CNN/Money 
graphic
Your Money > College
graphic
Buy it Now!
Saving smart is half the battle
Coverdell ESAs, 529s and custodial accounts. Which is right for you?
August 26, 2003: 1:51 PM EDT

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 in a rocky stock market, you may also worry your tuition nest egg won't go as far as you hoped. Stay calm. There are factors working in your favor.

For one thing, new tax rules have kicked in allowing you to save more of your money tax-free. It's knowing where to park your pennies, and how to search for free pots of gold, that will start you off on the right path.

Here's a look at the three most popular ways to save – Education IRAs, 529s and custodial accounts – and how they affect your financial aid eligibility.

Education IRAs: New and improved

Let's start with Education IRAs, which have officially been renamed the Coverdell Education Savings Accounts (ESAs). Often overshadowed by the increasingly popular 529 savings plans, ESAs recently have become a more attractive education-savings vehicle, especially for families in the higher tax brackets.

Related tools
graphic
College cost finder
College savings planner
Student loan calculator

The 2001 Tax Relief Act raised the maximum annual ESA contribution to $2,000 per child, up from a measly $500. And it raised the income eligibility limit for married couples wishing to open an account to $220,000 a year. If your adjusted gross income is between $190,000 and $220,000, the amount you can contribute is gradually reduced. Also under the new tax rules, you will no longer be penalized for contributing to both an ESA and a 529 in the same year for the same beneficiary.

Contributions to an ESA are not tax-deductible, but they grow tax-free. You can invest your contributions any way you wish, but withdrawals must be used for qualified educational expenses, the definition of which was broadened by the Tax Relief Act. In addition to using ESA money to pay for college, families can now use it to pay for tuition at elementary and secondary schools, as well as 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 presumed to be a student asset under federal financial aid formulas. Families are expected to kick in a larger portion of the student's assets (35 percent a year) than the parents' assets (up to 5.6 percent). So the more assets your child has, the less aid he or she is likely to get.

529s: The High-Octane, Tax-Free Choice

Thanks also to the 2001 Tax Relief Act, 529 college savings plans offer some of the biggest tax breaks around. Money in these accounts now grows completely free of federal tax, as long as it's spent for higher education. In addition, contributions are tax deductible in many states.

For very high-income families who are not eligible for Education IRAs, 529s are a great option. There are no income limits, you can contribute up to $11,000 a year without triggering the gift tax, and the lifetime contribution limits to a plan are much higher, exceeding $200,000 in some states. Middle-income parents can also benefit from the tax-free compounding.

These plans do have some drawbacks, though. Many 529 savings plans offer limited investment choices, typically a handful of age-based funds, which shift investments to a more conservative mix of stocks and bonds as your child ages. Switching investment tracks can be cumbersome. And some plans levy high fees or require you to pay a sales charge. Plus, if the money in your account is not spent for higher education, you will pay taxes plus a 10 percent penalty on the earnings.

Related stories
graphic
Choosing a college
The catch-up college plan
Secrets of the free ride

Like Education IRAs, a 529 plan can hurt your child's chances of qualifying for financial aid. Until now, the earnings portion of a 529 withdrawal has been considered student income, and under financial aid formulas, up to 50 percent of student income (as opposed to 35 percent of assets as for ESAs) is considered eligible to pay for education costs. Now that 529 withdrawals are tax-free, however, experts say it's unclear whether they will reduce a student's aid eligibility. In the event that the treatment of 529 withdrawals does not change, you can lessen the financial aid impact by deferring withdrawals until your child's junior or senior year of college, after most aid has already been awarded. And if you can hold off using the 529 funds until your child gets his or her Bachelor's degree, you can use the money instead to help with graduate school, when aid may be tougher to get.

Pre-paid tuition plans, of course, are also looking like a pretty good bet these days. Such plans, which are a type of 529, allow you to buy education contracts at today's prices to be used for tuition some time in the future. In essence, you lock in tomorrow's college costs today. Not a bad deal considering tuition fees have been rising two to three times faster than the Consumer Price Index since 1980.

As a 529 plan, earnings in pre-paid accounts are exempt from federal income tax, and contributions are tax deductible in many states.

Traditionally, pre-paid plans have been sponsored by individual states and designed to pay for tuition at public institutions within that state. Most are still limited to state residents, but many, too, have taken steps to become more competitive with 529 savings plans.

For example, many states now pay a minimum interest rate on pre-paid contracts, which guarantees some return even in the unlikely event that tuition prices don't go up. And some are giving full refunds to participants who pull their money out of the plans. States also have made it easier to convert their prepaid contracts to tuition at private schools and schools outside of the state.

While pre-paid plans continue to evolve on the state level, private schools have been given the green light to offer their own such deals. Under the 2001 Tax Relief Act, withdrawals from a private school's pre-paid plan will be exempt from federal taxes as of 2004. You would otherwise have been taxed on the increased value of a tuition contract from the date you bought it to the date you redeemed it.

At present, more than 220 private schools, ranging from liberal arts schools like Ripon College in Wisconsin to well known universities like Princeton and the University of Chicago have joined a consortium of schools called Independent 529 Plan.

Parents can buy pre-paid contracts good for tuition at any of the member schools. And if your child does not end up going to one of the schools in the network, you will get a refund of your contributions plus or minus 2% for each year in the plan, depending how underlying investments fared. Call 877-874-0740 (toll-free) or visit www.independent 529plan.org for information.

Remember, there's no one type of 529 plan that's right for everyone. Pre-paid plans and savings plans both have their rewards. If you believe in the stock market's ability to produce steady returns and you've got more than five years before your child heads off to the dorms, you may be better off in a savings plan where you can choose more aggressive investments. You can do this while your children are young and reduce your risk as they get older. But if you're risk averse or spooked by the markets, you may find that what you lose in potential returns, you gain in peace of mind through pre-paid plans.

Custodial Accounts: Tax-advantaged Way to Transfer Money to a Minor

The new tax rules did not make changes to custodial accounts, known as Uniform Transfers to Minors Act accounts (UTMAs) or Uniform Gifts to Minors Act accounts (UGMAs). Compared with the souped-up 529s and ESAs, the tax-advantaged UTMAs and UGMAs now look less attractive. And since custodial accounts are considered an income-producing student asset, they can cost you more in aid eligibility than you save in taxes.

A potential lack of control over how the money is used is another drawback for parents. Unlike money from a 529 plan or ESA, money in an UGMA or UTMA does not have to be used for educational purposes. And since your child gains control of the account when they reach the age of majority (typically 18), you won't have any say in the matter if the money is spent on something other than college.

Little wonder, then, that many families are looking for ways to undo their custodial accounts. Many, but not all, 529 plans allow transfers from custodial accounts, according to SavingforCollege.com, but they only accept cash, which means any investments in an UGMA or UTMA would have to be liquidated before transfer.

For families who maintain a custodial account but will be seeking financial aid, it may be wise to spend down the account before college rolls around. You can legally spend the assets on anything that benefits your child, including private school tuition, an SAT prep course or a computer.

If, however, your child is well under 14 and you have only a small amount invested (too small to make it worth the hassle of transferring to a 529 plan), let the account ride for awhile. You can then invest just enough to earn up to the $750 a year in tax-free income allowed.

Tricks of the Financial Aid Trade

As the college years approach, if you anticipate needing financial aid, strategize the timing of your college savings withdrawals, since aid decisions are based on your financials in the tax year before the school year in which the aid is used. In other words, if your child is entering college in September 2003, your 2002 financials will be the basis for aid decisions.

One of the key strategies is to keep your income as low as possible since income is a heavily weighted factor in needs assessment – up to 47 percent of parental income is considered eligible to pay for school costs. As such, try not to incur capital gains in the tax year before aid is needed. Capital gains count both as income and as an asset – a double-whammy.

No matter what vehicles you use to save for college, be sure to regularly review your overall investing strategy. Your plan should take into account your children's ages, the anticipated tuition costs when your kids matriculate, and whether or not you expect to need financial aid.

But perhaps most important, the amount you earmark for college should never, in any way, jeopardize what you need to save for retirement. Your child can draw on plenty of resources to pay for school, but no one's going to give you a scholarship to retire. Saving for your retirement should always take priority. And the good news is a fat nest egg will not reduce your child's aid eligibility. Financial aid formulas do not take your 401(k) and IRA savings into account.

The excerpt you just read is from "Get a Jump! The Financial Aid Answer Book," which includes contributions from CNN/Money editors. If you're interested in more of the practical and money saving financial aid advice the book has to offer click here.  Top of page




  More on COLLEGE
Four myths about college costs
Forecast: Hiring for grads to be up 20%
Top 10 degrees in demand
  TODAY'S TOP STORIES
7 things to know before the bell
SoftBank and Toyota want driverless cars to change the world
Aston Martin falls 5% in its London IPO




graphic graphic

Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.

Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.