COLLEGE SAVINGS Investors have options other than the 529 plan

Income, the future and saving abilities all affect investors' choices.
By ANDREA COOMBES
CBS MARKETWATCH
SAN FRANCISCO -- With college costs rising almost exponentially, saving for children's future tuition makes sense no matter how you do it.
While there's a simple beauty to the state-sponsored college-savings vehicles known as 529 plans -- with their provisions that earnings grow tax-free -- there are also some details that complicate the decision for many investors.
"At first blush, the 529 looks unbelievable," said Jay Heller, president of the HJ Financial Group, a financial management firm based in Philadelphia.
But, he said, investors who need flexibility may want to consider other options. For instance, 529 withdrawals not used for college are hit with a 10 percent penalty on earnings -- and those earnings are taxed at ordinary-income rates.
Also, state residents can often get a tax deduction if they use their state's plan, but that limits investors' choices, Heller said. While some states offer two or more plans, others provide only one. And some plans allow reallocations only once a year, he said.
Good, bad savers
Some states have enacted changes that make it more onerous for state residents to invest in out-of-state plans. Residents of Tennessee, for instance, face a tax on earnings gleaned in other plans.
New York offers a $5,000 tax deduction for assets deposited into its 529 plan -- but if a state resident pulls out of the fund, those tax savings have to be paid back.
"Somebody that's middle- or upper-income that really has the whole world of investments open to them" may be better off with a tax-efficient mutual fund, Heller said.
Still, Heller said, he recommends 529s to clients who aren't saving at all. "If you take somebody that's not a good saver, whether high or low income, it's very easy to get them to do an auto-withdrawal out of their account," he said. "We'll use 529 plans often in cases where we can't get somebody to save."
Countering arguments
It seems for every argument against 529s, there's a countervailing one in favor. For instance, though flexibility is limited because unqualified withdrawals are penalized, the plans make good estate-planning tools, some say.
Investors can usually pass the account on to the next generation without incurring any estate tax, said Bruce Harrington, vice president and director of 529 plans at MFS Investment Management, based in Boston.
The plans have important benefits, Harrington said. For instance, a special exemption in 529 plans makes them useful as estate-planning tools: Generally, one person can give another person a maximum of $11,000 per year gift-tax free, but with 529s, five years' worth, or $55,000, of that tax-free gift can be given in one year.
"A grandmother and grandfather who have 10 grandchildren -- they give their combined gift, they get a million out of their estate immediately," Harrington said. "But they retain control: They direct the investment. If they change their mind and need to use the money for a nursing home down the line, they say we need the money back."
Tax-law change
And what does the IRS think of this use of 529s?
"Regulations as they are written to allow for this type of planning," Harrington said. "It's one of the key benefits of a 529."
Some say the tax-law change reducing capital gains rates to 15 percent make other, more flexible investments far more attractive.
"If you have $200,000 invested with a very tax-efficient money manager and they kick out $5,000 or $10,000 in capital gains, you're not paying all that much tax on the growth of the money," Heller said. "If you need flexibility, you're not paying all that much tax."
Still, others say that nothing beats tax-free earnings. Investors will "tell you the thing they hate most is paying taxes," Harrington said. "The ability to have tax-free growth is still a very powerful thing. Granted it's a little less powerful because the taxes are a little less."
Also, Harrington said, the tax-law changes that make other investments more alluring now are set to sunset in 2008.
Of course, those less enamored of 529 plans warn that their tax-free advantage is set to expire in 2010. Congress may decide to extend either law -- or not.
Counting assets twice
Some colleges count 529-plan assets twice in their financial-aid calculations, once as the parent's asset, and then the following year, after a plan withdrawal is made, as the student's untaxed income.
"The industry is lobbying against that. It's unfair," Harrington said. "You're looking at the same asset twice."
Generally in financial-aid estimations colleges count 529-plan assets as the parent's rather than the student's, Harrington said, with 5.65 percent of the parent's assets considered eligible for college costs.
Investors should also know that when filing their tax returns, the Lifetime Learning or Hope education credits can't be used in conjunction with tuition costs paid by 529-plan withdrawals.
"You can't use [the credit] for the same dollars," Harrington said. "A good strategy is to use your Hope and Lifetime in your first year or two of college, and then use your 529 in your last years of college," thus maximizing the benefit of letting your earnings grow tax-free.