Tax cut increases options in college planning

Associated Press

NEW YORK – Saving for college is about to get easier.

The federal tax cut enacted earlier this year increases the amount families can save in special tax-sheltered accounts, eliminates the tax on withdrawals for school expenses and allows more options in spending from the accounts.

“I think saving for college is on the minds of a lot of parents because costs are rising so fast,” said Brenda Schafer, senior tax research coordinator for H&R Block in Kansas City, Mo. “With the changes that come about in 2002 – especially the new flexibility with these tax-favored accounts – there will be more incentive to save.”

The most popular choices for most families are the state-sponsored Section 529 college savings plans and the new, improved Education IRA, officially known as the Coverdell Education Savings Account for the late Sen. Paul Coverdell, R-Ga.

There are advantages to both programs that parents must weigh.

In the past, most parents didn’t bother setting up an Education Savings Account for their children because annual contributions were limited to $500.

But starting in January, parents can set aside up to $2,000 a year in these accounts – a sum that when compounded over 18 years at 10 percent interest would yield more than $110,000.

What’s more, the new law also expands what the account can be used for. In addition to higher education tuition, fees, books and room and board, Education Savings Accounts can be tapped to pay for elementary and secondary private or parochial school tuition and expenses.

Withdrawals aren’t taxable by the federal government, and some states also give a tax break.

These state-sponsored plans, named for a section of the tax code, have much higher contribution limits – up to $265,000 in some states. They’re also generally managed by mutual fund firms, which offer a variety of investment choices.

In the past, the student faced taxes on withdrawals. But the new law exempts withdrawals for college tuition and qualified expenses from federal taxes. The law also allows parents to change from one state plan to another once a year with no penalty.

Because earnings in Section 529 accounts grow tax-free, they accumulate faster than in taxable accounts, according to calculations by asset management firm T. Rowe Price in Baltimore, Md.

The company said a $5,000 annual investment in a 529 account would grow to $278,000 after 18 years in a growth fund with a 10 percent return, compared with $225,000 in a taxable account.

The penalty for withdrawals from the accounts for non-education purposes is set at 10 percent of earnings.

So which option should parents choose?

Joseph F. Hurley, author of “The Best Way to Save for College – A Complete Guide to Section 529 Plans,” says small savers should look at 529 plans first.

In some cases, states exempt Section 529 account contributions from state income taxes as an added bonus, Hurley said. Also, professional managers watch out for a family’s investments.

On the other hand, he said, the Education Savings Account would be a better choice for a family that wants access to its savings for high school expenses or wants to play an active role in investing, for example by buying and trading specific stocks for the account.

H&R Block’s Schafer says families also need to assess how both accounts will affect a child’s eligibility for scholarships. Section 529 plans are counted as the parents’ money, while Education Savings Accounts are seen as the child’s.

“When it comes to scholarships, the child’s assets count much more than the parents’ assets, so sizable ESAs could reduce the chances for financial aid,” Schafer pointed out.

Still can’t decide which account would be best for your family? The new tax law allows families to open both a Section 529 and an Education Savings Account starting in 2002. In addition, funds from Education Savings Accounts can be rolled over into Section 529 accounts, although not the reverse.