the Holy Grail of estate planning for people who aren't mega-wealthy."

The Nuts and Bolts

Even though these plans have been around since 1988, they really took off in 1996 after the

Internal Revenue Service

wrote guidelines for Qualified State Tuition Programs into the tax code under Section 529. These guidelines have served as a blueprint for states that are designing their own programs.

A key component of these plans allows the parent to maintain complete control over the account, unlike accounts set up under the Uniform Gifts to Minors Act. With an UGMA, the child gains control of the account when he or she hits the age of majority, typically 18 or 21. With a state tuition plan, you don't have to worry about your children blowing his or her college savings on a cross-country tour of brewpubs.

These plans, a.k.a. 529 plans, come in two flavors: prepaid tuition programs and tax-deferred savings plans.

A

prepaid tuition plan

is a promise you can buy a future tuition credit at today's prices. Basically, you purchase credits or certificates that entitle the beneficiary to waive future college tuition costs.

"The Florida Prepaid College Program is the largest prepaid tuition program out there with over 500,000 contracts sold," says Joe Hurley, author of

The Best Way to Save for College

. But the best benefits are reserved for those who go to a Florida school. If a child goes to an out-of-state school, Florida will give you back your money, plus guarantee you 5% compounded interest on your contribution. But some states give you nothing, notes Hurley.

Tax-deferred savings plans

act like nondeductible IRAs. You pay no state or federal taxes on the plan's earnings until it's time to withdraw them. At that point, earnings are taxed at the beneficiary's rate -- which is typically lower than yours. The money must be used at an accredited school where students can get financial aid. Graduate and professional schools count. So do some two-year vocational and technical schools. Depending on the plan, the money also can be used to pay for books, room and board, supplies and equipment.

Unlike IRAs, you don't get to choose how to invest your money in these savings plans. Your money generally is placed in a preselected portfolio based on the beneficiary's age. For instance, New Hampshire's

Unique College Investing Plan

will invest 88% in equities and 12% in bonds for a 2-year-old child, but only 20% in stocks and 80% in bonds for a budding teenager.

Returns may be more conservative than, say, an index fund, though. Most plans are not designed to return more than the cost of college. "We've designed investment allocations that best stay ahead of college inflation while trying to minimize inflation risk," says Tom Pinto, spokesman for

TIAA-CREF

, which runs the

New York State College Choice Tuition Savings Program

. (The company will launch similar plans in California, Missouri and Vermont by year-end.)

"You very well might do better investing in

Microsoft

(MSFT) - Get Report

, says Abram Claude, vice president of marketing higher education products at Fidelity. Fidelity, which runs plans for Delaware and New Hampshire as well as Massachusetts, aims to do slightly better than the

Wilshire 5000

, which has risen in value 278% over the last ten years, vs. a 305% increase for the

S&P 500

.

But don't confuse saving for retirement and saving for college. Your accumulation period is shorter when you save for college -- 18 years, at best, if you start at a baby's birth. For retirement, you've probably got more like 30 years to plan.

In addition, the college savings payout is much quicker -- as little as four years and up to eight years if the student goes to medical school. You could be withdrawing on your retirement benefits for up to 40 years.

State Perks

To research all the state's plans, check out the College Savings Network's

Web site for details. Compare investment options, contribution limitations and fees. And keep in mind that while most plans don't have a residency requirement, some states treat their residents better than they do out-of-staters.

If you live in New York and invest in the state's program, you'll get a deduction on your state tax return for your contributions up to $5,000 ($10,000 for a married couple). In addition, earnings on the account are state-tax-exempt when the beneficiary withdraws them, as long as the money is used for educational purposes. And if you file a non-resident tax return in New York, you can get a partial deduction.

New Jersey exempts from taxation qualified earnings from

any

state's tuition plan, not just the residents-only

New Jersey Better Educational Savings Trust

. "We're hoping to see other states follow suit," says Fidelity's Claude.

Better still, the residents-only

Louisiana Student Tuition Assistance and Revenue Trust Program

, will throw in additional scholarship money as long as the annual plan contributions hit $100. The grant can be as high as 14% and is based on the donor's federal adjusted gross income.

Federal Rules

There is bipartisan support in Congress to make earnings from state college savings plans federally tax-free at withdrawal. A proposal to do that is part of a tax relief bill proposed by House Ways and Means Committee chairman Bill Archer (R., Texas).

But there are other federal tax considerations you'll need to keep in mind. The money you put into these plans is subject to gift-tax rules. That means you and your spouse can each contribute only $10,000 a year per child gift-tax-free. But you can elect to use your next five years' $10,000 annual gift-tax exclusion in one year. This one-time option allows parents to contribute up to $100,000 gift-tax-free in one year.

Not all state plans will allow you to contribute that much. For example, the

College Savings Iowa

plan, run by

Vanguard

, limits annual contributions to just $2,000 a year per donor.

But even that is still better than the Education IRA.