The CPA Journal

By Ann Galligan Kelley

The Economic Growth and Tax Relief Reconciliation Act of 2001 has given parents and grandparents increased options to save for college. Two of the most significant changes relate to IRC section 529 plans and Coverdell Savings Accounts. The section 529 provisions have been expanded beyond state-sponsored programs to include certain programs established and maintained by private institutions.

As college costs continue to escalate, state-run IRC section 529 plans will continue to be popular as investment options, due to their unique tax and estate planning benefits. For example, Rhode Island’s section 529 plan, the CollegeBoundfund, has seen its assets grow from approximately $8 million to over $2 billion in three years. Coverdells share some of the same tax advantages as retirement accounts and have also benefited significantly under this tax act. The big question for taxpayers is whether they should invest in a section 529 plan or a Coverdell.

College Costs

The College Board’s 2001 “Trends in College Pricing” states that tuition at a four-year private college or university now averages $17,123; room and board account for another $6,455. Tuition for a four-year public college or university, for in-state students, now averages $3,754, and room and board account for another $5,254. In today’s dollars, a typical four-year private college education could cost nearly $100,000 per child and a public one $45,352 per child; with college costs rising 5% a year over the past decade, this amount only figures to grow. How should a family approach this challenge?

End of Custodial Accounts?

A long-used vehicle for college savings has been the custodial account, which parents and grandparents used to shift assets and annual income into a child’s name. The advent of potentially tax-free savings accounts like section 529 plans and Coverdells might make the custodial account obsolete. Section 529 plans allow the donor to control the disbursement of any funds, unlike custodial accounts. The value of custodial accounts will also be counted against a student’s eligibility for need-based financial aid.

The New College Savings Options

The ability to make Coverdell contributions are phased out for donors with adjusted gross incomes (AGI) between $190,000 and $220,000 (for married filing jointly) and between $95,000 and $110,000 (for single, head of household, and married filing separately).

“Parents or others who are restricted from contributing to a Coverdell due to AGI limitations, though, should consider making a cash gift of up to $2,000 to the student or other eligible person, who could then contribute the $2,000 to a Coverdell,” advises Mark Caccia, MST, CVA, CPA. Higher-income families should also consider section 529 plans, which do not have AGI limitations.

Starting in 2002, annual contribution levels for Coverdells will increase from $500 to $2,000 per year. If a taxpayer can save more than $2,000 a year per child, a section 529 plan should be considered in addition to a Coverdell. Depending on the rules of the particular section 529 plan, a taxpayer might be able to contribute in excess of $200,000 in one lump sum.

Before a taxpayer gives in to the argument that saving money for college will only reduce her chance for financial aid, she should know that, on average, 60% of financial aid is given in the form of loans. Taxpayers that can afford to contribute large sums to a savings plan are probably not eligible for need-based financial aid anyway. Because they are considered the owner’s asset, section 529 plans are more advantageous in cases where there is some chance that a student will be eligible for need-based aid.

Section 529 plans are offered by almost every state and are frequently managed or distributed by large investment houses. The majority of them encourage nonresidents to participate, and many section 529 plans are aggressively marketed nationally. Nevertheless, some plans do provide extra benefits to in-state residents that may be worthwhile. For comparative information on state plans, see www. savingforcollege.com.

While most section 529 plans have not been in existence long enough to develop a meaningful investment track record, it is important to know who is managing the plan’s funds. Donors do not legally have a voice in how their funds are invested. An important criterion to be considered is the annual management fee. The difference between a plan with a 1% or 2% fee seemed insignificant during a bull market; in the current environment, however, it can make a tremendous difference over the life of an account.

Section 529 plans allow donors to front-load up to five years of gifts into one lump sum. Individuals can gift up to $55,000 per beneficiary in one year ($110,000 per beneficiary in one year for married couples), and the gift is treated as if it were made over a five-year period.

Taxpayers cannot use the tax-free distributions from a section 529 plan or a Coverdell to pay education expenses while claiming the Hope or Lifetime Learning credit for such expenses. The best strategy is for the taxpayer to use his own funds, or student loan proceeds, to pay higher education expenses, such as tuition, that are eligible for the tax credits. He could then use the tax-free distribution from the section 529 plan or Coverdell to pay for expenses that are ineligible for the tax credits, such as room and board.

Under federal tax law, a taxpayer cannot actively manage the funds in a section 529 plan. Most plans allow the donor, upon establishing an account, to select from several broad-based investment strategies designed exclusively by the manager of the plan. Thereafter they can only change their selection once each calendar year, or when there is a change in the designated beneficiary. The typical choices of investment strategy are conservative, aggressive, or age-based (which automatically changes the asset allocation from aggressive to conservative as the child ages).

The tax law does allow funds to be moved between different section 529 plans without changing the beneficiary once every 12 months. If taxpayers are not satisfied with how their funds are being managed, they can transfer their plan assets to a different investment manager without triggering a taxable distribution.

The 2001 Tax Act provides more flexibility if the beneficiary does not need the funds because of a full scholarship or a decision not to go to college. Under a section 529 plan, the donor can change the named beneficiary to another relative, now expanded to include first cousins of the original beneficiary. Under current tax law, unused section 529 plan assets can be handed down in perpetuity from one generation to the next while generating tax-deferred or tax-free earnings on a compounded basis.

With Coverdells, the money is actually being donated to the child, so the donor cannot change their intended beneficiary. An interesting statement in the 2001 Tax Act, however, indicates that one form of qualified education expense for a Coverdell is a contribution to a section 529 plan. Thus, certain individuals that have not used up all their Coverdell funds before age 30 might be able to roll them over into a 529 plan.

Finally, it is worth remembering that distributions from both section 529 plans and Coverdells that are used for ineligible expenses will be taxed as current income and the earnings will be subject to a 10% penalty.

Which Is Best?

Under the new tax law, one can withdraw the funds from a Coverdell tax-free for a wider variety of college expenses than are allowed under a section 529 plan. There are some minor differences in using the tax deduction or Hope and Lifetime Learning tax credits, but who can predict if they will still exist when a child goes off to school?

If parents can save more than $2,000 per year per child or their income exceeds the limits for contributing to a Coverdell, a section 529 plan is generally the best option. Parents might wish to use both a Coverdell and a section 529 plan if they have more than $2,000 to donate. Even parents that qualify for Coverdells but do not have investment management experience might be better served by using a section 529 plan with professionally managed funds. They should remain careful about checking on the investment options and terms as well as the fees that a plan will charge.

The new tax laws make saving for education easier and more attractive. Parents should not let the notion that they will not be able to save the entire cost of a four-year degree deter them from saving as much as reasonably possible. Any amount of savings will decrease the amount of loans that a family will have to incur.

Ann Galligan Kelley, CPA, is an assistant professor of accountancy at Providence College in Rhode Island.