In this report
Overview

Tax-wise ways to save for college

How do 529 plans stack up against other options, like Roth IRAs and Coverdell ESAs?

Last reviewed: July 2011

Even in a time of low overall inflation, higher-education costs increase 6 percent annually, year-in and year-out. Two-thirds of college graduates receive student-loan payment coupons with their diplomas, with the average balance approaching $25,000. Nationwide, student-loan debt now exceeds credit-card debt.

There are ways to lessen the bite, like attending a lower-cost public university or community college. But even a four-year public university costs about $60,000 to $80,000 today and will be even more down the road. If you'll be paying tuition for a child or grandchild (or even yourself), it pays to start saving as soon as you can. This month, we look at some of the plans and how to use them to maximum advantage.

Plans get more conservative

State-sponsored 529 plans now attract the most savings for higher education. Assets currently total $157 billion, according to the College Savings Plans Network, an organization set up by U.S. state treasurers.

Those plans vary widely in their investment options. Some 529s offer a choice of individual mutual funds or age-based plans that are structured somewhat like target-date retirement funds. They invest more aggressively when the beneficiary—the student—is young, and they adjust the portfolio's asset allocation to more conservative investments as he or she gets close to college age. The major difference is the length of the glide path, which is the formula by which the asset allocation shifts over time. Target-date funds are designed for 30 years or more of savings; once you reach the target date, the focus is on preserving your money for another 25 or 30 years after the contributions stop. In a 529 plan, you're saving for about 18 or 20 years and spending all of it in four years or so.

Since it's tough to bounce back from, say, a 25 percent loss in a short time frame, most age-based 529 plans are very conservative. At least now they are. In 2008 many 529 plans, like most investment vehicles, got hit hard because they were overexposed to stocks. In early 2009, when the stock market was near its bottom, we looked at the asset mixes of age-based portfolios for 15- to 17-year-olds. Most still had more than one-third of their portfolios in stocks, which was too aggressive for students who would soon need those funds. Now the trend is toward more conservative options. TIAA-CREF and Franklin Templeton, for example, offer new conservative age-based funds.

Value of tax deductions

But skewing conservative presents an obvious problem: how to keep up with the 6 percent annual inflation rate of college costs. Bonds, even long-term ones, currently yield far less than that, and expectations for stock returns have been lowered recently to about 7 or 8 percent a year in average long-term performance, from 9 or 10 percent. Fortunately, some plans have sliced expenses, which will help overall performance.

Favorable tax treatment provides a further boost. Any gains you earn from the plan can be used for tuition and other qualified expenses free of federal income taxes. And some states allow a tax deduction for contributions to their 529 plans. For example, New York allows individuals to deduct contributions to in-state plans of up to $5,000 ($10,000 for married couples filing jointly) on state income-tax returns. In Illinois, individuals can deduct $10,000 a year ($20,000 for joint filers). In other states, there's little or no additional tax advantage: California and Massachusetts, for example, don't allow deductions for 529 contributions, while Florida, Nevada, and New Hampshire don't have state income taxes to begin with.

Depending on where you live and whether or not you choose your own state's plan, that tax benefit might make up for some drags in plan performance. To test this theory, we analyzed how a 529 investment might do for a couple earning $100,000 in five higher-taxed states' plans vs. an out-of-state plan that doesn't allow you to deduct contributions on your state income tax (see Impact of tax benefits). An out-of-state plan that earned one percentage point more than an in-state plan would be more advantageous in four of the five states we analyzed.

Impact of tax benefits

How valuable is the state tax deduction on 529 contributions? That depends on your state income tax and how well the plan performs. If you contributed $1,000 a year to an in-state plan that earned 4 percent, you'd have a total of $20,825 after 15 years. We calculated the difference—more or less—in earnings if you had put the same money into an out-of-state plan without a deduction.

State Tax rate Out-of-state plan earning …
    4% a year 5% a year
Illinois 3.00% - $625 $1,152
Connecticut 5.00 -1,042 700
New York 6.85 -1,427 280
North Carolina 7.75 -1,614 77
Oregon 9.00 -1,875 -207
Source: CR Money Lab. Assumes a couple earning $100,000 a year at current state tax rates.

Prepaid option

Some state 529 programs offer prepaid plans, which allow your funds to grow at the same rate as in-state public university tuition. Essentially, you pay for future tuition costs with today's dollars. But locking in against college inflation with those plans hasn't proved to be the guarantee one might hope. Blame foundering state budgets. Since the finances of many states that sponsor prepaid plans are so precarious, some aren't keeping their promises. Georgia, Tennessee, and Illinois are the latest states to put the brakes on prepaid tuition plans, either by no longer offering them to new participants or by paying out somewhat less than a fully prepaid tuition.

One way to sidestep state fiscal woes is to choose the Private College 529 Plan, which is constructed specifically for use at the nation's private colleges. Historically, private colleges cost roughly twice as much as state universities, and their inflation rate is somewhat higher as well. This plan allows you to purchase tuition certificates good for credits at a participating school for up to 30 years. For more information, go to www.privatecollege529.com.

Do-it-yourself approaches

Recently some financial advisers have been promoting Roth IRAs as a smart way to save for higher education. Roth IRAs are retirement accounts funded with after-tax dollars that provide tax-free income once the owner reaches 59½ and has held the account for at least five years. But even if you're younger than 59½ you can withdraw your contributions (but not earnings) without a tax penalty after five years. So with proper planning, Roth IRA accounts can be used to accumulate funds for college as well as retirement.

You're eligible to fund a Roth IRA if your 2011 adjusted gross income is less than $107,000 for singles ($169,000 for couples). The main advantage to using one for college is flexibility. You choose how to invest the money instead of being locked into a 529 plan's investment options. And perhaps more important, if your child or grandchild decides not to go to college, you can continue to fund the account for your retirement. By contrast, if you don't use the money in a 529 plan for qualified educational expenses, you'll pay a 10 percent penalty on any gains the plan has earned over the years.

Putting money into a Coverdell educational savings account (ESA) is another do-it-yourself option. Like 529 plans, ESAs allow your money to grow free of federal tax if it's used to finance qualified educational expenses. The difference is that ESAs currently can be used for elementary and high-school education expenses in addition to college. (Congress will need to act to extend this coverage to K-12 education beyond 2011.)

One serious drawback is that ESAs don't allow you to sock away large amounts—the current maximum annual contribution is $2,000. But you can contribute to both a 529 and a Coverdell simultaneously. And you can decide how to invest the money. There are also income limitations: To get the tax break, your adjusted gross income can't exceed $110,000 for single tax filers ($220,000 for married couples).

College savings methods: How they compare

College savings option Income limits Contribution limits How the funds can be used Type of investments Tax benefits
529 plan None. $13,000 per year, per contributor. Maximum account size $250,000 to $300,000 for most. For qualified higher educational expenses as defined by the government. Individual mutual funds, age-based portfolios. No taxes on income or withdrawals used for qualified expenses. Contributions to in-state plans may be deductible on state tax return.
Roth IRA For 2011, under $107,000 for single filers; $169,000 for couples. $5,000 per year, $6,000 if over age 50. After 5 years, no penalty for qualified expenses for self, spouse, children, or grandchildren. Virtually unlimited. After 5 years, no federal or state taxes on earnings if owner is 59½ or older.
Coverdell ESA For 2011, under $110,000 for single filers; $220,000 for couples. In 2011, $2,000 per year, per child. For qualified expenses at elementary school, secondary school, or college. Stocks, bonds, mutual funds, bank deposits, CDs. No taxes on income or distributions for qualified expenses.
Prepaid plan None. No dollar limit. You can buy credits for 4 years of future tuition. For tuition and expenses at in-state or in-network college. Prepaid tuition credits. Price appreciation of prepaid credits not taxed.

This article appeared in Consumer Reports Money Adviser.

Posted: August 2011 — Consumer Reports Money Adviser issue: July 2011