Investors get smart with savings plans for college
Dick Hoyt has thought for a while about how to pay his 14-year-old daughter Brooke's college tuition.
"I've been saving for it since the day she was born," said Hoyt, 59, a retired airline customer-service representative from Burien. He started by purchasing stock in stable companies, those "that have been around for 100 years, and will be around for 100 more." But in 1997, he added something new to his daughter's portfolio. That was one of the first years education IRAs — first cousins of the tax-friendly individual retirement accounts — were available.
Hoyt was drawn to them for the same reason he invested in an IRA for himself: Contributions grow tax-free and can be withdrawn tax-free for most educational expenses.
"Anytime you don't have to pay a tax, that's a good thing in my mind," Hoyt said. With the $1.35 trillion tax cut passed in June 2001, Congress gave generous breaks to parents saving for college tuition.
Changes to education IRAs, also known as Coverdell Education Savings Accounts, opened the door for saving for private tuition, said David Aramaki, a college-planning specialist with American Express Financial Adviser's Seattle office. Now Coverdell accounts can be used tax-free for expenses, including books, tuition and computers, at elementary and secondary schools, public or private. And, the maximum contribution was raised from $500 to $2,000 a year.
Even with these changes, the bulk of college-savings benefits came with the elimination of taxes on most withdrawals from state-run Section 529 plans.
Named after the part of the federal tax code that governs them, Section 529 plans come in two varieties: savings plans, which offer portfolios managed by investment firms, and prepaid-tuition programs, which guarantee future tuition at today's rate.
Regardless of the technical specifics, the allure of Section 529 plans remains the same. Money invested in 529 plans is not taxed when used for educational expenses. Withdrawals used for other purposes are taxed 10 percent.
"They're really flexible," Aramaki said. All state plans cover tuition, fees and books; some will pay for room and board and even transportation.
Section 529 plans have surged in popularity since Wyoming established the first one in 1987. In the past two years, the number of 529 accounts nationwide has more than doubled, while the dollars invested has tripled. As of 2001, $15.06 billion had been invested in 2.6 million accounts. By the end of 2002, each state and the District of Columbia will operate at least one.
|
Forty-one plans accept investors from any state, although some charge out-of-state residents additional fees. Most states provide incentives for their residents to invest in-state, whether it be through reduced enrollment fees or state income-tax deductions. New York residents, for example, get up to $5,000 in deductions.
"Without a state income-tax benefit possible, I'm not sure what incentive there will be to choose (the Washington plan) over other plans available. We'll have to wait and see the details," said Patrick McDevitt, a certified financial planner with Ragen MacKenzie Investment Services.
Washington's 529 program
Washington runs a prepaid-tuition program called GET, or Guaranteed Tuition Education.
GET is a very conservative and virtually risk-free investment. The state backs the program and guarantees that 100 units will equal one year of tuition and mandatory fees at Washington's most expensive public university. If the child decides to attend a private or out-of-state school, the student can withdraw the money tax-free.
After a $50 enrollment fee, parents can purchase units roughly equivalent to today's tuition prices. A year's worth of credits costs $4,200 while tuition at Washington State University for this school year is $3,898.
"People are essentially buying the guarantee," said Betty Lochner, GET's director.
According to Lochner, 312 students used GET credits this year. Those who bought plans in 1998, when a year's worth of credits cost $3,500, and used them this year received an 11.4 percent return on investment.
"Two years ago, when I started working here, people started saying 'Why is this a good investment when I can get 20 percent from the stock market,' " she said. "But this year we heard horror stories of students who went to take money out of those accounts and didn't have the money they expected."
Lochner said a sour stock market combined with the tax-law changes and increased exposure through television ads have helped double the number of GET enrollment applications this year compared with the same time last year. About 7,900 investors enrolled in the program's first year, and as of March 31, about 15,400 accounts have been opened.
Lochner said parents cannot buy enough GET units to cover all of a college student's expenses. She expects that once Washington starts a savings plan, parents will split their investment, purchasing GET credits to cover tuition and using savings-plan returns to cover housing and supplies.
"I think it is best suited if you want a guarantee and may be uncomfortable with the uncertainty inherent in a program invested in stocks and bonds," McDevitt said.
Aramaki doesn't have many clients investing in GET and predicts that once Washington establishes a savings plan, GET will become less enticing for even the most cautious investor.
Kiplinger's Personal Finance magazine and Savingforcollege.com, a top resource on 529 plans, have rated GET poorly because of restrictions on the accounts, such as a requirement that accounts be active two years before the first withdrawal and another that allows withdrawals only in increments equivalent to one year.
"Say you have four years' worth invested currently and it turns out your kid goes to private school. You think you have $16,000, but you can only pull out $4,000 at a time," Aramaki said.
How to choose an investment
First, know what you intend to get out of the program. Estimate how much you're likely to spend once your child reaches college age and how much you should save each year to reach this goal. There are plenty of online calculators to help do-it-yourselfers. The rule of thumb is the earlier you start investing, the less money you will need to set aside each year.
"If you want to try to accumulate a large college fund, say to cover tuition at a private college, room and board, a computer, etc., a 529 savings plan is probably your best option," McDevitt said. "The contribution limits are very high and not restricted by a contributor's level of income."
Most 529 plans offer age-based programs that invest primarily in stocks for young children and gradually adjust the portfolio to mostly bonds and money-market funds as the child ages.
"The portfolio for a newborn is very aggressive and gradually becomes more conservative over time," Aramaki said. "All the portfolios end up being conservative portfolios by the time the person enters college, because you can't afford for these investments to go down during the actual expense time."
Some states also offer a choice of aggressive, moderate and conservative portfolios, which are not tied to the beneficiary's age. The choice of investments is broader in Coverdell plans, giving parents more control.
If you've decided to select 529, picking a standout performer is difficult because the performances are very similar, Aramaki said.
Section "529s are very conservative, even when you pick aggressive growth," he said. "They're made up of several different mutual funds, so even when a fund does really well, it gets watered down. For one plan to stand out, all its (underlying) funds would have to do really well."
Returns have ranged last year between losses of 17.22 percent and gains of 9 percent. By comparison, the S&P 500, the index of the 500 largest U.S. companies, dropped 13 percent in 2001.
The difference among Section 529 plans, said Aramaki, boils down to the fund manager. Check out the fund manager's background and choose one you trust.
Look carefully at the fees. Some plans charge flat yearly fees, some charge a percentage of your account.
If you purchase the plan through a broker, expect even more fees. Some states allow brokers to charge a percentage of the deposit — like front-end-loaded mutual funds, others come with yearly fees.
According to Lochner, GET's director, brokers are not required to disclose which state's fund they are selling, they may not tell you about local tax benefits, and some will push higher-commission plans. Lochner came across a less-than-candid broker when looking to invest last year.
"He was really reluctant to tell me what state it was through. He finally told me it was through New Mexico," she said. If Washington had a state income tax and offered a deduction, this could have cost her a tax break, she said.
Finally, keep in mind the impact that saving for college can have on other financial preparations, such as securing an estate.
The impact Section 529 and Coverdell accounts have in these matters is very favorable: 529 and Coverdell deposits and earnings do not figure into estate-tax calculations.
Section 529 plans are particularly useful for making large contributions. The contribution limits are set as high as $270,000, but even that limit can be skirted, said John Hurley, editor of Savingforcollege.com and an expert on 529 plans.
"Conceivably, if you wanted to put more into a 529 plan than a particular program allows, you can do that by opening up accounts in more than one state" for the same beneficiary, he said.
McDevitt points out that 529 plans come with provisions that allow for gifts above the normal limit on tax-free gifts, which increases to $22,000 per couple in 2002.
"I see a lot of grandparents use this," Aramaki said. "When a grandparent wants to give money to the kids but doesn't want to give them straight cash, which they could go blow on a car or whatever, they can set up a 529. It helps the child, but they control where the money goes and how it's used."
Like the 529 plan and a Coverdell account but can't decide between them? Thanks to the tax-law changes, you don't have to. Beginning in 2002, you can invest in both.
Amy Trask can be reached at 206-464-2032 or atrask@seattletimes.com.