Yes, there's still college
Now's the time to review old accounts and start a tax-sheltered savings plan.
NEW YORK (CNN/Money) - War or peace, economic expansion or prolonged recession, you still intend to send your child to college--indeed, you may be more determined than ever.|
But with the stock market plunging, you may also worry that your tuition nest egg won't go as far as you had hoped. Stay calm. There are factors working in your favor. For one thing, you may be able to take advantage of the market downturn to reduce this year's income taxes on some of your college savings.
In addition, starting in 2002 new tax rules kick in that will allow you to save more of your money tax-free in 529 college savings plans and Education IRAs.
Moves to make now
Let's start with your 2001 taxes. If you have been stashing money for your child in a custodial account, such as an UTMA (Uniform Transfers to Minors Act account, also called Uniform Gifts to Minors Act, or UGMA, in some states), you probably racked up losses this year--or at the least, unimpressive gains. If so, says Kalman Chany, author of Paying for College, consider cashing out some or all of your UTMA by year's end and moving that money to a custodial account in a 529 savings plan.
Here's why: The tax breaks on regular custodial accounts are modest--the first $750 in interest income is tax-free until your child turns 14; the next $750 is taxed at the child's 15 percent rate. Any amount above that, however, is taxed at the parents' rate, as high as 39.1 percent this year, until your child turns 14 (at that point, the entire amount is once again taxed at the child's rate).
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By contrast, earnings in a 529 plan are completely tax-free (assuming you make withdrawals before 2011--more on that below). Moreover, some 15 states offer tax deductions on your contributions.
"By selling now, you can lock in losses and reduce your child's 2001 tax bill," says Chany. "And your college savings will grow faster with the tax treatment in a 529."
Before you shift your portfolio around, however, take time to review your overall college investing strategy in light of the changes in the tax law that become effective in January. Your plan should reflect your children's ages, your income and your financial aid eligibility. And bear in mind, the new tax breaks expire at the end of 2010, unless Congress renews them. (If not, contributions to 529s will go back to being tax deferred until withdrawal, when earnings would be taxed at the student's rate.)
Here's what you need to know about the three most popular ways to save--Education IRAs, 529s and custodial accounts--with tips on choosing the right strategy for your needs.
Education IRAs: More families will be eligible
Starting in 2002, this often ignored savings option--officially renamed the Coverdell Education Savings Account (ESA) but still best known as the Education IRA--becomes a serious choice. "For many families in high tax brackets, the Education IRA is a great place to save," says financial adviser Judy Miller of College Solutions in Alameda, Calif.
The new law raises the maximum contribution to $2,000 annually per child, up from a measly $500. (Contributions are not tax deductible.) Married couples earning as much as $220,000 a year will be able to open accounts, up from $160,000 previously. (Between $190,000 and $220,000, the amount you can save is gradually reduced.) One reason financial advisers favor the ESA is its flexibility, since you can choose among mutual funds, banks or brokerage accounts.
And under the new rules, families can use ESA money to pay tuition for private or parochial elementary and secondary school, as well as for ancillary expenses such as tutoring or computers.
For families who count on financial aid, however, ESAs can backfire. That's because money in these accounts is deemed a student asset under the financial aid formulas. Colleges expect families to kick in a larger portion of the student's assets (up to 35 percent a year) than the parents' assets (5.6 percent). So instead of opening an ESA, invest in your own name in an index fund or tax-managed fund, both of which minimize taxable gains.
529 savings plans: They'll be tax-free
Starting in January, 529 college savings plans will offer some of the biggest tax breaks around--money in these accounts will grow completely tax-free, as long as it is spent for higher education. In addition, some 15 states, including Michigan, Mississippi and New York, offer state income tax deductions for investing in their plans.
For high-income families who are not eligible for Education IRAs, 529s are a great option: There are no income limits, and you can put away large amounts--more than $200,000 in some states. But even middle-income investors, especially those in high tax states, can benefit from the tax-free compounding.
These plans do have some drawbacks. Most 529s offer limited investment choices, typically a handful of funds, including an age-based account that shifts investments as your child ages. You can make only one investment switch a year. Some plans levy high fees or require you to pay a sales charge. And if your 529 money is not spent for higher education, you will pay taxes plus a 10 percent penalty on the earnings. The biggest hitch, though, is that 529 plans, like Education IRAs, can hurt your chances of qualifying for financial aid. Granted, 529s are currently considered a parental asset. But that is likely to change as families pump more money into these accounts.
What's more, under the aid rules, a withdrawal from a 529 saving plan is considered student income and assessed at a 50 percent rate. You may be able to lessen the financial aid impact, suggests Raymond Loewe of College Money in Marlton, N.J., by deferring withdrawals until a child's junior or senior year of college, after most aid has already been awarded. And if you can hang on without using funds from your 529, you can use the money for graduate school, when aid may be tougher to get.
Custodial accounts: Small is beautiful
The new tax rules did not make changes to custodial accounts, but compared with the souped-up 529s and ESAs, UTMAs and UGMAs now look much less attractive. And for those seeking financial aid, money in an UTMA is still considered a student asset, which can cost you more in aid than you save on taxes.
Little wonder that many families are now looking for ways to undo their custodial accounts. "We call it 'UTMA regret,'" says attorney Kaye Thomas of tax Web site Fairmark.com. "Parents realize that setting up custodial accounts was the wrong move, and they are looking for a way out." Fact is, you can't legally take back an UTMA or UGMA--those savings now belong to your child.
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But in 32 states (at last count), you can move that money into a 529 savings plan, where it will receive better tax treatment. For families seeking financial aid, it may be wise to spend down the money in their custodial account before college rolls around. You can legally spend the assets on private school tuition, an SAT prep course or a computer, for example. And don't overlook the third option: Just leave the custodial account alone.
If you have only a small amount invested, you can earn interest completely tax-free. Moreover, unlike 529s, custodial accounts give you complete freedom to choose investments; and unlike ESAs, you can spend the money for any purpose that benefits the child, not just educational expenses.
Of course, the risk is that when your child eventually gets control of the account, he or she won't manage it the way you'd wish. But if you take advantage of more attractive options for most of your college funds, that's a risk you can breathe easier about taking.