Saving for a child's education comes with tax benefits

With the price of college rising faster than the average family income, parents are forced to save more for their children's college tuition, and to start thinking about it earlier.

Though the news on tuition might seem unremittingly grim, one bright spot is the growing variety of plans that make it easier for parents to put off paying taxes while they save for college.

The problem now: Which is best? And how much to put away?

Though every family's situation is different, most advisers recommend the government's two tax-deferred savings plans: the Section 529 Savings Plan and the Coverdell Education Savings Account.

Perhaps no college-savings vehicle has grown as fast as the 529 plan, created by Congress in 1996 after the IRS challenged the tax deductibility of college savings accounts in several states. These plans go by different names in different states; the Massachusetts version is called the U.Fund College Investing Plan. They work like mutual funds, in which the parents set up an account, and then choose and manage the investments within it.

A parent can put up to $11,000 a year into a 529 plan without paying gift tax. With two parents, the limit goes up to $22,000. In Massachusetts, the total savings in a 529 plan can be as much as $250,000. Once the money is in the account, the parents pay no taxes on investment gains or withdrawals, as long as the money is used to pay for qualified college costs. Since taxes can eat up one-third of investment income, some families stand to save thousands of dollars by keeping their money in this kind of account.

In some states, but not Massachusetts, contributions to 529 plans have an additional benefit: They are fully or partially deductible from state income taxes.

Not surprisingly, assets in 529 plans have ballooned from about $3 billion in 2001 to $35 billion at the end of last year, says Joseph Hurley, who runs a website, Savingforcollege.com, devoted to 529 plans.

The one tricky part: Parents can invest in a 529 plan anywhere in the United States, and there are a dizzying number of them. Plans are sponsored by individual states, and some states have multiple versions managed by various mutual fund and investment companies. Parents can invest in several plans from different states, depending on which ones have the combination of investment choices, fees, and expenses they like best.

"It's reasonable to look around for a plan with the lowest expenses," said Beverly Chapman, a financial planner in Newton.

Nevada's 529 plan, for example, includes investments from several mutual fund companies, some with very low expenses. Like plans from most states, Nevada's plan is available to nonresidents.

Several websites and books are available to help parents compare features, costs, and benefits of 529 plans and Coverdells. (See box.)

If your child decides not to go to college, you can take your money out of the 529 plan, because you retain control of the account. However, you would still owe tax on the earnings and have to pay a 10 percent penalty. Alternatively, you can name another beneficiary, such as another child or grandchild, and keep the account's tax-deferred status.

Coverdell accounts

The 529's main rival is called a Coverdell account, which used to be called the education IRA.

Like 529 plans, Coverdells offer tax-deferred growth and tax-free withdrawals if the money is used for education purposes. And, like 529 plans, the parents choose and manage the investments.

But unlike 529 plans, which can be used by anyone regardless of income, Coverdells are limited to joint filers with adjusted gross incomes below $220,000 and single filers with incomes below $110,000. Also, contributions to Coverdells are limited to $2,000 per student each year.

With this account, the beneficiary owns the assets, so if he or she does not go to college, the donor cannot get the money back.

While parents cannot put as much money into Coverdells, tax-free withdrawals can be used for a wider range of educational expenses, including elementary and secondary school, tuition for private and parochial schools, and special education, as well as college.

For example, a family facing potentially high costs for private school or special education may benefit from being able to save on taxes while they invest for that schooling, even if their child does not go to college.

Recently, parents with Coverdell accounts got a break from the US Education Department when it said that money in Coverdells will be considered parental property, putting the accounts on a level with 529 plans. This is important to families seeking financial aid because when the government calculates how much a family can afford to pay for college, it expects parents to contribute up to 5.64 percent of their assets, compared with 35 percent of the student's assets. Previously, the Coverdell had been considered student property.

Regardless of which savings plan, parents are still left with the question: How much should we put away?

The answer: Quite a bit. For example, in order to have $250,000 in a 529 plan in 18 years, parents of a newborn would need to save about $6,200 a year, assuming an 8 percent annual return.

When choosing where that money goes, the age of the child has a lot to do with the kind of investments parents choose for 529 plans or any college portfolio, says Stephen Gorman, a financial planner in Hingham. If a child is only two or three years away from college, that may not be enough time to invest in something like stock mutual funds that could get hit by a down market just as college bills are due, he points out.

"On the other hand, today's 15-year-old may not finish the fourth year of college until they're 22 or 23," Gorman said. "Plus they may go to graduate school." This means that parents may want to stop looking at college savings as just a single chunk of money. Parents of teenagers, for instance, might choose fairly conservative investments like short-term government bond funds to cover the first two years of college. But in saving for the junior and senior years of college, as well as graduate school, stock funds may work, since these investments have more time to ride through a couple of market cycles.

If the children are in elementary school or younger, advisers often suggest a heavier dose of stock funds, perhaps as much as 90 percent to 100 percent of the portfolio. But some parents of younger children may not be comfortable seeing their investments lose too much value now and then. For them, advisers suggest a blend of 60 percent to 70 percent stocks, with the rest in bond funds.