The New Math of Paying for College

Changes in the law could either help you significantly or throw you a curve.

By Jane Bennett Clark, Senior Associate Editor

From Kiplinger's Personal Finance magazine, October 2006

529s get a boost. As an alternative, many parents will direct new savings into 529 plans. These state-sponsored accounts let your contributions grow tax-deferred. Distributions escape federal taxes if you use them for qualified college expenses. (If not, you pay the federal tax on earnings plus a 10% penalty.) Most states offer residents a tax deduction on contributions. Kansas, Maine and Pennsylvania let residents take the deduction for out-of-state 529s as well.

These enticements persuaded René Sahilan of San Diego to set up an account in the Alaska 529 savings plan for his 3-year-old son, Matthew. "I'm 46," says Sahilan. "By the time he starts college, I'll be of retirement age, so I'm basically looking at aggressively saving for college." If his son skips higher ed and Sahilan has to pay taxes on the withdrawals, his age will work in his favor. As a retiree, he says, "my tax bracket will be lower."

Aside from the tax benefits, 529s have several advantages over custodial accounts. First, the parent usually owns the account and can switch beneficiaries or use the money for nonqualified expenses, paying the tax and penalty. And students benefit if they apply for financial aid because 529s are usually parent-owned assets. The government uses the parent's assessment -- 5.6% -- to calculate your family's contribution to college costs, rather than the 35% bite on student-owned accounts. That distinction becomes less meaningful next year, when the assessment on student assets drops to 20%.

A level field. Once, 529s had a leg up on prepaid-tuition plans, which let you lock in tomorrow's tuition at today's prices (or thereabouts). Rather than being considered a parental asset, prepaid plans were assessed dollar for dollar against any financial aid. Now, however, such plans are treated the same as 529s and other parent-owned assets.

Here's how the prepaid plans work: You buy chunks of in-state tuition at current rates, often plus a premium, which the state invests. If your child ends up going to college out of state or to a private school, you can transfer the funds, including the earnings, without paying federal tax on the income. If college drops off your child's radar screen, you can transfer the account to another beneficiary. Or you can withdraw the money, but you'll owe tax on any earnings, plus a 10% penalty. And the state may penalize you as well.

The Independent 529 plan offers a similar arrangement for private institutions, with the same tax advantages. Member schools sell tuition credits at a minimum 0.5% discount off the current price and guarantee a refund (plus or minus 2%) if a child attends a school outside the plan. You have to buy the credits at least 36 months in advance of using them.

Participating schools absorb most of the investment risk, but parents do face the risk that their kids will end up at a school outside the plan. Dana and Lori Klimp of St. Paul, Minn., got around that problem by waiting until each of their two children, Julie and John, had been accepted at St. Olaf College, a participating school. Then the Klimps purchased their kids' senior-year tuition at the freshman-year price.

More good news: The new pension-reform law made permanent the favorable tax treatment enjoyed by 529 plans and their sister programs, prepaid plans. Previously, the tax provisions were set to expire after 2010.

Flexible Coverdells. The Coverdell Education Savings Account is a great way to cover your bases. You set up the account on behalf of a beneficiary and contribute up to $2,000 a year, which grows tax-deferred. You must use the money by the time your child hits 30, or the earnings will be taxed as income plus a 10% penalty.

As with 529 plans, withdrawals for qualified educational expenses are tax-free, but the term "qualified" covers a broader range of expenses, including private elementary and high school tuition, which gives you more flexibility. Generally, Coverdell accounts go on the parent's side of the ledger in federal financial-aid calculations.

Not everyone qualifies for a Coverdell; to contribute, you must have an adjusted gross income of no more than $110,000 as a single filer, or no more than $220,000 if you're filing jointly. These and other provisions could revert to less generous terms after 2010. The failure of Congress to make the provisions permanent puts Coverdells "in a bad spot," says Hurley, although he expects Congress to rectify the situation before the 2010 deadline.

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