Business: Congress gives college savers a boost

Congress gives college savers a boost

By HELEN HUNTLEY

If college expenses are in your future, Uncle Sam has a couple of great deals for you: 529 college savings plans and the vastly improved Coverdell Education Savings Accounts, formerly known as the Education IRA.

What's the attraction? Tax-free accumulation of savings to pay not just tuition, but room, board, books, supplies and transportation for your college student. Even computers and Internet access qualify.

Congress just rewrote the rules for both plans, making them far more attractive for savers.

"Education IRAs were basically dead; nobody had any interest in them," said Phil Behnen, a financial planner at A.G. Edwards & Sons in St. Louis. "And 529 plans were so new, we found the majority of people didn't know about them."

He said the changes are generating new interest and predicted the popularity of both plans will take off next year when the new rules go into effect. Big mutual fund companies and brokerage firms are starting the marketing push.

"Our primary target market is grandparents," Behnen said. "Grandparents love to put money away for their grandchildren."

He said grandparents find the 529 plans especially appealing because the donor maintains control over the money. Donors also get a break on gift tax rules; the law allows a donor to contribute up to $50,000 in one year for each child.

"You can put money away in the name of the grandchildren and they don't even have to know it exists," he said. "You get money outside your estate and you still have control over it. There's really no other investment tool like that."

Marketing hype aside, 529 plans and Education Savings Accounts, or ESAs, are especially good news for Florida families. Most other education tax breaks created in recent years apply only to tuition and fees. But at Florida public colleges and universities, living expenses are the biggest part of college costs. It isn't just that tuition is relatively modest; for thousands of Florida students it's partly or entirely free thanks to Bright Futures Scholarships. And expenses paid by scholarships cannot be used to claim tax credits and deductions.

Thanks to their broad coverage, 529 savings plans and ESAs offer the potential for significant tax savings whether children are headed to college in or out of state.

Starting next year, ESAs can be used to pay expenses for elementary and secondary students. While the appeal is obvious for parents saving for private school tuition, the plans also can be used to pay for extras such as computers, tutoring and after-school programs for public and private school students.

However, neither type of plan offers an immediate tax break. Since their main benefit is the ability to withdraw investment returns tax-free, the plans' main beneficiaries will be families of young children who get the advantage of many years of compounding returns before they need to withdraw the money.

There are some drawbacks to the accounts. Like all college savings, they reduce eligibility for financial aid based on need. The accounts can be transferred to a family member if the original beneficiary doesn't go to college, but if the money ends up being spent on something besides education, it is taxed on withdrawal -- generally with a 10 percent penalty on top. In addition, there is the possibility that an account controlled by a grandparent could disqualify the grandparent from eligibility for Medicaid.

Savers can set up ESAs with mutual fund companies, banks and brokerage firms, although not all of them offer the accounts. Some rejected the old Education IRA because the initial $500 annual limit on contributions wasn't worth the administrative headaches. Since Congress increased the limit to $2,000 (effective next year), financial services providers now have more incentive to offer the accounts.

For most Florida families interested in saving $2,000 a year or less, ESAs probably will be the first choice. But they are off limits to the wealthy. Contributors to an ESA must have incomes of less than $110,000 if single or $160,000 if married filing jointly (increasing to $220,000 next year.) Some wealthy families get around those limits by having a relative make the contribution.

The 529 plans will appeal to families interested in socking away significant amounts of cash. Like 401(k) retirement savings plans, these plans take their numerical designation from a section of the IRS code. They are better known in their home states by names such as "Bright Start" (Illinois) and "Learning Quest" (Kansas). Each state is eligible to create its own savings plan and 33 have them in operation.

Most of the rest, including Florida, are expected to have them by next year, said Joseph Hurley, a Rochester, N.Y., CPA who became so enthralled with the plans that he wrote a book on them and now operates a Web site that tracks them (http://www.savingforcollege.com).

The plans come in two basic versions: guaranteed tuition plans and the newer savings plans, which offer a variable rate of return based on stock and bond market performance.

The Florida Prepaid College Program is by far the largest 529 program. It has sold about 655,000 contracts guaranteeing tuition, fees or dormitory rent and accumulated more than $3-billion in assets, more than all the savings programs combined. Last year, about 35,000 students collected on its benefits, which can be used at more than 1,700 colleges and universities across the country.

But the prepaid plan does not help much with living expenses (most participants buy only tuition contracts) and it penalizes students who end up going to college out of state.

Florida is working out the details for its own savings plan and is in negotiations with two potential providers: TIAA-CREF and the Hartford Group.

The savings plan will be offered in tandem with the prepaid plan and families will be able to sign a child up for one or both options.

Although the details vary from state to state, the plans generally allow more than $100,000 in contributions and offer a choice of investments based on the age of the child, starting out with an aggressive mix and reducing stock market exposure as the child approaches college age.

"The plans have changed quite a bit since they first came out," said Behnen of A.G. Edwards & Sons. "Investment choices are improving and we think that trend will continue because the state plans compete against one another."

Because most plans are open to residents of any state, Behnen and Hurley suggest that college savers look beyond their own state's plan.

"You really have to look at each plan and try to match it to your own situation and preferences," Hurley said.

But some financial advisers say clients feel more comfortable investing in their home states.

"I think the consumer is still kind of funny about opening an account in Ohio or Kansas," New Port Richey financial planner Steve Athanassie said. "I don't think they understand it."

He said confusion about savings options may keep some people from saving for college at all.

"It's like saying, "I'm not sure which gym to join, so I'm not going to work out,' " he said. "I've been encouraging people to just get something started. I get them to put money in a segregated account and we just call it "the education fund.' In a year or so, when everything settles, they may flip the money over to one of the plans, but the key is to just get started."