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Archive for Sunday, August 5, 2001

529 savings plans, now tax free, still best bet for college savings

August 5, 2001

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Tax-free college investing sounds great, but how does it affect financial aid?

That, in a nutshell, summarizes a raft of questions I've received from readers after a couple of recent columns on Section 529 plans.

The short answer: These plans can reduce a student's eligibility for aid.

But that's not a fatal flaw. After all, you're not sure how much aid you could get or how much would be in loans you'd have to pay off anyway. It's pretty risky to skimp on college savings in hopes of getting more aid.

To back up for a second, 529s allow parents, grandparents or others to invest for a student's college education while escaping federal income and capital gains tax on profits. Currently, these are state-sponsored programs, although private colleges are starting to develop them as well. Most 529s are flexible enough that withdrawals can be used at just about any public or private school anywhere.

Under the 2001 tax-cut law, withdrawals made after this Dec. 31 will be free of federal income or capital gains tax. Previously, taxes on investment gains were deferred until withdrawal, and then income tax was charged on gains at the student's rate.

The new tax rules make little, if any change, in the financial-aid implications, says Joseph Hurley, an accountant and author of the leading book on 529s, "The Best Way to Save for College."

Under the federal aid formula used by most schools, the two types of 529s are treated differently.

The first type, known as a prepaid tuition plan, offers an opportunity to buy credit hours at current prices, protecting against future rate hikes. The aid formula considers assets in these programs to be a "resource" available to pay the student's college costs. Every dollar available through a prepaid plan, therefore, reduces the student's aid eligibility by a dollar, Hurley says.

Other 529s offer mutual fund investments that can produce larger returns if stock and bond markets do well, but you can lose money, too. Assets in these "savings-type" plans are considered the investor's the parents' or grandparents' rather than the student's.

This is good because the aid formula assumes that only about 6 percent of the parents' assets are available for a student's college costs each year, and it doesn't count any assets held by grandparents or others. In contrast, it assumes that all of a student's assets can be tapped over four years.

But savings-type plans can hurt aid eligibility nonetheless, because the portion of any withdrawal attributable to investment gains is counted as the student's income. Even though this money is not taxable, it reduces aid eligibility by raising the student's income.

On balance, savings plans probably will hurt the typical participant less than a prepaid plan would.

Should aid considerations keep you away from these programs? In most cases, no. Most other approaches to college saving have down sides as well.

Parents who save in ordinary taxable accounts, for instance, can face hefty tax bills when they draw money out to pay college bills, even though the financial aid effect may be small. Custodial accounts, in which parents or others manage investments in the student's name, can be easy at tax time because income and profits are taxed at the student's rate.

But as student assets, they count heavily against aid. Moreover, the student has total control of the account upon turning 18 or 21 (depending on the state).

Assets in an Education IRA are considered the student's and can have the same damaging effect on aid as a custodial account.

But the Education IRA may have one advantage over the 529, says Kal Chany, author of the book "Paying for College Without Going Broke." At the end of 2010, the recent tax cuts are scheduled to expire and the old rules will come back into effect. Education IRA withdrawals were tax-exempt under the old rules, while 529 gains were taxed as income, at the student's rate.

To some extent, saving for college is a bet on whether Congress will do the right thing and make its fine new rules permanent.

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