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Tax Law Makes College Savings Plans More Attractive

College savings plans are finally coming of age. They won new tax breaks in the latest federal tax law, and have been embraced by every state in the nation. According to Diana Cantor, Executive Director of the Virginia College Savings Plan, all 50 states now have a college savings plan in place or have enacted the necessary enabling legislation, up from approximately 30 states just two years ago. Together, these developments present varied opportunities for parents saving for their children's education.

College savings plans, also known as 529 plans after the section of the IRS code that created them, have attracted relatively little interest from parents until now. Speaking at the Stable Value Investment Association's 2001 National Forum in Washington, D.C., in October, Cantor noted that although there were 1.5 million active 529 accounts with more than $9.5 billion invested at the start of this year, a survey by Harris Interactive found that only 8% of parents knew what the plans were and only 1% were using them.

That may soon change. The Economic Growth and Tax Relief Reconciliation Act of 2001 makes the plans more attractive by specifying that withdrawals for educational purposes will be entirely free of federal income taxes beginning in 2002. Previously, earnings were simply tax-deferred until withdrawal, much like the earnings in a 401(k) plan or Individual Retirement Account.

The new federal law also increases limits on qualified room and board expenses, and improves the portability of the plans by expanding the definition of a family member to include first cousins; allowing annual rollovers from one qualified tuition program to another; and permitting tax-free rollovers from Coverdell Education IRAs into 529 plans. Finally, the new law makes it possible for private sponsors, such as colleges and universities, to launch their own qualified tuition plans. Soon, some investment professionals predict, 529 plans will become to college savings what 401(k) plans are to retirement savings.

"We're going to see explosive growth in this market, particularly as a result of the new tax law," predicts attorney Mark Weisberg, a partner and co-chair of the employee benefits department of Katten Muchin Zavis in Chicago, who spoke with Cantor at the SVIA Forum.

While stable value investment options play a big role in the 401(k) industry, accounting for about 23% of the assets held in those plans (SVIA Fifth Annual Investment and Policy Survey), they could attract an even greater percentage of 529 assets with appropriate education. Parents (or grandparents) saving for a child's college education have a shorter investment horizon than workers saving for retirement, which makes the return and principal stability that comes with stable value products all the more attractive.

The Commonwealth of Virginia, which has included stable value investment options in one of its college savings plans, has already reaped the benefits of that decision.

"Since the stock market's downturn, our portfolios have outperformed those of most other state college savings plans due in large part to the fact that we have stable value in our plans," Cantor said.

Weisberg says private institutions that set up their own 529 plans may find stable value products quite appealing because of their return and principal stability. "Private institutions don't have the whole state standing behind them," he said at the SVIA Forum in Washington. "They will want to make sure they will be able to meet their (benefit) obligations."

Two Kinds of Plans

College savings plans come in two main varieties: prepaid tuition plans and savings plans.

Savings plans are similar to defined contribution plans, and, as such, work much like 401(k) plans. With them, a family invests money, selects an investment portfolio offered by the operator of the plan (usually a state), and reaps whatever gains or losses that portfolio achieves over time. Some savings plans do, however, guarantee a minimum rate of return.

One of the Virginia plans described by Cantor is an example of a savings plan. Called the Virginia Education Savings Trust (VEST), it allows families to save for all sorts of college costs, including tuition and fees, room and board, textbooks and computers. Participants can invest in one of seven different balanced or lifestyle investment options with varying risk and return objectives. The most conservative portfolio is invested 100% in stable value investments. The most aggressive allocates 5% of assets to stable value investments, 15% to fixed income, 20% to international equity, 20% to small cap/mid cap equity, and 40% to large cap equity. These portfolios automatically migrate over time towards a more conservative investment mix.

Prepaid tuition plans, also known as tuition account programs, are similar to a defined benefit plan. There are two types. With the first—prepaid unit plans—families buy units that represent a fixed percentage of tuition costs. In Ohio, for example, 100 units equals one year's tuition and fees at an Ohio state school. Any private institution that sets up its own 529 plan must structure it as a prepaid plan.

With the other type of prepaid plan—a contract plan—families purchase a specified number of years of tuition. The price they pay depends upon the age of the child and the type of payment plan chosen, lump sum or installment. The pre-purchased tuition is guaranteed to increase in value at the same rate as college tuition, thereby insulating participants from the inflation associated with college tuition.

In addition to its VEST program, Virginia also offers a prepaid plan called the Virginia Prepaid Education Program, or VPEP. Participants prepay future college tuition at today's prices. Their payments are invested so their growth will cover future college tuition and mandatory fees at any Virginia public college or university. Benefits may also be applied toward the cost of tuition and fees at private Virginia schools, as well as most colleges and universities nationwide, although without the guarantee that the plan will cover the total costs at out-of-state or private schools. Unlike a savings plan, prepaid plans do not allow participants to use funds for educational expenses other than tuition and fees.

Both of Virginia's plans offer investors the same favorable state and federal tax benefits, including federal tax exemption on earnings (beginning in 2002), a Virginia tax exemption on earnings, and a Virginia income tax deduction for every dollar invested.

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