Y Money kiplinger’s | may 2004
CO L L EG E | We did your homework
to find the best way to save for
college, circa 2004. By Kristin Davis
f 529 plans were presidential candi-
dates, they’d be the front-runners in the
college-savings race, the darlings of the
press. But they wouldn’t be a sure thing
at the polls. Plenty of financial planners
have elected other college-savings vehicles for their
clients—and for their own kids.
PHOTOGRAPHS BY SEAN JUSTICE
q Blake Starnes and his
little brother, David (see
photo at left), already
have college savings
accounts, and Mom and
Dad will open one for son
number three ASAP.
for future scholars
Y Money kiplinger’s | may 2004
“I love the Coverdell education-savings account—it’s got in any other plan and use the money at any accredited col-
everything,” says William Starnes, a financial planner in lege in the U.S. as well as many schools abroad.
Newark, Del., who puts the legal limit of $2,000 a year into The accounts appeal to savers at all income levels. You
Coverdells for his two sons, ages 4 and 3. (He’ll soon open can open an account with as little as $25 a month or make
a third account for his newborn son.) Starnes and his wife, a six-figure contribution all at once. And there are no
Lynda, put additional savings into Roth IRAs, which can be income restrictions to shut out high earners. But the down-
tapped for college bills, too. sides should give some savers pause.
Coverdells first, then 529s, is Cheryl Costa’s creed. She’s an
adviser in Natick, Mass., who invests accordingly for her No guarantee. Earnings may or may not be tax-free for
three youngsters, ages 11, 10 and 6. younger children. The legislation that grants 529s tax-free
Jon Houk, an Atlanta planner, disagrees. He favors custo- status expires after 2010. It’s anticipated that Congress will
dial accounts for his children, ages 12, 10 and 9. Money in eventually make tax-free withdrawals permanent, but there
those accounts—and the tax bill on earnings—belongs to is no guarantee. If the law does “sunset,” children under age
the kids. Clients sometimes ask about 529 plans, he says, 11 or so today may wind up paying taxes on earnings.
but he steers them to custodial accounts instead. “I want to
control the investments and buy anything I want in the ac- Shifting sands. “Owners of 529s have three masters: state
count,” Houk says. government, federal government and plan sponsors,” all
No wonder parents who aren’t financial planners are con- of whom can make changes, points out Steven Wightman,
fused when it comes to how best to save for college. In fact, a planner in Lexington, Mass. Last year, for instance, New
there’s no perfect choice. York’s contract with TIAA-CREF expired, and the state
But custodial accounts have gained luster since the 2003 switched to a Vanguard-run 529 plan. Participants’ money
tax cut reduced the rate on dividends and capital gains to as was moved into entirely new investments. Timothy Hayes,
little as 5% for those in the lowest tax bracket. Since that’s president of Landmark Financial Advisory Services, in
usually where youngsters reside, it means you could pay Rochester, N.Y., likes the new plan—for his clients and
minimal taxes on up to $1,600 a year in earnings in a child’s for his two children—but misses the TIAA-CREF option
name—no tax on the first $800 and 5% on the next $800. that paid a guaranteed 3%. He often recommended that
(For children under age 14, the parents’ higher tax rate— choice for children nearing high school graduation.
probably 15% on dividends and capital gains—applies to Oregon dropped Strong Capital Management as its plan
higher earnings. Older kids always use their own tax rate.) administrator last November after the CEO was charged
Falling tax rates devalue the prime appeal of the 529 and with illegal market-timing activity. Parents will have to
Coverdell tax shelters—the fact that earnings are tax-free if choose from a different slate of options under a new plan
used to pay college bills—and mitigate the tax man’s sting that uses Oppenheimer and Vanguard funds.
on custodial accounts.
Plus, starting in 2004, both Coverdells and 529 plans are Investments are limited. You’re stuck with the choices—
treated as parental assets in college financial-aid formulas— usually a selection of mutual funds—offered by the plan.
reducing the chance that Coverdells will knock you out of New Hampshire, for example, offers Fidelity’s Unique plan,
the financial-aid ballgame. With both vehicles on an equal which includes one age-based portfolio that changes the mix
financial-aid footing, Coverdells look much better than they of stocks and bonds as a child matures, and three “fixed”
used to for families who might qualify for aid—the very portfolios (100% stocks, 70% stocks, etc.). Virginia’s College
folks who may not be bothered that contributions are limit- America plan includes 21 stand-alone mutual funds that
ed to $2,000 a year per student. you can use to custom-build a portfolio, but even then your
options are limited to three growth funds, five bond funds
A HARD LOOK AT 529S and so on, all from the same family: the American Funds.
tate-sponsored 529 plans still have plenty of
fans. “Tax-free is a bigger deal than tax reduction, so Fees are high. Even among plans that aren’t sold by brokers
education planning really hasn’t changed that much (and thus don’t have high upfront loads or annual sales fees),
lately,” argues Steven Weydert, a planner in Park Ridge, Ill. expenses are higher in most 529 plans than in equivalent
As long as withdrawals are used for qualified expenses— mutual funds. Fund-rating service Morningstar calls a 529
college tuition, fees, room and board, books, and supplies— plan “reasonably priced” if the annual expense ratio is less
529 earnings are tax-free. Plus, 26 states and the District of than 1% for a portfolio that’s half in stocks and half in
Columbia allow parents to take a tax deduction or credit for bonds. Below 0.70% is considered cheap. Owning Van-
all or part of the contributions made to their home state’s guard’s Moderate Growth Portfolio (50% stocks and 50%
plan. If you don’t like your state’s offering, you can invest bonds) inside New York’s 529 plan costs a mere 0.60%. But
q The Costa family added
$1,700 to Matthew’s, Eric’s
and Christina’s 529 plans
last year thanks to credit-
you can buy the same combination of funds directly from THE CASE FOR COVERDELLS
Vanguard and put it in a Coverdell or custodial account and e’ll differ with planner and parent William
pay annual expenses of no more than 0.22%. “The reinvested Starnes: The Coverdell has almost everything.
expense savings can add five digits to the outcome of college There’s no booby trap in the law that might
savings for a preschooler,” says Wightman. take away Coverdell’s tax-free earnings. The account works
more like an IRA (before it was renamed in honor of the late
The threat of penalty. You’ll pay a penalty (10% of earn- Georgia senator Paul Coverdell, it was called an education
ings) plus taxes if the money isn’t used for education by the IRA) in that you can choose any investment. You can use the
original beneficiary or by a family member. proceeds not only for college expenses but also for a private
So how do the new-and-improved contenders compare? elementary or high school or even for other “educational”
Y Money kiplinger’s | may 2004
expenses, such as camp or a computer. There are no extra lay-
L I F E T I M E S AV I N G S A C C O U N T S
ers of management expenses to eat into your returns. And
now there’s no financial-aid “penalty,” compared with invest-
ing in 529 plans. (Previously, Coverdells were considered a
student asset, which meant that 35% of the account balance Going NOWHERE fast
each year went toward the amount a family was expected to
or the second year in a row, President Bush has pro-
contribute to college costs. Now—like 529s—Coverdells
posed Lifetime Savings Accounts, superversatile tax-
are a parental asset, so the bite is no more than 5.6% of your
free savings accounts that would end, once and for
all, any argument about which kind of account is the best
Technically, top-tier earners are shut out by an income
for college savings. Anyone could contribute up to $5,000
ceiling: You can’t contribute the full amount to a Coverdell
per child per year, regardless of his or her income. Over the
if you earn more than $190,000 a year as a married couple or
years, it would be easy to amass enough to cover the cost
more than $95,000 if you’re single. However, there is a back
of a private, four-year education, and the contribution limit
door. You can give $2,000 to your child and let him or her
would rise each year with inflation. You could invest in any-
contribute to the account. Or, if the child’s grandparents’
thing you like and make tax-free withdrawals at any time for
income is below the threshold, they can fund it.
any purpose—with no age limits and no complex rules about
The Coverdell’s big flaw is that no more than $2,000 per
year can go into a child’s account, no matter how many peo-
But the proposal isn’t high on the President’s to-do list in
ple contribute. That amount works fine for parents who start
this election year, and we think Congress will once again ig-
young, contribute a little at a time (say, $166 a month) and
nore it. If the accounts make it off the drawing board, you’ll
don’t aspire to save more than half the cost of a private edu-
be able to roll 529-plan and Coverdell money directly into
cation. But it falls painfully short for those who can save
more or who want to invest lump sums.
That shortcoming doesn’t trouble Starnes at all. “It’s hard
to save the entire amount in the Coverdell, but who cares?” 15% of the gains to Uncle Sam in the form of capital-gains
Starnes says. “Most people shouldn’t be saving 100% of an- taxes, they’ve begun to gift the stock to Stuart’s UTMA
ticipated expenses in a vehicle that has a penalty for non- (Uniform Transfers to Minors Act) account. Stuart pays
education use.” Recognizing that most people are saving for nothing on the first $800 in gains he realizes inside the
college and retirement at the same time, Starnes likes to cou- account and just 5% on the remainder.
ple the Coverdell with a Roth IRA. The Roth allows you to Yes, a tax-free withdrawal from a 529 plan should be even
take out contributions at any time, tax- and penalty-free, so more appealing than a low-tax capital gain in a custodial
you can tap the money for college expenses if you need to or account. But not necessarily—if, for instance, your return
let it ride for retirement if you don’t. has been retarded by higher expenses in a 529 plan than
One added quirk of the Coverdell is that if the money in would have been the case for a comparable investment in a
the account isn’t used for education by the time the benefi- custodial account. If the limitations of 529s and Coverdells
ciary is age 30, the proceeds are paid out to him or her, sub- leave you cold, the difference between tax-free and low-tax is
ject to taxes and a 10% penalty on the earnings. narrow enough to make UTMAs a reasonable alternative.
Cheryl Costa prefers to pair the Coverdell with a 529. “I Aside from the low tax rates (good at least through 2008),
nearly always recommend that my clients put $2,000 into custodial accounts have great flexibility: You can invest the
Coverdells before they put money into 529 plans,” she says. money in anything you like and not face a penalty if the pro-
ceeds are used for something other than education. “I like to
So who’s the ideal Coverdell saver? A family with young make changes in the portfolio given market conditions,” says
children that plans to save for college a little at a time. Or adviser Houk. (With a 529 plan, you can shift among the
any college saver who doesn’t mind supplementing a investments within the plan, or move to another state’s plan,
Coverdell with a second account. only once a year—and that involves time and paperwork.)
The flip side, of course, is that money you put in a custo-
NEW LIFE FOR CUSTODIAL ACCOUNTS dial account is an irrevocable gift to the child. At a certain
big cache of Dell stock is the college kitty for age—21 in most states but 18 in a few—your son or daugh-
A Stuart Hutchison, 16, who lives near Austin, Tex.
His parents, Abigail and Wayne Hutchison, invest-
ed $6,000 in the computer retailer in the early 1990s. Today
ter gains control of the account. A house or a Harley, a bac-
calaureate or a bacchanal? The choice will be your child’s.
Not everyone worries about the money being squandered.
the shares are worth close to $500,000—enough to pay for “Our son is a really responsible kid. We don’t have any fear
college, grad school and then some. But instead of paying of that happening,” says Abigail Hutchison. Besides, if your
state is among those where custodial accounts end at age 21, Who can go it alone? Investors with big stock-loss carry-
you may well deplete the account paying college bills before forwards. And parents (or grandparents) who want to keep
the child gains control. the money for other purposes if it is not needed for college.
For financial-aid purposes, UTMA accounts are considered
student assets, assessed more heavily than 529 plans or SOMETIMES, 529S STILL WIN
Coverdells. So stay away if you expect to qualify for need- o be fair, plenty of planners haven’t turned their
based aid. (In the real world, few families where Mom and backs on 529 savings plans. In a perfect world, Wey-
Dad’s income exceeds $100,000 qualify for need-based aid dert says, most folks should put the first $2,000 in a
other than loans.) Coverdell, then fund a 529 plan. In practice, he says, most of
Finally, super-low capital-gains rates are set to expire after his clients just set up 529 plans because they offer one-stop
2008, so the added appeal of UTMAs is temporary unless shopping. Who can choose a 529 without looking back?
Congress extends the tax breaks or makes them permanent.
That makes the best assets for these accounts ones you plan Parents of older kids, who will use most of the funds before
to sell before 2009. In fact, the capital-gains rate for lowest- 2011.
bracket investors drops to zero, for a single year, in 2008—a
brief opportunity to sell custodial-account investments and Parents who will put college savings in income-producing
pay no capital-gains taxes at all. assets, such as bonds, certificates of deposit and money-mar-
ket funds. Income from such investments doesn’t qualify
The best candidates for UTMAs. High-income families with for the reduced capital-gains rates that make alternative
older children who are not likely to qualify for financial aid strategies appealing.
benefit most. Also, those who want maximum flexibility for
their investments and who want to contribute more than the Parents who want to put their college investments on auto-
Coverdell’s $2,000 limit. pilot. Investment choices are limited inside a 529 plan, but
the age-based portfolios that automatically fine-tune your
SAVE IN YOUR OWN NAME holdings according to your child’s age are just right for par-
ower capital-gains rates also boost the appeal ents reluctant to make their own selections or unlikely to
of keeping your kids’ college money in your own monitor the investments carefully.
name. By using a tax-efficient investment, such as a
stock index fund or an exchange-traded fund, you’ll avoid Parents in a position to max out on 529-plan-affiliated
unpredictable annual capital-gains distributions that are a credit-card benefits. This may sound frivolous, but Cheryl
fact of life with mutual funds. When it comes time to sell Costa doesn’t sneer at the $1,700 in 529-plan contributions
the investment, you can decide whether it makes sense to she amassed in rebates on her MBNA Fidelity 529 Plan credit
gift some of the money to your child—to take advantage of card last year. She got a 2% rebate on everything charged to
lower taxes on gains—or keep it in your own name. Keeping the card, which included her husband’s reimbursable business-
it in your name would mean a higher capital-gains rate, for travel expenses. (MBNA has since set a rebate cap of $1,500
example, but would reduce the expected family contribution per year.)
that is cranked into the financial-aid formula.
Of course, if you’re carrying big capital losses from the Wealthy parents or grandparents who want to make large
bear market, you might avoid tax on the gains altogether. lump-sum contributions. The plans are the only financial ve-
“We have been booking stock losses for the past three years hicles that allow you to contribute up to $55,000 at once (or
and suggesting that parents sequester education dollars $110,000 for a married couple) without gift-tax consequences.
in accounts holding tax-efficient index funds,” says John
Henry McDonald, a planner in Austin, Tex. “Losses against Residents of states with generous tax deductions and
gains equal tax-free withdrawals with no penalties if the low-cost 529 plans. In New York, for instance, married cou-
18-year-old shows up with strange piercings and a Fender ples can deduct contributions of up to $10,000 per year to
guitar.” the state’s low-cost Vanguard plan. Deductions are also gen-
erous in Mississippi and Missouri, which use TIAA-CREF–
5 2 9 S S TAT E B Y S TAT E managed plans.
See how your state’s college-savings plan measures up to Still aren’t sure which college-savings candidate gets your
others across the country. Plus, share your questions in the vote? Go ahead, pick one, and pull the lever anyway. Saving
Kiplinger Community. kiplinger.com/magazine/links somewhere is always better than saving nowhere at all.
—Reporter: ELIZABETH KOUNTZE