Saving for College

For many of the people reading this, saving for their children's college education is a major concern. With that in mind, we'd like to call your attention to a set of investment offerings which, while they are not index funds, are sufficiently attractive in other ways to merit your consideration.

With the cost of college education rising substantially faster than consumer prices, a few years ago a states began to offer their residents a way to pay in advance for tuition at their respective state colleges and universities. Gradually, these plans spread across the U.S., and then somebody asked the obvious question: why can't the funds built up in these plans be used to pay tuition at any school, be it public or private, in-state or out-of-state. Thus was born the Qualified State Tuition Program.

What has really made these plans attractive, however, are the new regulations governing them that were issued by the IRS in 1998 (Code Section 529). There are five that are critical:

1. A plan is established by a sponsor for a named individual (the beneficiary).

2. The returns on funds invested in these plans are not subject to tax for as long as they are in the plan. When they are withdrawn, as long as they are used for "qualified educational expenses'' (which are broadly defined by the IRS), they are taxed as ordinary income to the beneficiary (at a lower tax rate than the person who places the money in the plan would pay). If the funds withdrawn are used for any other purpose, there is an additional 10% penalty.

3. An individual can give up to $50,000 in one year to a plan without incurring federal gift tax, provided that no additional contributions are made to the plan over the five year period, and that the gift is treated as a series of five equal annual gifts on the next federal gift tax return after the $50,000 gift is made. Alternatively, an individual can give $10,000 to a plan each year without incurring federal gift tax. For example, a couple with three children could establish 6 plans (each parent establishes a plan for each child) and in so doing transfer up to $20,000 per year to each child. The maximum amount that can be given to a single plan by a single sponsor varies by state (depending on their interpretation of the IRS regulations). The highest today is the Massachusetts plan, which allows up to $164,000 to be contributed (not including investment gains).

4. The amounts given to a Qualified State Tuition Plan are not included in the sponsor's estate for estate tax purposes. They are treated as "complete gifts."

5. Now comes the truly unique benefit of these plans. Despite their treatment as "complete gifts" for estate tax purposes, until the funds are actually used to pay for education expenses, the plan sponsor retains control over the account -- that is, they can change the name of the beneficiary. This is the only exception that we know of to the general rule that in order to be treated as a gift for estate tax purposes, control must be given up.

However, contributions to the plan must be made in cash, and the sponsor can exercise no control over the investment of the funds. Practically, this has meant that every state higher education authority has had to figure out how to invest the funds. Most of them have hired institutional investment managers to do this. A few (notably, New Hampshire and Massachusetts) have hired Fidelity. The latter has established what we believe to be a very reasonable investment policy for the funds, which varies the mix of equities, bonds, and cash in a beneficiary's plan depending on the years remaining before he or she starts college.

By now you are probably asking, "why, if these plans have so many benefits, haven't I seen them advertised?" There is one main reason: the biggest financial services companies (e.g., the banks and mutual funds) can't (with a few exceptions like Fidelity) figure out how to make money from them. They would much rather that you use the taxable products they offer to save for college -- despite the fact that they are much less efficient vehicles for doing so (from both an income and estate tax point of view). For more information, we recommend that you look at www.savingforcollege.com .

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