Picking the Right College Savings Plan

June 4, 2002 -- Picking the right tax-free state college savings plan can be almost as daunting as picking the right college. At last count, 46 states sponsored one of these plans, most run by financial services companies and open to residents of all states.

Each plan has its own set of fees, investments and rules. But all share a powerful attraction: Under Section 529 of the tax code, money put in them grows tax-deferred and can be withdrawn federally tax free so long as it's used to pay college costs.

The 529 plans also have two unusual estate/gift tax advantages of particular interest to grandparents. First: Money contributed to a 529 is out of your estate. But so long as you're listed as the owner, you can still take it back if you need it, by paying taxes at your ordinary income tax rate, plus a 10 percent penalty, on the earnings you withdraw.

Second: Normally you can't give another person more than $11,000 a year without its counting against your $1 million lifetime exemption from gift and estate taxes. But you can stash $55,000 at once in a 529 and count it as five years' worth of $11,000 gifts.

With tax breaks like these, if a family isn't likely to qualify for college financial aid (see box), deciding to invest in a 529 is easy.

Far more difficult, however, is figuring out which plan to use and what to put in it. Until late last year this was mostly a one-time decision — once you picked an investment option for a 529 plan you were pretty much stuck with it, unless you were willing to engage in some fancy maneuvers, such as switching beneficiaries while rolling the account from one state plan to another. But Congress and the IRS have loosened the rules, and now you can adjust your investment allocation once a year, without changing the named beneficiary or the state.

Do’s and Don’ts

Some do's and don'ts for college savings plans:

Do check if you get a deduction for contributing to your own state's college savings plan.

Do — to get more tax savings — treat a 529 as part of your total portfolio and put taxable bonds into it.

Don't ignore big fees. Many broker-sold plans charge high loads and annual expenses.

Don't forget to make sure you aren't likely to qualify for college financial aid before funding a 529 plan.

That, combined with an explosion of investment choices within 529s, gives parents and grandparents an opportunity to treat their 529 holdings as part of their total portfolio — and to squeeze more tax benefits from them.

Consider: The most popular option among 529 investors is an "age-based" portfolio that mechanically shifts asset allocation from mostly stocks to mostly bonds as a child approaches college age. But many families can wring even more tax savings from a 529 by investing it all along in taxable bonds — whose interest would otherwise be taxed at a federal rate of up to 40 percent (including the effect of an itemized deduction clawback) — and holding index funds or individual stocks in their taxable accounts, says Yale School of Management professor Matthew Spiegel.

Here, then, is a step-by-step approach to evaluating your 529 options.

Look at Home First

About half the states offer residents an income tax deduction for contributions to their home state plan.

In high-tax states the savings can be significant. New Mexico, with a top state rate of 8.2 percent, allows an unlimited deduction. A New York City couple can deduct up to $10,000 a year, saving as much as $1,050 in tax. More typically, the state deduction is capped at $2,000. Virginia has a bizarre loophole: Residents can deduct up to $2,000 a year per account, but the state allows a couple to open dozens of accounts.

Here's the key, wherever you live: You can open plans in as many states as you wish, for the very same child. So don't contribute any more to your state's plan than you are permitted to deduct without first comparing it with plans in other states. The table on page 200 highlights some attractive, low-fee plans for different investment preferences.

Opening a plan in a second or even a third state does more than just give you extra investment choices. It also allows you greater freedom to change investments. Under federal law you can reallocate within a single 529 plan just once a year. With multiple 529s, you get to make multiple adjustments. And should you want to withdraw funds for a purpose other than college, you can take from the plan with the smallest earnings, thus minimizing your tax and penalty hit.

What if your state grants a big deduction for contributing to its plan, but you don't like its investment options? You may be able to contribute to the plan, claim the deduction, then roll the funds into another plan, says New York CPA Joseph Hurley, who runs www.savingforcollege.com and has written a book on 529s. But check to make sure your state doesn't "recapture" deductions following such a rollover; several states, including New York and Virginia, do, and more might if this ploy catches on.

Nearly all states let residents make tax-free withdrawals for college from their own plans, but eight, by Hurley's count, tax college withdrawals from other states' plans. That's not as bad as it sounds, since the tax will typically be at the child's rate. And usually you can dodge the tax by rolling over from the other state's plan to your own just before you start making withdrawals, says Hurley.

Study Fees Closely

If you're not careful, much of what you save in taxes could go to pay fees and mutual fund loads. Hurley predicts that more than two-thirds of the $25 billion flowing into plans this year will come through commissioned salesmen. Even TIAA-CREF, which runs 13 states' no-load plans, is preparing a broker-sold version.

How high can these charges go? West Virginia's Smart 529, run by Hartford Life, offers a front-end load of 5.5 percent and annual expenses of 1.46%, or no load and an annual 2.15 percent expense. Arizona's InvestEd plan, run by Waddell & Reed, gives you three choices, all pricey: One is a front-end load of 5.75 percent and annual expenses of 1.70 percent to 1.83 percent.

If you are going out of state (see above), consider instead the Utah plan, which uses Vanguard funds. You pay no load and expenses of just 0.28 percent to 0.30 percent a year.

Go for Flexibility

Look for a plan that won't penalize you if you switch to another state. You want this flexibility in case the plan you're invested in jacks up fees or switches investment managers or you discover a plan you like better.

Unless you have claimed a state deduction that's being recaptured, you can normally roll over your funds to another state for a $25 to $75 administrative exit fee. Nasty exception: Pennsylvania slaps its 2.8 percent income tax on the earnings of residents who roll from one state plan to another.

You might also want to look for plans that won't force you to withdraw 529 funds within a fixed period after a student finishes high school. Why? You may want to use other assets first. Some grandparents may even prefer to pay college bills directly — the tax code allows anyone to pay anyone else's tuition without the payment counting as a taxable gift — and leave the money in the 529 to grow tax-deferred to fund their grandchildren's graduate school or great-grandchildren's college. Wealthy parents can prefund their grandchildren's education this way, with the money compounding tax free for decades; many states allow balances to build to $250,000 or more.

Here, too, rollovers are your friend. Utah requires you to start drawing down the money when a child turns 27; enjoy its low fees now and roll to another state later.

Consider the Big Picture

Don't think about your 529 as an isolated investment. Think of it as part of your entire family investment portfolio.

The narrow perspective is one reason age-based portfolios are popular for college saving. It's assumed that when the child is young, college money for him should be mostly in stocks, since they offer the best long-run return. As the kid gets older, the age-based portfolios will shift him toward bonds, so he runs less risk of a big loss right before college withdrawals begin.

Sounds sensible. But it doesn't fully exploit the tax-free benefits of a 529. To do that, you must fill your 529 with your most heavily taxed investments. For most families, that means corporate or U.S. government bonds, whose interest payments are taxed at higher ordinary-income rates. Stocks and index funds, which benefit from much lower long-term capital gain rates, can go in your taxable accounts. And remember, as investors in losing 529 funds are now discovering to their chagrin, you can't harvest capital losses from a 529 account, as you can from a taxable one.

Yale's Spiegel recommends intermediate-term corporate bond funds in tax-favored savings accounts. They return about the same as long-term bonds with lower interest-rate risk and pay substantially better than short-term bonds.

Another good bet for a 529 would be Treasury Inflation-Protected Securities (TIPS), which currently return approximately 3 percent plus whatever the inflation rate turns out to be. (Currently, that works out to a combined 5.5 percent, according to Vanguard's John Hollyer.) Unfortunately, the only 529 investors with access to reasonably priced TIPS are residents of South Dakota, who can buy into a Pimco TIPS fund with no load. Nonresidents looking for this fund must go through a broker and pay a charge of up to 5.5 percent. The 529 law doesn't permit states to offer self-directed brokerage accounts, so you can't buy TIPS directly.

Conservative Alternatives

There's yet another reason grandparents looking to stash a large sum in 529 plans may favor fixed income: You can only fund a 529 plan with cash. If grandparents sell appreciated stocks to raise that cash, they have to pay gain taxes and lose the opportunity to step up the basis in these stocks at their deaths.

If, instead, they cash in bonds and certificates of deposit, and then invest the proceeds in taxable bonds in a 529, they haven't altered their overall asset allocation, but have improved their tax situation. Conservative investors cashing in CDs might also want to consider a CollegeSure CD, which is indexed to college costs and offered through Montana and Arizona. (Warning: There's usually a big penalty for cashing out these CDs early.)

Or, if you think the market is overvalued now and want a place to park money for a time, consider the Guaranteed Option offered in plans run by TIAA-CREF. You can switch out of these without a penalty. Recent yield for New York's Guaranteed Option: 5.2 percent.

Do stocks ever make more sense than bonds in a 529? If you're looking for growth and you want to hold a bunch of actively managed stock funds that turn over their holdings a lot, generating short-term taxable gains, stash them in a 529.

That's what Hampton and Lana Crump of Baton Rouge, La., are doing in 529 accounts for their kids, Amanda, 7, and twins Daniel and David, 1. They chose Rhode Island's plan, run by Alliance Capital, because it offered a broader range of investment options than Louisiana's plan. "I think we've made a good choice," says Hampton. "But there are so many plans out there it's hard to be sure."

For more, go to Forbes.com..