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State trust accounts might not be wisest way to fund college eduation

By John F. Wasik
Bloomberg News

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Before you pick the right one for your family, you'll have to examine several traditional college plans and note the pluses and minuses of each.

Mike Prisby is an Indiana banker with a baby on the way and has researched college financing. He's leery of the state-sponsored 529 plans and Uniform Gift to Minors Act, or UGMA accounts, which are trusts set up for children in their names and are funded by parents or grandparents.

Allowing you to invest up to $250,000, 529 plans feature mutual funds that are held in parents' or grandparents' names. The assets then can be withdrawn tax free for college expenses.

Like most sticker-shocked parents who have seen how much college costs have risen in recent years, Prisby estimates that Notre Dame University, for example, will cost $250,000 when his child is of college age.

He's considering several funding plans that combine high, after-tax returns with low investment expenses. For now, though, Prisby's staying away from 529s and UGMA accounts, which were considered traditional college-funding programs.

The trust account behind the UGMA can be a Pandora's box. At the age of majority — 18 in most states — the parent loses control of the money in these accounts. That means the teenagers for whom the funds are allocated can legally spend the money however they please.

In addition, any assets in the child's name will reduce their chances of obtaining financial aid. According to aid guidelines, children's incomes are assessed up to 50 percent and assets up to 35 percent in the federal formula.

Parental income counts for 47 percent in the formula, while assets are assessed at only 5.65 percent.

This means that money sitting in a child's trust and in their name is seven times more likely to reduce the chance of qualifying for financial aid.

"I've seen it happen with my banking clients," Prisby said. "Mom, dad and the grandparents put money in the kid's name, sometimes up to $40,000. And then the kid can't get aid until after two years in college. This is the biggest mistake I see."

Where do you put college money if not in a trust account?

"If it's possible your child will qualify for aid, put it into your individual retirement account (IRA)," says Vicki Hampton, a certified financial planner in Lubbock, Texas. "Retirement assets won't count as parents' or children's assets in the financial-aid formula."

You can also sock money away in a low-cost Roth IRA or any other IRA — if you qualify — and withdraw it without penalty if it's used for college expenses.

Comparing plans

If you don't put college savings in a child's name, then 529 plans are natural choices because their assets are most likely in the parents' name. Despite the initial 529 plan advantages, though, expenses become a bugaboo.

A recent study by the TIAA-CREF Institute, a financial-research organization, compared 529 plans with Coverdell college-savings accounts. A Coverdell allows you to invest $2,000 per year per child in any mutual fund for any education expenses.

A $2,000 annual investment earning 6 percent annual return over 18 years in this study would produce $64,304 in the Coverdell versus $61,248 for the 529 plan.

Expenses were the key. The 529 plan had annual expenses of 0.65 percent annually, compared with a stock-index fund within the Coverdell of 0.18 percent per year. Since more than 60 percent of 529 plans are sold through brokers, you easily pay over 1 percent in fees and commissions.

"Fees can destroy returns," Prisby said. "So why is a 529 plan better than an index fund?" He advocates low-cost stock index funds, which passively hold from 500 to 6,000 stocks at an annual rate of 0.20 percent per year versus 0.64 percent for the average 529 plan.

Specifically targeted colleges

Another alternative that merits caution is investing in a prepaid 529 tuition plan that earmarks dollars for specific state and private colleges.

A new program called the Independent 529 plan, sponsored by the Tuition Plan Consortium, a group of private colleges and the investment firm TIAA-CREF, for example, sets aside money for 284 private colleges in 42 states, including Ivy League schools such as Princeton University.

The prepaid plans essentially hedge against tuition inflation, which is running at more than 6 percent per year overall. A $10,000 investment in one of these plans will guarantee that those funds will buy $10,000 in tuition at matriculation. What you are getting is discounted tuition in the future plus a nominal 2 percent annual return on the funds within the plan.

Alternative funding

While prepaid plans may be ideal for families locked into a college choice long before a child reaches 18, they lower the chances for aid since the funds are viewed as children's assets.

"Prepaid tuition plans are currently treated as a student resource, which means they reduce financial aid dollar for dollar," says Mark Kantrowitz, publisher of finaid.com, a financial-aid Web site and search engine.

If you're still focusing on obtaining financial aid, here's an unlikely source for college savings: Home equity and retirement-plan assets aren't counted in the federal-aid matrix.

As last-resort sources for college, it makes sense to pay down your mortgage by adding money to principal payments every month and fully funding your 401(k) retirement plans.

When the time comes, you can borrow from your home in the form of a home-equity loan at relatively low rates and deduct the interest. You can also borrow from your 401(k) plan.

Of course, for most, home equity and 401(k)s should be considered only for those who have no other savings set aside. If you default on the home loan, you can lose your home.

There's also the risk with an adjustable-rate loan of having your monthly payments climb if mortgage rates rise. Loans from 401(k) plans must be repaid if you leave an employer or you face a full income-tax bill on the loan amount.

"I would stick extra money in your house," Prisby said.

At the very least, if your children decide not to go to college, your mortgage debt is lower. That kind of addition always works in your favor.

Copyright © 2003 The Seattle Times Company