It's never too soon to start.
By Sally A. Wahrmann
An Investment Alternative
Most states have established college savings plans to encourage savings for the future college costs of family members. There are two types: prepaid tuition plans, which are designed to hedge against increasing tuition rates, and savings plans, which provide tax incentives to save now for future college costs for family members.
Some plans are more restrictive than others. The author examines plans in Florida, Pennsylvania, New Jersey, Connecticut, and New York. The New York plan is examined in-depth, and two examples will help those looking at all the investment options for providing for future college costs.
Ten years ago, only three states had college savings programs. As of January 1999, 43 states plus the District of Columbia have adopted plans. Of the remaining seven states, three (Kansas, Arkansas, and Hawaii) are performing feasibility studies and should be on board soon. The four holdouts are Idaho, North Dakota, South Dakota, and Nebraska.
In 1991 the College Savings Plans Network (CSPN) was established as an affiliate to the National Association of State Treasurers (NAST). CSPN provides information to existing college savings programs and monitors Federal activities. It also promotes legislation that will have a positive effect on state college savings programs.
CSPN's website provides news on the 44 active state college savings programs with links to their websites. Exhibit 1 contains the website addresses of CSPN and other relevant sites.
Prepaid Tuition Plans vs. Savings Plans
There are two main types of college savings programs: prepaid tuition plans and savings plans. A prepaid tuition plan involves the purchase of tuition credits that will be usable in the future by the beneficiary. For example, if you buy one semester of college education now, it will always be worth the cost of one semester's tuition, even if used 10 years from now. These prepaid plans exist in 20 states. Although prepaid tuition plans offer tax advantages, they are usually less flexible than savings plans. Many plans are restricted to the state university systems; a few permit the prepayments to be used for selected in-state private schools. This is an obvious effort by some states to encourage students to seek higher education within the state. If a child wishes to attend college in another state or at a nonparticipating school, most states will return the amount contributed with a reduced investment return.
College savings plans exist in 22 states and the District of Columbia. The concept underlying this type of college fund is different from that behind prepaid tuition plans. Savings plans are maintained in the sponsor's name as opposed to the student's. Most plans permit a deduction for state income tax purposes for contributions made to the plan. Monies contributed to the plan are invested and earn a return on the investment portfolio established by the state. Also, monies can usually be used for colleges located both in and outside of the state where the plan is established. Exhibit 2 lists the states by type of program offered.
Plans in Action
A comparison of Florida, Pennsylvania, New Jersey, Connecticut, and New York's tuition programs will illustrate the differences in flexibility of plan types. Florida and Pennsylvania have prepaid tuition plans, while Connecticut, New Jersey, and New York have savings plans.
Florida's Prepaid College Tuition Program began in 1988; Pennsylvania's Tuition Account Program (TAP) was created in 1992. Florida limits the purchase of tuition contracts to children residing in the state. Specifically, children must be under age 21 and have not yet entered the 12th grade. There are two exceptions to this rule: 1) children of military personnel stationed outside of Florida, and 2) children with a noncustodial parent living in Florida. The plan supports in-state universities and public community colleges. If a student attends a school outside of the state, the funds may be transferred with a return limited to five percent on amounts invested or the rate of increase in matriculation fees for Florida's public community colleges or state universities (whichever is less). Refunds are limited to the same return. If the child moves out of the state, he or she is still eligible to attend a Florida school as a resident.
Pennsylvania requires that either the purchaser or beneficiary of a TAP account be at least 18 years of age and a resident of the state. Unlike Florida, residents are permitted to open accounts for themselves if they meet the age and residency requirements. There are 33 universities and community colleges in the program. Although funds may be used to attend out-of-state schools, TAP only provides tuition protection if one of 14 state-owned schools are chosen for attendance. If a TAP account is terminated, a refund will be issued at 90% of the value of the account or 90% of the tuition credits purchased, whichever is less. TAP account balances do not affect eligibility for state financial aid but may be included for Federal aid evaluation purposes.
The New Jersey Better Savings Trust (NJBEST) program requires that either the contributor or the beneficiary be a resident of New Jersey at the time an account is opened. Otherwise, there are no restrictions as to age or income. Earnings are tax free for state purposes, contingent upon the funds being used for the beneficiary's higher education expenses. Up to $25,000 can be accumulated before any funds are considered in qualifying for state financial aid. The minimum contribution necessary to maintain an account is either $25 per month or $300 per year until a balance of $1,200 is reached. After that, no additional contributions are required. The maximum account balance permitted is $100,000. Service fees consist of an annual maintenance fee of $15 and a one percent service charge. If a nonqualified withdrawal occurs, a 10% penalty on earnings will be assessed. NJBEST uses the New Jersey Department of Treasury, Division of Investment, as fund manager.
Connecticut Higher Education Trust (CHET) was established in 1997. Only residents of the state are eligible to open accounts. There are no income or contribution limits. The minimum required investment is $500. However, the minimum can be waived if automatic investment plans are established with a $50 per month contribution. If funds are not used for their intended purpose and a withdrawal occurs, a 15% penalty on earnings will be assessed. CHET requires a $15 annual account fee and an annual asset-based management fee of 1.55%. Collegiate Capital Group, Inc., is the investment manager.
New York State's College Choice Tuition Savings Program is very liberal in comparison to other states'. New York permits an income tax deduction for funds contributed to an account. Furthermore, the state does not tax earnings, although there is a 10% penalty for an unauthorized withdrawal. Funds may be disbursed to any school of higher education in the United States. Account contributors or beneficiaries do not have to be residents of the state.
The New York State Program
The New York State College Choice Tuition Savings Program is designed to provide families a tax-free vehicle to save for college costs. The program is administered by the Office of the State Comptroller and New York State Higher Education Services Corporation (HESC).
The New York State College Choice Tuition Savings Program Act (1997 NY Laws, c. 546) took effect on September 10, 1997, and is applicable to tax years after 1997. Section 3 of the act added Article 14-A to the New York Education Law, which established the program, and section 4 of the act added section 78 to the New York State Finance Law, which provides that the program's assets be held by the comptroller as trustee.
On November 10, 1997, the comptroller and HESC entered into a memorandum of understanding relating to the implementation of the program. The comptroller was authorized to implement the program through the use of financial organizations as account depositories and managers. Teachers Insurance and Annuity Association of America (TIAA) was selected as the program manager after a competitive bidding.
The program manager is required to provide separate accounting for each designated beneficiary. All investment decisions will be made by TIAA with oversight by the comptroller, and account owners and designated beneficiaries cannot use their interest as security for a loan.
The program's assets are under the trusteeship of the comptroller in a trust fund held by a newly formed limited liability company. This LLC is managed by TIAA and structured as a series fund. As such, contributions to accounts will be invested based on nine program series determined by the designated beneficiary's year of birth. Each program series has an underlying portfolio, which will pursue distinct investment objectives and policies.
TIAA has so far established three underlying portfolios as follows:
* College Savings Growth Fund. Seeks a long-term return through capital appreciation by investing in a diversified portfolio of common stocks.
* College Savings Bond Fund. Seeks a long-term return through high current income consistent with preserving capital.
* College Savings Money Market Fund. Seeks high current income to the extent consistent with maintaining liquidity and preserving capital.
Other portfolios may be established in the future, subject to approval by the comptroller. The age of a designated beneficiary will dictate the program series into which funds are allocated. For example, a program series designed for younger beneficiaries will have investment allocations weighted more heavily in stocks, whereas a program series for older beneficiaries will lean toward bonds and money market instruments.
Tax Status of New York Program
Advisory Opinion TSB-A-98(19)C/TSB-A-98(12)I/TSB-A-98(3)M, issued October 7, 1998, responded to questions about the taxability of the program. Based upon the opinion, it would appear that neither the program, its assets, the trust fund, nor the LLC are entities subject to any New York State franchise taxes, with the exception that TIAA will be subject to tax on its distributive share of the LLC's income. Furthermore, the income of the program, trust fund, and LLC will not be subject to tax on unrelated business income.
The last point warrants further elucidation. IRC section 529(a) states that a qualified state tuition program will be subject to the Federal income tax on unrelated business income. Article 13 of the New York Tax Law imposes a similar tax once it is assessed at the Federal level. The New York State Department of Taxation, however, has taken the position that the program has such a close relationship with the state as to be exempt from taxation under Article 13.
Rules for Establishing an Account
Since New York State's program meets the requirements of IRC section 529 as a qualified state tuition program, earnings on the savings accounts will be tax deferred until disbursed for Federal income tax purposes. New York State will not tax either principal or earnings of the plan if distributions are for qualified education expenses of the beneficiary.
Each year, an individual (account owner) may contribute, and subtract from New York State gross income, an amount up to $5,000 ($10,000 for a married couple filing jointly). More than $5,000 may be contributed in a given year, however, any excess amount is not deductible. Individuals may establish several accounts since each account may have only one beneficiary. The maximum deduction is limited to the $5,000 ($10,000 for a married couple filing jointly) in total for all such accounts. The person who establishes the account is the only person who may contribute to it. Although the account owner may designate any individual as a beneficiary, there are no family, relationship, or residency restrictions. An individual may even open an account for herself. Additionally, an account owner may transfer all, or a portion, of a tuition savings account from one designated beneficiary to another as long as the transferee is a member of the original beneficiary's family. The law defines "member of the family" to be quite far-reaching (See Exhibit 3 ).
All contributions must be made in cash. Cash includes contributions made by check, payroll deduction, or automatic deductions from a bank account. Periodic contributions made by automatic bank or payroll deductions can be as little as $25; otherwise, minimum contributions must be at least $250. Once the account is open, it must remain open for at least 36 months before any monies may be disbursed for qualified education expenses. Furthermore, unqualified withdrawals are subject to penalties. The account owner's total contribution cannot exceed $100,000 per beneficiary. Any excess balance with respect to a specific beneficiary should be promptly withdrawn or transferred to another account.
Money accumulated in an account may be withdrawn for qualified expenses such as tuition, fees, books, supplies, and equipment required for enrollment or attendance by a beneficiary at an eligible educational institution. Room and board can be included as a qualified expense if the beneficiary is enrolled at least half-time. The use of funds is not limited to New York State schools. However, the school selected must be recognized and approved by the regents of the University of the State of New York or be accredited by a nationally recognized accrediting agency or association. Withdrawals made as a result of the death or disability of either a designated beneficiary or an account owner are also considered qualified. Furthermore, any withdrawal made on account of a scholarship will be a qualified withdrawal. All other withdrawals will be designated nonqualified and subject to a minimum penalty of five percent of the portion of the withdrawal constituting income. However, the comptroller and HESC may be forced to increase the penalty. Under IRC section 529(b)(3), a program will not be treated as a qualified plan unless it imposes a "more than de minimis penalty." Evidently, the IRS does not feel a five percent penalty is adequate.
Investment Restrictions. The New York State, HESC, the comptroller, and TIAA make no guarantees as to specific rates of return on investments. New York law requires quantitative and qualitative limitations on the investments in the underlying portfolios. For this reason, it is expected that TIAA will invest conservatively.
The allocation guidelines limit flexibility for allocating monies between funds. This is dictated by the age of the beneficiary and the nine program series investment strategies. If an individual is age 16 or older, the allocation percentage to the growth fund is only 10%, with 90% invested in more conservative investments.
Unfortunately, this type of investment strategy does not consider the intentions of the account beneficiary. For example, a 30-year-old accountant wishes to change her career, anticipates going back for graduate school by age 40, and opens a tuition savings account. The investment profile unnecessarily limits her income return. A larger percentage of the accountant's investment might be better allocated to the growth fund when withdrawal is not imminent.
The Taxpayer Relief Act of 1997 (TRA '97) changed some rules that make these programs more appealing. The law now permits funds to accumulate savings for room and board (effective retroactively to August 20, 1996). The programs may also be used for any school that is an educational institution for purposes of the Hope Scholarship or Lifetime of Learning Credits. TRA '97 also broadened the definition of family members by adding stepsiblings and spouses of family members (See Exhibit 3 ).
Tax and Financial Planning
Families planning for the financial costs of higher education will be pleased to learn that a New York tuition savings account will not affect any state-administered financial aid program. Federal aid programs, however, may take amounts accumulated in tuition savings accounts into consideration. Some institutional aid programs might also consider the account balances.
Are college savings programs the answer for funding the rising costs of higher education? The following two examples will illustrate the power of tax-free and tax-deferred savings. If a tuition savings account can return enough to keep up with rising tuition costs, the program has accomplished its goal.
Example 1. A family with taxable income of $60,000 desires to take advantage of the program. The parents are only able to save $100 per month. If they start saving when their child is born and receive a modest four percent return, by age 17 the fund's value will be $29,149. Tuition at a State University of New York school currently averages about $3,400 per year. By applying the same inflation rate to tuition costs (four percent), the fund will cover tuition costs and have $6,846 remaining for other expenses.
The taxpayers will have received a $1,200 deduction each year for state income tax purposes and paid no Federal income tax on the earnings of the fund. The New York tax savings amounts to $1,603. Assuming the taxpayers are in the 28% bracket, Federal taxes deferred amount to $2,450. When the funds are disbursed to pay for the beneficiary's college education, the earnings of the account ($8,749) will be taxed to the student over a four-year period, resulting in a Federal tax savings of $1,138. The family would also qualify for the Hope Scholarship and Lifetime of Learning Credits, since their annual income is within the limits provided by law.
Example 2. A family with taxable income of $300,000 also would like to participate. This family can afford to save $5,000. The same savings pattern, a four percent return invested at birth, would result in a fund value of $121,457 at age 17. Federal taxes deferred over the period amount to $14,437; the earnings of $36,457 will be taxed to the student over four years at 15%, resulting in a Federal tax savings of $8,968. The taxpayers will shelter all $121,457 from state taxes, since they received a $5,000 deduction for each year of contribution and pay no state tax on the earnings or qualified distributions. The highest tax rate in New York of 6.85% results in a tax savings of $8,320.
Example 2 presents an attractive strategy for the more affluent family. But using a tuition savings plan should be evaluated against the potential of after-tax funds that might produce a higher return. Since New York's program is brand-new, there is no performance record for the underlying portfolios.
Under IRC section 529(c)(1)(A), contributions to qualified plans are considered completed gifts. However, IRC section 529(c)(2)(B) treats the contributions as being made ratably over a five-year period beginning with the calendar year of the contribution. This means a $50,000 contribution may pass gift-tax free in one tax year. Since a completed gift has occurred, monies in the savings plan will not be included in the estates of contributors even though they maintain full control over the accounts until disbursed for their intended purpose. This may lead to substantial savings in estates where parents or grandparents wish to transfer money to children or grandchildren and avoid a substantial estate tax burden. *
Sally A. Wahrmann is an associate professor of accountancy at Long Island University, C.W. Post Campus. Her e-mail address is firstname.lastname@example.org.
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