How to pump up college savings

Not counting on much financial aid? You won't need it with these saving strategies.

By Anita J. Slomski

You swore you'd contribute religiously to a college savings account, but deposits have been diverted for more pressing living expenses. Now tuition looms as an enormous threat. What can you do?

You probably earn too much to qualify for need-based financial aid. The income cutoff is about $90,000 with one kid in college and $150,000 to $175,000 with two, according to Raymond Loewe, president of the financial planning firm College Money, in Marlton, NJ.

The good news is that college savings plans have recently been improved, and tax laws now make saving for higher education much easier. Here's what you need to do now to take advantage of the changes:

Take a new look at 529 plans. If you have young children and a long investment horizon, your best bet may be a 529 college savings plan, named for the section of the IRS code that regulates it. Already a popular choice, 529 plans became even more attractive with passage of the recent tax bill.

The biggest change: Starting in 2002, you pay no federal tax on the earnings, as long as they're used to pay for higher education. Most states also offer residents a tax deduction on 529 plan contributions, and some exempt the earnings from state income tax. The funds can be used for tuition as well as room and board at any college or university in the country.

All states have 529 plans, and you can invest in many of them, regardless of what state you live in. Each plan offers different fund options, which are managed by a variety of investment houses. For example, at TIAA-CREF, which handles 12 state-sponsored plans, parents typically have a choice of three funds—an allocation fund that shifts to a less aggressive portfolio as the child ages, an all-equity fund, or a conservative money market-type fund.

The 529 plans have several other advantages. Unlike Coverdell Education Savings Accounts (formerly called Education IRAs), which have a $2,000 annual limit, 529s let you invest large sums—up to $245,000 in some programs. You also ensure that the money will be used for college, which isn't a given if you fund an account in your child's name. In addition, these plans offer grandparents a way to move assets out of their estate tax-free, with the guarantee that the gift will be used for a grandchild's education. Donors can combine five years of tax-free gifts, which means a married couple can give $100,000 to each grandchild at one time.

Now for the drawbacks of 529 plans. They don't offer much investment flexibility. Once you pick a fund, you're stuck with it unless you shift the assets to another state's 529 plan—an option you can exercise once every 12 months. Or you can put new contributions into a different fund within one state's plan.

And what if Junior declares he'd rather open a pizza parlor in Samoa than attend college? You can use the money for another family member's college or graduate school costs, but if no one else is college-bound and you withdraw the money, you'll pay taxes on the earnings at your tax rate, plus an additional 10 percent. (You can withdraw money penalty-free if the child dies, becomes disabled, or wins a scholarship.) Still, if the money stays in the 529 plan for about four years, the tax-free savings should negate the 10 percent penalty, according to Neil Brown of Abacus Planning Group in Columbia, SC.

Because some 529 plans are more attractive than others, you need to do some research before investing. Obviously, if your state's 529 plan offers state tax breaks, that plan should get serious consideration. But you also should look at management fees, the variety of fund choices, and the maximum investment amounts. The Web site www.savingforcollege.com rates the 529 plans, as does the book The Best Way to Save for College: A Complete Guide to 529 Plans (BonaCom Publications, 2002).

The College Savings Plans Network's Web site, www.collegesavings.org , also offers a variety of information.

Start a custodial account if you want to control the investments. A custodial account set up under the Uniform Transfer to Minors Act (or, in some states, the Uniform Gift to Minors Act) is worth a look only if you hate not having complete control over the investments in your college fund. When your child withdraws the money, the earnings are taxed at his or her rate, which as of 2002 will be 10 percent for ordinary income. Capital gains will be taxed at 10 or 8 percent, depending on how long the assets were held. Custodial accounts are also hit with a "kiddie tax"—earnings above $1,500 a year are taxed at the parents' highest rate—until the child is 14.

Another downside to custodial accounts is that, legally, your 18- or 21-year-old can use those assets to buy a Corvette or open a tattoo parlor. Some planners don't consider this a problem, however. "In 16 years of financial planning, I've never seen a child misuse this money," says Cheryl Holland of Abacus Planning Group. "In fact, they ask me how much they'll have left if they choose one school over another. If it were their parents' money, we wouldn't have a discussion about the price of quality."

Consider saving in your own name. You might look into tax-managed growth funds that don't generate many capital gains and dividends, and hold them for a year or longer. Then, when the child is at least 14 and you're certain he'll attend college, you and your spouse can begin making money gifts annually in a UTMA/UGMA account, without gift-tax consequences. Currently, each of you can give a maximum of $10,000 annually to each child, but the amount is indexed to rise with inflation. When the child withdraws that money for college, he'll pay a long-term capital gains tax of 8 or 10 percent on the earnings instead of the 20 percent (or 18 percent after 2006) you'd pay if you cashed in the mutual fund.

Contribute more to a Coverdell Account. The recent tax bill increased the annual investment limits from $500 to $2,000, and, for the first time, you can use the money for elementary and secondary education as well. The problem is that couples earning more than $220,000 are ineligible to fund one. If you're not eligible to contribute to a Coverdell Education Savings Account for your child, however, a relative might be.

The author is the former Group Practice Editor of Medical Economics.

Waiting too long

Okay, your kid is in high school and the college fund is looking pretty sparse. Don't worry, other money is available. Here's how to tap some of it:

Get your merit aid or scholarship applications in by deadline. Many private schools increasingly use their endowments to attract top students. "Thirty-four percent of students whose parents earn more than $100,000 get some form of merit aid," says David L. Warren, president of the National Association of Independent Colleges and Universities.

"With more than 3,000 colleges in the country, most students would be considered a strong candidate at one or more schools," says financial planner Judy Miller of College Solutions in Alameda, CA. Don't count on a handout from the likes of Harvard or Princeton, however. The top 50 private universities and colleges award aid only to students who can prove financial need, according to Warren.

Schools generally require students to submit financial aid forms by February or March, although deadlines vary. Foundations, service organizations, and corporations that award scholarships may have deadlines as early as September for the following year.

You can also apply for national scholarships. Find information about them in some college guides, on college Web sites, and on www.collegeboard.com , www.finaid.com (which also has information on scholarship scams), and www.fastweb.com .

Apply for student loans. It makes more sense for your child to get a loan than for you to borrow money, since a student will pay a lower interest rate than you would. "Student loans establish credit for the kids, and you can help pay them off after your kids graduate," adds Raymond Loewe, president of the financial planning firm College Money, in Marlton, NJ. (Check out www.ed.gov and www.salliemae.com for loan information.)

Also, the new tax law eased the restrictions on deducting student loan interest. For one thing, deductions are no longer limited to the first 60 months in which interest is paid. Now, each year for as long as their income remains below the phaseout range borrowers can deduct up to $2,500 of the interest they pay.

The phaseout ranges have been raised as well: For single taxpayers, the deduction starts dropping when adjusted gross income reaches $50,000, and it disappears at $65,000. For married couples, the range is $100,000 to $130,000. Moreover, voluntary interest payments, such as those made while a loan is in forbearance, are now deductible.

Take out a federal or home equity loan. If you need to borrow to supplement student loans, the federal PLUS program will loan you 100 percent of college costs with interest tied to the T-bill rate and capped at 9 percent. Depending on current interest rates, you may be better off taking out a home equity loan, says Norman M. Boone of Boone Financial Advisors in San Francisco. "You can borrow up to $100,000 and the interest is tax deductible, unlike the interest on a government loan," he explains.

A word of caution if you're seeking college money: Leave your 401(k) intact, no matter what. "There are many loans available to a kid going to college, but I don't know of any loans designed specifically to pay for retirement," says Miller. Besides, your child has more years to pay off a college loan than you have to replenish your retirement funds.

 

Anita Slomski. How to pump up college savings. Medical Economics 2002;2:43.