What is the best college savings plan?

One of the more significant changes under the Tax Relief Act of 2001 that affects saving for college is the revamping of the education individual retirement account.

But as with many tax changes, it raises a difficult financial question. In this case, is it better to save for college by using the revamped education IRA or a Section 529 college savings plan?

Before the new act passed, there was little contest between the two. You could only save $500 a year in an education IRA — often not enough to buy a year's worth of college textbooks. But under certain circumstances, parents could invest as much as $100,000 in a single year in some 529 plans. (A 529 plan is a tax-advantaged program established under Section 529 of the Internal Revenue Code.)

However, the new tax rules strengthen the education IRA (now called the education savings account, or ESA). Here are some considerations when weighing which vehicle might work best for you.

Beginning in 2002, the annual contribution per student has been raised to $2,000 a year, and contributions can be made as late as April 15 following the tax year. For families expecting to send their children to an expensive college, $2,000 a year won't be enough, even with tax-free earnings, so the 529 savings plan likely will be the better alternative. However, for families expecting to fund a more modest education, or who simply don't have the income to invest more than $2,000 a year, the ESA may work well for them.

One major advantage of the education savings account is that you control the investment decisions — as much as you can in any IRA. With a 529 plan, investments are determined by the plan's managers and may be more aggressive or conservative than meets your needs. However, the new law will allow participants to change 529 plans once a year without changing beneficiaries, and the Internal Revenue Service will even allow investors to change accounts within a plan once a year. This will make it easier to switch to a plan with more suitable investments.

Another major — and controversial — change to ESAs is that you can now apply the account's earnings tax-free to pay for qualified expenses at public and private elementary and secondary schools. This includes tuition, tutoring, room and board, and computer equipment.

The law also raised the adjusted gross income phase-out range for joint filers who contribute to ESAs. You can contribute the maximum $2,000 a year as long as your adjusted gross income doesn't exceed $190,000. That amount begins to phase out above $190,000, and married taxpayers who earn $220,000 or more can't contribute at all. Although this is an improvement, 529 plans still have no income restrictions, which make them more attractive to high-income taxpayers.

According to Dennis Filangeri, a certified financial planner based in San Diego, you'll now be able to contribute to both education savings accounts and 529 plans in the same year without triggering an excise tax on "excess" contributions. This will allow you to choose different plans for different children, or simply sock away more for a single child. You'll also be able to make tax-free withdrawals from an ESA in the same year you claim the Hope Scholarship or Lifetime Learning tax credits, as long as the withdrawals are not used to cover the same expenses for which you are claiming the credits.

But drawbacks remain for education savings accounts when stacked up against 529 plans. One of the biggest is that ESAs are custodial accounts. That is, the assets in the account are treated as belonging to the beneficiary, even though the parent or other "responsible person" controls the account. Although there is some movement to change this, colleges traditionally have counted the assets in a child's name more heavily than assets in a parent's name when calculating financial aid. Under 529 plans, parents own the assets, which helps from a financial aid standpoint and gives parents the flexibility to keep contributions and earnings (subject to tax and penalties) should the child not go to college.

Earnings grow tax-free in both education savings accounts and 529 plans. However, roughly 20 states offer a state tax deduction for some or all of the contributions for a 529 plan, but they don't offer such a deduction for ESA contributions. There is no federal contribution deduction for either type of plan.

Zall is a retired federal employee who since 1987 has written the Bureaucratus column for Federal Computer Week. He can be reached at miltzall@qis.net.

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