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College Savings Vehicles Authors: Barbara
J. Raasch, CPA, CFA Anthony
Amitrano, M.S., Tax Ernst & Young, LLP Editor's note: If you would like more information about this column, contact Mr. Amitrano at (212) 773-7404. Today, it can cost over $35,000 per year to send a child to private college. Even in-state public universities can run over $10,000 per year. With these hefty costs staring parents in the face, it is no wonder they seek advice on how to reduce the burden. For years, tax advisers and financial planners have been formulating college-funding strategies designed to save taxes; yet the task continues to get more difficult and complicated. Federal tax rules have not changed much since the enactment of the Taxpayer Relief Act of 1997 (TRA '97), but the addition of new qualified tuition plans and the modification of already existing plans, state tax rules and changes in the economy continually affect funding strategies. The TRA '97 provided much-needed aid to parents planning for their children's college education. It not only provided help in the form of the Hope Scholarship and Lifetime Learning Credits, but also created new planning investment vehicles, such as the Education IRA and college savings programs (CSPs). While the Education IRA disappointed parents and planners alike, (because of adjusted gross income (AGI) and maximum contribution limits), CSPs are gaining popularity as states improve their offerings. The changes raise the question of the "best" college funding strategy, which is more difficult to answer today than ever before.
Pre-TRA '97 Before the TRA '97, tax advisers focused on the income tax and estate tax benefits of transferring assets to a child using custodial accounts under the Uniform Transfers to Minors Acts (UTMAs) and the Uniform Gifts to Minors Acts (UGMAs) (see Exhibit 1) and irrevocable trusts (see Exhibit 2). This analysis centered on whether tax benefits were sufficiently large to outweigh the costs associated with trusts, as well as the lack-of-control issues pertaining to custodial accounts (and, to a lesser extent, to trusts).
Sometimes a simpler solution better meets a client's needs. Simply saving for a child's costs in an investment account may be a viable alternative, because there are no incremental cost or control issues. In these cases, U.S. Series EE Savings Bonds (see Exhibit 3) may be appropriate, because they can provide Federal and state tax savings. While EE bonds are not expected to produce relatively high rates of return, they are insulated from losing value during a stock or bond market downturn. As a matter of fact, unlike other bonds, they actually benefit when interest rates increase.
Even after the passage of the TRA '97, advisers must still continue to consider these three strategies when determining how to best meet their clients' college-savings goals.
The TRA '97 The TRA '97 introduced several new options. It created a new tax-advantaged savings vehicle, the Education IRA (see Exhibit 4), the Hope and Lifetime Learning Credits (see Exhibit 5) and Sec. 529.
College Savings Options Qualified tuition programs are the most complex college savings options. There are two types: prepaid tuition programs (see Exhibit 6) and CSPs. These programs were granted beneficial tax treatment by the TRA '97, which added Sec. 529 to the Code.
Prepaid tuition programs. Prepaid tuition programs often come up a little short on two counts. First, states generally restrict the prepaid tuition programs to state residents. This can be quite burdensome if a child decides to go to an out-of-state school, and the total value of the plan does not fully cover actual costs. Second, by definition, the money contributed to a program will earn a rate of return equal to the inflation rate of the applicable state's average tuition. According to the 1998–1999 College Board Annual Survey, last year, the average inflation rate for tuition charged by public four-year colleges and universities was approximately 4%. This is significantly less than the return most investors earned during that same period and much less than the annual 7–9% tuition inflation rates experienced when prepaid tuition programs were first conceived. CSPs. The big news in college funding is CSPs. The number of such programs continues to grow and their features have been changing dramatically in an effort to offer greater benefits as states compete with each other for applicants' college funds. The benefits of CSPs include: 1. All investment earnings are tax-free until withdrawn. 2. When withdrawn, investment earnings are taxed at the beneficiary's tax rate for Federal income tax purposes, as long as he uses the funds for qualified education expenses. 3. For state tax purposes, such withdrawals may also be tax-free, depending on the state of residence and the state program used. 4. Some states (such as New York) provide a limited deduction for contributions made by state residents to their programs. 5. Contributions are eligible for the $10,000 ($20,000 joint) annual gift tax exclusion. Moreover, each taxpayer can accelerate up to five years' annual exclusions to minimize the gift tax on contributions. Therefore, if a joint election is made, $100,000 per child can be contributed gift tax-free in a single tax year. 6. Funds invested in CSPs are excluded from both the donor's and the beneficiary's estates. There is an exception if the donor dies during the special five-year period granted for the annual gift tax exclusion. 7. Funds can be used, without penalty, for all qualified education expenses, including housing costs and student supplies (e.g., books, computers, etc.). 8. Funds can be used at any university approved by the Department of Education, including some foreign universities. 9. Under most circumstances, any individual can use CSPs, regardless of his or a beneficiary's state of residence. 10. Any individual is eligible to be selected as a beneficiary. Once a beneficiary has been chosen, a contributor can change the beneficiary by selecting another member of the original beneficiary's family. The disadvantages of CSPs include: 1. Similar to other transfer strategies, the contribution is not eligible for the additional gift tax exclusion for tuition payments. 2. Each state limits the amount that can be contributed to its plan on behalf of any one beneficiary. This amount currently ranges from $100,000–$168,000. 3. To the extent withdrawals are used for something other than qualified education expenses, the state will charge a penalty when withdrawn. Currently, states will keep 10%–15% of any amounts withdrawn and used for an ineligible purpose. 4. Most states' plans charge annual management fees, which can be as high as 1.86% per year. 5. Some states charge an enrollment fee. Frequently, the fees charged to nonresidents exceed those charged to residents of the state sponsoring the plan. Sometimes these fees can be waived if a minimum account balance is met. 6. Neither the contributor nor the beneficiary controls the investment decisions. 7. Investment performance has varied dramatically among state plans, due to risk preference and manager success. 8. Because CSPs are relatively new, no long-term investment performance information is yet available. Investment performance. One of the greatest differentiating factors between programs offered by various states is expected investment return. The differences in the expected returns and risks of these tax-advantaged vehicles can be so great that it is often appropriate to forgo special state tax savings of a resident's state's plan and instead invest in another state's plan to achieve the desired investment risk and return. Most states use a professional investment firm (such as TIAA-CREF, Merrill Lynch, Salomon Smith Barney or Fidelity) to manage their CSP investments. While the security selection decisions made by the particular investment manager contribute to the difference in the investment performance of these plans, the major differences in the expected investment returns and risks of the various states' CSPs come from their asset allocation requirements. Studies have shown that, by far, the greatest contributor to the return and risk of a long-term portfolio is the asset allocation decision. As noted, neither a contributor nor a beneficiary of a CSP may make investment decisions; the plan determines the asset allocation for all assets contributed to the program. Currently, most states offer an asset allocation based on a beneficiary's age. In the child's younger years, the age-based option exposes the portfolio to more risk, by allocating more of the funds to equity investments. As the child grows older, more and more of the funds are allocated to bonds and cash, which decreases the amount of risk in the portfolio as the date the first tuition check needs to be written nears. This strategy makes good sense, because most parents do not want to see their child's college funds decline in value by more than 10% (as has occurred more than once this year already), just before "Junior" is about to go to Stanford. Even though most states offer age-based options, they vary greatly from state to state. For example, New York's CSP is run by TIAA-CREF and provides an average equity exposure of 38.6%. In contrast, New Hampshire, Massachusetts and Delaware use Fidelity's CSP, which provides an average equity exposure of 58.8%. This can have a huge impact on the projected savings needed to fund college costs, as well as the probability of having sufficient assets in that fund to pay these costs. In an answer to some taxpayers' desire for a larger amount of equity exposure (or in some cases, smaller), some states now offer fixed options. Maine and Wyoming, for example, currently offer options that invest 100% of the funds in equities (or 75% of the funds in equities) for the life of the account. Arkansas and Missouri, on the other hand, have created a 100% bond option. Many states are looking to offer one or a combination of these fixed portfolios in the near future. These fixed options provide investors with as many benefits as they do disadvantages. The greatest benefit of fixed options is the ability to select an asset allocation that meets a client's specific investment objectives. However, the greatest disadvantage is that the asset allocation will be fixed. For example, an investment entirely in stocks will be in stocks until withdrawn. While an all-equity allocation may be appropriate for funding a baby's college costs, it is probably too risky to use a year before the child goes to college. A fund's desired long-term investment strategy must be determined up front; the investment may be in existence for a long time and, once the money is invested in the CSP, control over its asset allocation ceases. It is critical to make sure the asset allocation requirements of the selected CSPs are appropriate to meet investment objectives today—as well as in the future. Plan evaluation. When evaluating CSPs, it is important to keep in mind not only that they are not all the same, but also that their availability and features change frequently. Eighteen months ago, only 15 states had plans available. Soon 40 states will offer them. The following is a three-step process for evaluating which CSP is best suited to a client's needs:
Advisers should also compare the pros and cons of the selected plan with all the other alternatives—Education IRAs, custodial accounts, irrevocable trusts and U.S. Series EE Savings Bonds. When formulating an appropriate college savings strategy, it is critical to evaluate both the tax and the financial aspects of all the possible alternatives. |
