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Ask Dr. Don
By
Don
Taylor,
Ph.D.,
CFA
•
Bankrate.com |
College savings plans
Dr. Don:
What are the pros and cons of getting into the prepaid college program
vs. the college IRAs I have been seeing advertised? My daughter
is 7, so I have 10 years of saving time.
Jeanette Junior
Dear Jeanette,
Both methods of investing for college expenses just got better with
the passage of the Economic Growth and Tax Relief Reconciliation
Act of 2001. (The new tax bill.)
Starting in 2002, qualified distributions from Section
529 college savings plans will be tax-free. Section 529 Plans include
both the prepaid tuition programs and investment accounts.
The new tax bill also will allow private plans offered
by eligible educational institutions. Plans are currently offered
only through state governments.
Savingforcollege.com
and CollegeSavings.org
are two Web sites that provide information on all the states' plans.
Savingforcollege.com reviews the state plans from both a resident's
and non-resident's perspective and ranks each plan with one to five
mortarboards.
Prepaid tuition plans typically guarantee a return
sufficient to cover in-state tuition at a state college or university.
In contrast, the investment accounts don't guarantee
returns, but allow some measure of flexibility in how the contributions
are invested. If your investment returns outstrip the percentage
increases in college tuition cost, then you're better off in the
investment account.
Depending on the state's program, the investment accounts
may have advantages over a pre-paid tuition plan if your child decides
to go to a private college or an out-of-state school.
The tax bill also increased the annual contribution
limit for Education IRAs starting next year to $2,000 from $500.
That change also becomes effective in 2002.
The Education IRA's tax-free withdrawals will no longer
prevent you from claiming any Hope or Lifetime Learning credits.
You will also be able to make eligible contributions to both an
Education IRA and a College Savings Plan in the same year without
triggering a penalty tax.
The tax bill also provides for a tuition expense deduction
for families with income below a certain level. Using the deduction
is an alternative to using the Hope and Lifetime Learning credits
and would require coordination with any qualified Education IRA
and College Savings Plan distributions taken in the same tax year.
How much you plan to invest, and how much control
you want to have over that investment will influence whether the
College Savings Plan or Education IRA is better for you. If you
like managing your own investments, then you're going to feel restricted
by the Section 529 plan choices. You should also take the time to
figure out what part of your annual return is going toward management
fees and mutual fund expenses before signing up for any plan.
Paying for professional management of these investments
will make sense for most investors, so I'm not telling you to avoid
these accounts based on fees and annual expenses. I'm saying that
you should be aware of these costs before signing up for a plan.
That's true for the Education IRA as well, but you'll
have more flexibility in both how the account is invested and the
annual expenses associated with that investment.
So much depends on your personal finances, if and
where you daughter decides to go to college, and your state's income
tax code that I can't give you a definitive answer about which plan
to choose. Investing in your child's future will always be a winning
proposition.
The new tax bill has tilted the playing field in your
favor. If you look at your options and end up not being able to
decide, then consult a tax professional to help you make a decision.
-- Posted: July 20, 2001
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