Unborn Children And The College Tax Dodge

William Baldwin, Forbes Staff Education Tax Deductions Advice to young adults: It’s never too early to start saving for your kids’ college costs. Start, if you can, ten years before they are born. Compounding works wonders over long stretches of time. You can set up a Section 529 college savings account anytime. Create one naming yourself as beneficiary. Years later you can change the beneficiary to your first-born. You can make another change, splitting the account in two, when the second baby arrives. A childless adult who funds a college account is ostensibly saving for him- or herself (you might, after all, start grad school at age 35). Tax-free earnings start accumulating right away. You can change your mind later about whose degree will be funded. Why would you start saving so far in advance of a tuition bill? Because college is ridiculously expensive. Without a discount, an Ivy League degree is going to cost today’s freshman just about a quarter of a million dollars. If you start putting aside $10,000 a year when the baby arrives, you’ll have contributed only $180,000 when the kid matriculates. There will be earnings on the account, presumably, but a good guess is that they will just keep up with inflation in college costs. Eighteen years at $10,000 won’t pay for Dartmouth. You have three kids? You’d need $750,000 today, and God knows how much if the oldest starts attending two decades from now. What if you set up a college account and then don’t have children? Or they don’t go to college? You can liquidate the account and use it for other purposes. If the money isn’t spent on higher education, you’ll owe state and federal income tax on the earnings plus a 10% federal surtax on those earnings. The pain of the surtax is partly offset by the value of the tax deferral. The net effect is that the 529 ploy may be a wise gamble if there is even a 50-50 chance that you or someone in your family will eventually use the money on education. But it wouldn’t make sense to set up a 529 if there’s no chance the account will be used for the proper purpose. Withdrawals from a 529 plan are free of income tax so long as the proceeds are used on higher education (tuition, room and board). Each state sponsors its own plan, but its citizens are free to invest in another state’s plan, a good strategy if the home-state plan has stiff fees. Two-thirds of the states offer a deduction or credit against their own income tax for contributions to the home-state plan. The person who funds the account is the “owner” and names the beneficiary. The owner can change the beneficiary from himself to a relative or from one family member to another without penalty. (Changing the ownership is another matter; it’s difficult to do in some states but rarely necessary.) Because of these rules, it is often a good idea for a saver to set up an account before it’s clear who will be using it. “I advocate this for grandparents who have a lot of grandchildren but don’t want to go through the paperwork and Social Security numbers right away,” says Joseph Hurley, who runs Savingsforcollege.com, a repository of info on 529s. “Just open the account in your own name and figure it all out later.” Newlyweds should consider funding a 529, even if they are planning to hold off on starting a family. For that matter, you could open an account while you’re just dating. Before plunging in, though, answer three questions: Are you saving the max in your 401(k)? That’s $17,500 a year for younger employees. Two reasons to fund retirement before college: The retirement account is a more powerful tax tool than the 529, and retirement assets won’t count against you when your child applies for financial aid. Do you have spare cash? Do the 529 only after setting aside six months of living expenses plus enough for a house down payment. Does your home-state plan have low fees and/or a valuable tax deduction? If it doesn’t, sign up for the New York plan, which offers index funds at a cost of 17 basis points ($17 per year per $10,000 invested). The quickest way to see where your state stands is to go to Hurley’s site and use the “compare 529 plans” function. I’ve run some calculations to see where a couple living in New York State would come out 20 years after plopping $10,000 into the New York plan. That’s the highest contribution that a couple can deduct, per year, against their state and city income. My assumptions: –The Vanguard stock index fund offered by the plan will return 7% a year before expenses, the bond index fund 2.5%. –The 529 deduction saves the couple $500 on state taxes, net of any effect from having a lower state tax deduction on their federal return. In effect, they are investing only $9,500. If the account isn’t used for college, the deduction is recaptured at a cost of $500. –The savers would otherwise have put the $9,500 into index funds outside the plan at a cost of 5 basis points for stocks or 10 basis points for bonds. Tickers for the Vanguard ETFs in question: VTI and BND. The savers reinvest dividends. –They are in a 40% combined state and federal tax bracket for ordinary income and 20% for dividends and long-term capital gains. Inside the plan, the bond account would grow to $15,850. Outside, it would grow only to $12,650. If they set up the plan but don’t use the account for college they’d have $12,430 after taxes and the penalty. In other words there is much more to be gained from a 529 used for college than to be lost on a 529 used improperly. So if there’s a 50-50 chance of having college-bound children, the 529 is a good move. With stocks you get a different result, the main reason being that a 529 account, if it ends up being taxed, converts capital gains and dividends into ordinary income. The stocks grow to $37,490 inside the plan and $30,550 outside. Put inside the plan but used in an uncollegiate fashion, the stock investment turns into $23,240. Here there’s more to be lost than to be gained. With children a toss-up, equity investors should steer clear of the 529.