529 Accounts Go To Head Of Class

Uncle Sam doesn't usually advise families how to invest their money. But after recent tax law changes, it's clear that the feds now believe 529 college savings accounts are the best option for most Americans struggling to keep up with rising educational costs.

Virtually every family with children must now strongly consider putting at least some college savings inside a 529 plan. Here's why:

First, these state-sponsored investment accounts — now offered by 49 states and the District of Columbia-allow parents and grandparents to invest large sums (often $250,000 or more per beneficiary). Moreover, just as with a 401(k), money invested in a 529 is allowed to grow and compound tax free. That offers parents a huge advantage over traditional brokerage accounts, whose gains, dividends, and interest income all are taxed along the way. Finally, 529s are advantageous from a financial-aid standpoint, because none of the money held in a 529 is considered the student's asset when calculating aid eligibility.

One key provision that made 529s popular-the ability to withdraw money from these accounts tax free for qualified educational expenses-was to expire in 2010. But the Pension Protection Act of 2006, which President Bush signed into law in August, made withdrawals from 529s permanently tax free when used for qualified purposes, such as tuition, fees, and room and board. "Now we can say with confidence that 529 plans are definitely the first place parents should look" when deciding where to put their college money, says Rita Johnson, a financial adviser with the Millstone Evans Group of Raymond James & Associates in Boulder, Colo.

Coverdells

Of course, 529s aren't the only savings accounts that allow parents to shelter their investments from taxes and to withdraw money tax free for college. So-called Coverdell education savings accounts do that, and unlike funds in 529s, Coverdell money can also be used to pay for primary and secondary school costs.

But Congress conspicuously did not extend some attractive features of Coverdells, which are due to sunset at the end of 2010. The benefits include the ability to contribute up to $2,000 a year into these tax-advantaged accounts. After 2010, maximum annual contributions into a Coverdell will fall to only $500. What's more, K-12 expenses will no longer qualify. As a result, parents now investing their kids' money in Coverdells "need to give strong consideration to the enhancements of 529s," says Elaine Sullivan, director of education savings for Putnam Investments. While the federal government could extend these beneficial Coverdell provisions, there are no guarantees.

But Bruce Harrington, director of 529 plans for the investment management firm MFS, still advocates "putting the first $2,000 into a Coverdell and then putting your remaining savings into a 529." That's because under current law, money invested in Coverdells can still be used for K-12 expenses. And unlike 529 assets, Coverdell money is permitted to purchase equipment like computers for kids between kindergarten and 12th grade. "Why not buy Johnny a laptop with tax-free dollars?" asks Harrington.

If the K-12 option does sunset in four years, as scheduled, the IRS allows Coverdell owners to roll over their accounts, tax free, into a 529, Harrington notes. Meanwhile, families are not permitted to roll money over in the other direction-from a 529 to a Coverdell. So why not preserve your options by first funding a Coverdell and then putting the bulk of your money in a 529?

While the government ignored Coverdells in its most recent tax package, newly passed legislation has actually made yet another college savings option-traditional custodial vehicles like Uniform Gifts to Minors Act accounts (UGMAs) and Uniform Transfers to Minors Act accounts (UTMAs)-much worse.

Before 529s came into existence in 1996, parents often relied on UGMAs and UTMAs to save for college. That's because the custodial accounts allow parents to take advantage of their kids' lower tax bracket. For instance, the first $800 of unearned income for children 13 or younger used to be tax free. The next $800 was taxed at the child's lower rate. And the rest was taxed at the parent's rate-until the kid turned 14, when all the unearned income would be taxed at the child's lower rate. This allowed parents to give appreciated stock to their kids, have the children sell the stock after turning 14, and then use the proceeds to pay for school.

Kiddie-tax change

But in May, Bush signed the Tax Increase Prevention and Reconciliation Act, which changed the kiddie-tax rules. Now, the first $850 of unearned income kids receive will be tax free, the next $850 will be taxed at the child's rate, and the rest will be taxed at the parent's rate until the child turns 18. Since kids now have to wait until their senior year of high school or freshman year of college to take full advantage of their lower tax rate, custodial accounts are far less attractive for parents saving for school. "In my opinion, UGMAs and UTMAs are essentially dead as a college savings tool," says Cal Brown, vice president of planning at the Monitor Group, a wealth management firm in McLean, Va.

A recent analysis by T. Rowe Price seems to back Brown up. Say you put $5,000 a year into a 529 for your daughter, and it earned 8 percent annually through investments in a blue-chip growth stock fund. After 18 years, you would end up with more than $218,000 for her college bills. By using a home-state 529 plan that offers residents a state tax deduction, you'd be likely to amass nearly $224,000, T. Rowe Price found. (Parents can choose any state's 529 plan; information about which plans offer tax breaks is at Savingforcollege.com.)

Now compare that with what you would save through an UGMA. Under the old rules, a typical parent in the 25 percent federal tax bracket could expect to accrue around $210,000 in the custodial account, according to T. Rowe Price. But under the new rules, you're likely to save even less: $207,700.

Plus, UGMAs and UTMAs are terrible from a financial-aid standpoint. As a rule of thumb, it's always better to save money in the parent's name, since Uncle Sam expects only 5.6 percent of parental assets to be used to cover college expenses. By contrast, the government will assume that 35 percent of the student's money can be used to pay for school (in the 2007-08 school year, this will drop to 20 percent).

By law, a custodial account belongs to the child, so having large amounts of savings in an UGMA or UTMA is detrimental for qualifying for aid. Meanwhile, 529 assets are not considered student money for financial-aid purposes, according to recent federal rulings.

If you've already started saving through an UGMA or UTMA, don't worry. Parents can roll over these accounts into a so-called custodial 529. While the money will still technically belong to the child, the assets will not be counted as student assets for aid purposes, even though the account maintains custodial status, the federal government recently said.

What about prepaid tuition plans, which allow parents to purchase units of future education at today's prices?

Earlier this year, the government gave these college savings vehicles a big boost by improving their financial-aid status. Under the old rules, the value of a prepaid tuition plan would reduce a student's aid eligibility dollar for dollar. But starting in July, the government put prepaids on a level playing field with 529 savings plans. Both savings vehicles are now beneficial for qualifying for aid since they are not considered student assets.

Even if you intend to use a prepaid plan to save for school, though, you will still probably want to start a 529 savings plan, too. That's because prepaid plans are good only for covering tuition and fees. They don't typically cover room and board. And in recent years, room and board has become nearly as expensive as tuition at many schools.

The bottom line, no matter what type of college savings vehicle you now use, is that you probably need to consider opening a 529. "These recent changes," says Joe Hurley, president of Savingforcollege.com, "really made the 529 more attractive relative to all other college savings vehicles out there."

By Emily Brandon