Saving for College 101

By Gregg Greenberg

June 9, 2005 — The college years are fleeting, but borrowers know that student loans can last forever.

That brings us to the much ballyhooed 529 plan. Created by Congress to ease the process of saving for college, 529s have been widely hailed as a slam dunk for parents, grandparents and prospective freshmen. Alas, there is another side to every argument, and some professionals counsel caution in the use of these plans.

These 529 plans allow an investor’s assets to grow tax-deferred, and distributions from the account used to pay for the beneficiary’s college are federally tax-free. Unlike a uniform gift to minors account, a 529 allows the plan sponsor to maintain control of the account, and the assets are managed by professional money managers in the state overseeing the account.

These accounts are wildly popular. Financial Research Corp. estimates that there’s $55 billion in 529 program assets today, and that figure will grow to $85 billion by the end of the year. Every state now has at least one 529 plan available.

But in the interest of giving both sides of the story, here’s a breakdown of five main risks facing 529 plans, as well as feedback from financial advisers on how to avoid them.

Watch the Sunset
Currently, investments in 529 plans grow tax-deferred, and the distributions are federally tax-free (provided they are used for education expenses). This treatment applies for distributions in the years 2002 through 2010. However, if Congress does not extend this tax break after the provision sunsets in 2010, then the earnings portion of qualifying distributions made after 2010 will be taxable to the beneficiary.

Jack Harmon II, CFP at Atlanta-based Harmon Financial Advisors, thinks the bipartisan support in Congress for education will override any budgetary concerns, and the break will be extended.

“It cuts across party lines,” says Harmon. “It doesn’t favor anyone; it just helps kids going to college.”

Frank Butterfield, CPA for Homrich & Berg in Atlanta, agrees that the tax benefits will be extended, because he feels any change would be politically unpopular.

Check the Expenses
Each of the 50 states has its own 529 plan with its own set of expenses, some higher than others. Investors are free to choose any plan in the U.S. regardless of where they live. This makes shopping for the best plan confusing and time-consuming.

“I think the 529 programs tend to be a little cloudy when it comes to fees,” says a New York-based financial adviser. “It’s very unclear in some cases, and some are as high as 3%. The majority of people using 529 plans do not have a good idea exactly what they are paying.”

Butterfield solved the fee problem by enrolling his clients in Utah’s plan, which he considers “the best in the Union. It’s run by Vanguard and has a low 0.35% expense ratio.”

Jim Spindler, a senior financial adviser at Univest, says the difference in fees is symptomatic of the brewing war between the states in pursuit of your child’s education dollars.

“The states are beginning to push you to your own state plan,” says Spindler. “For example, Illinois is starting to tax holders of out-of-state plans 3% on earnings from plans sponsored by another state.”

Deduct Those Taxes
Expenses are not the only relevant matter in finding the right 529 plan for your child. Tax deductions play into the decision-making process, and the tax situation between the states adds an additional level of complexity.

“Sometimes the small tax deduction you get from entering your state’s 529 plan will not offset the money you are paying on the higher expense side,” says Harmon. “That’s where an adviser should come and shop for you.”

Geordie Crossan, a CFP for NBS Financial Services, says taxes and expenses need to be weighed against each other. One solution he employed for a client was to “establish a 529 in his home state to gain the tax deduction but subsequently transfer it to another state’s plan for the potential of a reduced expense ratio.”

Butterfield displays similar Solomonic wisdom when it comes to tax deductions and 529 plans. “I split the funds if there is a tax benefit in one state. For example, in one case, I left money in a New York plan because they give $10,000 in deductions regardless of income. Then I put the remainder in Utah.”

Save for Other Schools
According to the Web site, Coverdell Education Savings Accounts, the forerunner to the 529 plan and formerly known as Education IRAs, had few benefits under the old tax law when compared with the 529 plan. But in 2002 when the annual contribution limit was raised from $500 to $2,000, Coverdell accounts became an attractive savings vehicle for many families looking to save for elementary school, secondary school and college tuition.

The disadvantages of Coverdell accounts are the limitations on parents’ income, as well as the fact that the funds have to be used for education by the time the beneficiary turns 30. For single tax payers, the eligibility phases out for incomes between $95,000 and $110,000. For married taxpayers filing jointly, eligibility phases out between $190,000 and $220,000.

Nevertheless, some financial planners, like Karen Folk, CFP at Folk Financial Planning, favor the Coverdell over the 529 because of its flexibility when it comes to paying for education expenses other than college.

“The biggest drawback is that 529 plans are so restrictive. Coverdell Savings Accounts have more flexibility, and you can use the tax-deferred money in Coverdell accounts for computers and private high schools,” says Folk. “Whereas with a 529 plan, the assets may only be used for college tuition and direct college expenses.”

Fund Your Accounts
No matter if parents put their children’s college funds into a 529 plan, Coverdell ESA or under their mattress, the hardest part of the process is actually saving the money.

According to Steve Goodman, educational consultant at, the idea of having the perfect 529 plan can often create a false sense of security in parents when it comes to meeting their child’s future educational expenses.

“The biggest problem with 529 plans is that people often erroneously believe that they don’t need to do any other saving for college,” says Goodman. “The price of college is going up so much that people can’t just put some money into an account and hope it grows to meet their educational expenses.”

Nevertheless, Goodman cites one positive of 529s, even with all their limitations: “They do encourage people to save for college, which is a good thing.”

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