A primer of college savings plans
Benjamin Franklin once observed, “An investment in knowledge always pays the best interest.” There is as much truth in that statement today as there was in Franklin’s time. Education contributes to the success of individuals and to the productivity and competitiveness of the United States. The importance of education is especially significant as the American workplace evolves. During the past five years alone, job opportunities requiring a postsecondary education have increased almost nine times faster than jobs requiring a high school diploma or less.
Today, the demand for educated and highly skilled workers is outpacing the supply of new graduates from professional, trade and business schools; junior colleges; community colleges; other two-year colleges; and four-year colleges and universities. As a result, the financial value of higher education continues to increase. According to the College Board, the average difference in lifetime earning potential between someone who spends two years in college and a high school graduate is $350,000. The typical bachelor’s degree recipient can expect to earn about 73 percent—or about $1 million—more over a working life than a typical high school graduate.
While most parents want their children to receive a postsecondary education, research shows that only one-third say they expect to be prepared to pay for their child's education. Since 1980, the cost of higher education has been rising about twice as fast as the Consumer Price Index, according to the College Board. The latest College Board numbers reflect that the cost of a four-year college education is over $50,000 for a current enrollee and will grow to over $130,000 for today’s newborn. These numbers are based on the average costs at a public institution. At a private institution, the costs can be two to two-and-a-half times more. The cost of a college education is increasing much more rapidly than median family income. In recent years, federal financial aid for higher education has shifted largely toward loans and away from grants. As a result, the percentage of family income required to pay the cost of higher education has increased significantly.
So how do parents and grandparents pay for college for their children and grandchildren?
The Coverdell Education Savings Account (formerly known as the Education IRA) allows individuals to set aside after-tax dollars for a loved one’s future education expenses. The funds grow tax-deferred and when they are withdrawn for qualified college costs, they come out free of federal and state income tax. Contributions can be made to the Coverdell account until the beneficiary attains the age of 18 and funds must be completely distributed by the time the beneficiary reaches age 30. A Coverdell account is a start, but won’t offer much help with its annual contribution limit of $2,000.
A Uniform Transfer to Minors Account (UTMA) is a custodial relationship, typically with a parent as custodian for their minor child. Historically, the advantages of these accounts have been the ability to transfer the income-tax liability on the assets from the parent’s higher bracket down to the child’s rate. Many Nebraska parents and grandparents have been turned away from UTMA’s based on the fact that the minor receives complete access to the funds at the age of 21 in Nebraska. The rules in other states may be different. For many individuals, giving up control with these accounts makes them less attractive as college-savings vehicles.
Fortunately, there’s another option for saving for college. College Savings Plans, often referred to as 529 Plans, are qualified tuition programs under section 529 of the Internal Revenue Code, which governs all state-sponsored programs. The 529 plans were started in 1996 as part of the Small Business Job Protection Act. The Nebraska Educational Savings Plan Trust was established by the Nebraska State Legislature, with an effective date of January 1, 2001. Governor Dave Heineman (then state treasurer) was the first trustee of the Nebraska plans.
The term “529” simply refers to the Internal Revenue Code Section. The 529 plans are much like your 401(k) retirement savings program, which refers to the code and section within the IRS. These programs are intended to encourage Americans to save for the future and provide tax incentives.
A 529 plan is a tax-advantaged savings plan designed to encourage saving for the future. These plans make saving for college easier and more affordable. They offer tax-saving advantages and provide multiple investment options, helping parents and grandparents make higher education a reality for their children and grandchildren.
There are two types of 529 plans: prepaid tuition plans and college-savings plans. All 50 states and the District of Columbia sponsor at least one type of 529 plan. At last count, there were well over 100 different College Savings Plans available around the country. At the end of June 2007, there was $100 billion in such plans. In addition, a group of private colleges and universities sponsor a prepaid tuition plan.
Section 529 college-savings plans allow individuals to invest in a predetermined menu of investment options. Many plans offer multiple investment options, including individual funds as well as premixed funds. Most 529 savings plans offer a variety of age-based asset allocation options where the underlying investments become more conservative as the beneficiary gets closer to college age. They also offer risk-based asset allocation options where the underlying investments maintain the same equity-to-fixed-income ratio regardless of the age of the beneficiary.
Lifetime contribution limits to section 529 plans vary from state to state, and you may have some flexibility on when you can contribute. In addition, there are no income thresholds and typically no annual contribution limits, although annual contributions above certain levels may require filing a federal gift-tax form and are subject to federal gift taxes. Contributions up to $12,000 annually ($24,000 when made jointly with a spouse) or a lump-sum contribution of $60,000 every five years will not incur gift taxes, up to the plan’s respective lifetime contribution limit. Any earnings in the account potentially grow tax deferred. If you select the plan in the state where you live, you may also be eligible for state tax deductions. Nebraska recently increased the state income tax deduction from $1,000 to $5,000. All of the states surrounding Nebraska with a state income tax also offer a state income tax deduction.
Once your child reaches college age, you may withdraw money from the account to pay for qualified higher education expenses. Assuming that you have followed the plan’s rules, there will be no penalties, and withdrawals used for qualified education expenses are tax free. Any money left over in the account can be transferred to a sibling, first cousin or other family member (as defined by the Internal Revenue Code) of the original beneficiary without triggering income tax consequences, as long as the new beneficiary is related to the original beneficiary.
529 College Savings Plans have four main advantages
First, you get unsurpassed income tax breaks. Although your contributions are not deductible on your federal tax return, your investment grows tax-deferred, and distributions to pay for the beneficiary’s college costs come out federally tax-free. The tax-free treatment was made permanent with the Pension Protection Act of 2006. If you invest in your home state’s plan, it may offer some tax breaks as well (like an upfront deduction for your contributions or income exemption on withdrawals), in addition to the federal treatment.
Second, you, the donor, stay in control of the account. With few exceptions, the named beneficiary has no rights to the funds. You are the one who calls the shots; you decide when withdrawals are taken and for what purpose. Most plans even allow you to reclaim the funds for yourself any time you desire, no questions asked. (However, the earnings portion of the “non-qualified” withdrawal will be subject to income tax and an additional 10 percent penalty tax). Compare this level of control to a custodial account under the Uniform Transfers to Minors Acts (UTMA).
Third, a 529 plan can provide a very easy hands-off way to save for college. Once you decide which 529 plan to use, you complete a simple enrollment form and make your contribution (or sign up for automatic deposits). Then you can relax and forget about it, if you like. The ongoing investment of your account is handled by the plan, not by you. Plan assets are professionally managed either by the state treasurer's office or by an outside investment company hired as the program manager. You won’t even receive a Form 1099 to report taxable or nontaxable earnings until the year you make withdrawals. If you want to move your investment around, you may change to a different option in a 529 savings program every year (program permitting), or you may roll over your account to a different state’s program, provided no such rollover for your beneficiary has occurred in the prior 12 months. (There is no federal limit on the frequency of these changes if you replace the account beneficiary with another qualifying family member at the same time.)
Finally, everyone is eligible to take advantage of a 529 plan, and the amounts you can put in are substantial (over $300,000 per beneficiary in many state plans). Generally, there are no income limitations or age restrictions. Thinking about going back to college or graduate school in the future? Then set up a plan for yourself!
What are the downsides of saving for college with a college savings plan?
An article in Slate magazine showed the high fees associated with these plans make them less effective saving tools than more traditional funds. A more recent analysis concluded that while some 529 plans have improved by reducing fees and expenses and offering more investment options, some plans still charge exorbitant fees that effectively negate the plan’s tax benefits. This analysis may not factor in the fact that the large size of 529 plans allows the “average” investors to benefit for the “institutional” pricing power of the plans total assets.
While the number and types of 529 plans is growing, not all investment vehicles are available in 529 form. Many states contract with a single asset-management firm to oversee the plan. This may limit your investment choices to “best in firm” choices rather than “best in class.” Some plans, like Nebraska, offer a more open architecture that expands the menu of investment choices to multiple-asset-management firms.
Another drawback to Section 529 plans is investment risk. Returns from Section 529 plans are not guaranteed. This means that your investment could lose value, perhaps just as your child is beginning college. Although the firms that manage Section 529 plans often use less risky asset allocations to reduce risk as your child nears the first day of college, risk cannot be eliminated altogether.
So how do you select the plan that is best for you?
Kiplinger’s magazine has two recommendations to help parents sort through the daunting range of 529 plans:
1. Maybe stay at home. Stick with your own state’s plan if state income taxes are high and you can deduct 529 plan contributions, as in New York and Michigan. The SavingForCollege.com site lists each state’s laws on state-tax-deductible or nondeductible contributions and on state-tax-exempt or non-exempt withdrawals.
2. Four good ones. If you’re looking out of state, Kiplinger’s suggests the following four 529 plans as strong possibilities to consider, because they offer a healthy combination of flexible investment options, appropriate risk management and low expenses.
*Kansas Learning Quest Education Savings Program
*College Savings Plan of Nebraska
*New York’s College Savings Program
*Utah Educational Savings Plan Trust
In addition, your financial advisor can help you select the plan that is best for your needs. If you are a “do it yourself” investor, there are a number of useful Web sites, such as:
www.sensible-investor.com/529_plans.html
www.naasa.org/investor_education/3136.cfm
www.collegeanswer.com/paying/content/529.jsp
The most important step for any parent or grandparent is to make sure they are saving for their own retirement first and foremost. Second, if saving for future college expenses is also an important goal, get started today. The key is to start a program as soon as you can and let time and compounding returns work for you. If you decide a 529 is right for your situation, the State of Nebraska has a nationally recognized 529 program, the College Savings Plan of Nebraska, which may be worth exploring. Consider the above variables, consider what is important in your situation, and get started. Many people do not plan to fail, but instead, they fail to plan. College will be here before you know it—make sure you’re prepared.
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