2001 Lane Reports

Help For The High Cost Of Higher Education Section 529 Plans Part 2

Sunday, April 1, 2001

Last month, we discussed a valuable weapon in the fight against the rising costs of higher education, the qualified state tuition plan ("QSTP"). This month we discuss the various types of QSTPs and describe the Illinois plans as well as the plans of some other states.

Types of plans. There are generally two types of QSTPs, prepaid tuition plans and savings plans. Within these broad categories there are other design differences among the plans.

A prepaid tuition plan is one in which the owner purchases tuition in today's dollars to be used in the future. The state sponsor guarantees the student will be able to enroll for the amount of college time purchased, if the student meets the academic criteria. The guarantee is usually limited to the sponsor state's colleges and universities, however, equivalent credit may also be given for private or out of state institutions. For example the owner of the QSTP account might pay $10,000 today for 4 semesters at a state college or university to be used 15 years from now. The "College Illinois" plan discussed below is such a prepaid tuition program.

A savings plan is a plan whereby the owner contributes money to an account that is invested. When the beneficiary begins attending college, money is withdrawn to pay the tuition and other costs. The Illinois "Bright Start" program discussed below is a savings plan.

Prepaid Tuition Plans
Many states have created prepaid tuition programs. Illinois has such a program called "College Illinois!" whereby the contributor can prepay tuition today, to be used in the future. The College Illinois! plan is qualified under Section §529 and, in addition, distributions are exempt from Illinois income tax. Under College Illinois! a contributor has a window of opportunity annually to contract to prepay, up to nine semesters of tuition at an Illinois public college or university, or community college. The window opens in October and closes at the end of February. This window closed February 28, of this year and won't open again until Fall 2001. Prices are based on how long the state has to invest the money and may change each enrollment period. The price of a contract during the last enrollment window for a student currently in high school for four years tuition at a public university was $19,956 (for 8 semesters) or $22,432 (9 semesters). For a child still in grade school the cost was $18,956 (8 semesters) or $20,903 (9 semesters). Contracts for community colleges cost even less, and there is a combined plan combining attendance at community college followed by attendance at a public university. This contract guarantees the four years of tuition credit regardless of any rise in tuition in the meantime.

Parents can always supplement this program with other methods, should children be eligible for and decide to go to a private school or out-of-state school. The purchaser of the contract or the beneficiary must be a resident of Illinois. Participation in these plans is generally limited to residents of the state, but the benefits can be used at private schools or out-of-state schools. That is, the program will pay for the equivalent amount of tuition at the private or out-of-state school, but the student will have to make up the difference.

Savings Plans.
The Montana sponsored plan is designed so that the purchaser contributes enough to purchase an investment similar to a certificate of deposit that is indexed to the rate of tuition inflation (the annual average was 5.36% over the last 10 years). The certificates are sold in units representing the national average tuition cost and the contributor purchases as many units as necessary to pay for the projected cost of tuition at any particular college or university. The advantage of this plan is that the units can be used anywhere in the country. The certificates are indexed to the rate of tuition inflation to ensure the contributions will grow enough to pay for the average tuition in the country. That is, each full unit of a CollegeSure CD will pay upon maturity a sum of money at least equal to the average cost of one year's undergraduate tuition, general fees, room, and board at selected four-year independent colleges in the United States, as measured by the Independent College 500® Index, which is prepared annually by the College Savings Board. As the college inflation rate increases so will the interest paid on the CollegeSure CD.

The disadvantage to this and other savings plans is that a contributor may be able to get a better investment return independently. However, such return will have to consider the QSTP tax advantage of the distributions being taxed at the child's lower income tax bracket. For example, assume the parents could earn 10% on their money, over 5 years, but pay income tax at 31% or higher rate. This must be compared to a QSTP earning 6.2% over the same period, with the child paying tax on the income at a lower rate upon distribution. Also, the advantage of being able to prepay five years of annual exclusion gifts (as discussed in Part 1 last month) allows more money to begin earning income sooner. Table 1 illustrates that if two parents invested $20,000 annually for a child's benefit for the next 5 years, assuming a 10% return, the investment would be worth $122,705.71 by 2006 and the parents would have paid a total of $10,201.11 in Federal income tax.

TABLE 1 PARENTS' INVESTMENT AT 10%.

Year

Balance

Income at 10%

Tax

Rate

2001

$20,000.00

$2,000.00

$620

31%

2002

$41,380.00

$4,138.00

$1,282.78

31%

2003

$64,235.22

$6,423.52

$1,991.29

31%

2004

$88,667.45

$8,866.75

$2,748.69

31%

2005

$114,785.51

$11,478.55

$3,558.35

31%

2006

$122,705.71

     

Total

$122,705.71

 

$10,201.11

 


In contrast, Table 2 shows that by investing $100,000 in a QSTP in 2001 at an annual return of 5.5%, the plan would be worth $130,695.98 in 2006, $30,695.98 or 23.5% of which is income. Therefore, if $30,000 was distributed from the QSTP in 2006 to pay for a year's tuition, the child would have income of $7,050 (23.5% of $30,000). Assuming no other sources of income, after applying the standard deduction and personal exemption, the child would probably pay no federal income tax. Therefore, the QSTP demonstrates a savings of $18,191.38 ($10,201.11 in tax savings and $7,990.27 in additional growth).

TABLE 2 QSTP at 5.5%.

Year

Balance

Income at 5.5%

Tax

Rate

2001

$100,000

$5,500

$0.00

 

2002

$105,500

$5,802.50

$0.00

 

2003

$111,302.50

$6,121.63

$0.00

 

2004

$117,424.13

$6,458.32

$0.00

 

2005

$123,882.45

$6,813.53

$0.00

 

2006

$130,695.98

 

$0.00

 

Total

$130,695.98

$30,695.98

$0.00

0


Last year, the Illinois General Assembly passed, and Governor Ryan signed into law, legislation providing for another §529 college savings plan, the Bright Start plan, to supplement the College Illinois! program. Under the legislation, the Illinois Treasurer established a college savings pool to receive monies paid into the program by participants and then invest the monies. The Treasurer will also develop limits on the total amount of contributions that may be made on behalf of a single beneficiary based on an actuarial estimate of costs of tuition, fees, room, and board for five undergraduate years at the highest cost eligible educational institution. Such limits shall be coordinated with amounts contributed to a College Illinois! prepaid tuition contract. If distributions are used for other than qualified educational expenses, a 10% penalty applies.

The main difference between the College Illinois! prepaid tuition program and this new program is that College Illinois! only covers tuition. Further, Bright Start is simply an investment vehicle which does not guarantee how much the investment will be able to pay for, whereby College Illinois! guarantees that tuition at a state school will be paid for.

However, under Bright Start, one can choose from several investment options. Bright Start portfolios are professionally managed by the Smith Barney Asset Management division of Salomon Smith Barney Inc., by allocating the assets to Smith Barney Mutual Funds or to a bank deposit pool managed by Smith Barney Asset Management. Investors usually pay sales charges ("loads") of up to 5% to invest directly in Smith Barney Mutual Funds, but these fees do not apply to participants in Bright Start. The Program offers several investment options. If one opens an Account through a financial institution that has chosen to accept Deposits under the Program, one has two investment options: the Age-Based Option or the Fixed Income Option. If the Account is opened through a financial institution that has chosen not to accept Deposits, there are three different investment options available: the Age-Based Option, the Fixed Income Option, or the Equity Option.

The Age-Based Option for Accounts opened through financial institutions accepting Deposits and the Age-Based Option for Accounts opened through financial institutions not accepting Deposits are distinct investment options as a result of differing non-equity investment components. Likewise, the Fixed Income Option for Accounts opened through financial institutions accepting Deposits and the Fixed Income Option for Accounts opened through financial institutions not accepting Deposits are also distinct investment options as a result of differing investment components. For each Account opened, the owner chooses the investment option. The choice of investment options may be based on the age of the Beneficiary and the owner's tolerance for investment risk, among other factors. Under federal tax law, however, owners are not permitted to direct the actual investment of the Account assets. Consequently, they may not choose the particular investments in which a Portfolio invests nor may the investment be changed from one investment option to another for the same Account. If an owner wishes to choose a different investment option for additional contributions, it is necessary to open a new Account.

The Manager will invest the assets of each Portfolio in certain mutual funds managed by affiliates of the Manager (the "Smith Barney Funds"), in certain Deposits (in the case of an Account opened through a financial institution accepting Deposits under the Act) or in other investments as directed by the Illinois State Treasurer.

The Manager will allocate Account assets to a particular Portfolio based on the investment option specified in the application completed to open the Account.

  1. The Age-Based Option
    The goal of a Portfolio under the Age-Based Option is to seek an asset allocation strategy consistent with the ages of the Beneficiaries of those Account Owners who have invested in that Portfolio. There are six Age-Based Portfolios for Accounts opened through financial institutions accepting Deposits and six Age-Based Portfolios for Accounts opened through financial institutions not accepting Deposits. The portfolios are based on a range of ages of the Beneficiaries. The younger the beneficiary, the higher the degree of risk. The assets generally do not remain in the Age-Based Portfolio in which they are initially invested. Account assets are redeemed when the Beneficiary attains an age that is greater than the upper limit of the age range that corresponds to a particular Portfolio, including the Portfolio in which assets were invested initially. The Manager then reinvests these assets in the Portfolio that corresponds to the age of the Beneficiary. This continues until the Beneficiary is 18 years old, or the assets are withdrawn, whichever occurs first. These reinvestments occur on the first day of the month in which the Beneficiary has a birthday on which the Beneficiary attains an age that is greater than the upper limit of the age range that corresponds to a particular Portfolio.

    The asset allocation strategy for the Age-Based Option becomes increasingly conservative with each successive Portfolio. Portfolio Six in the Age-Based Option is intended to be a conservative Portfolio, and is primarily invested in fixed income and short-term investments, such as money market instruments.

  2. Fixed Income Option
    The goal of a Portfolio under the Fixed Income Option ( a "Fixed Income Portfolio") is to seek the relatively more stable returns of a fixed income investment in exchange for giving up the long-term return potential that the stock market offers.

  3. Equity Option
    The goal of the Portfolio under the Equity Option (the "Equity Option Portfolio") is to seek long-term capital appreciation through investments in equity mutual funds. The Equity Option is only appropriate for investors with longer time horizons, who are comfortable with an increased level of risk while seeking higher longer-term returns, or who use this investment option as part of an overall college savings strategy that includes less aggressive investments. If the Account is through a financial institution not accepting Deposits, the Equity Option is not available. If the Account is opened through a financial institution accepting Deposits, the Owner may not select the Equity Option because the Portfolio invests entirely in equities, and does not invest in Deposits. The Manager will invest the assets of the Equity Option Portfolio in the Smith Barney Funds, representing a combination of mutual funds investing primarily in United States equity and non-United States equity investments.

Other State Plans
Fidelity Investments manages the New Hampshire state tuition program, entitled the Unique College Investing Plan. Contributions to this plan are invested in a combination of Fidelity equity, bond, and money market funds depending upon the age of the child for whom the plan is established. The asset allocation becomes more and more conservative as the child becomes closer to college age. This is similar to the Aged-Based Option under the Illinois Bright Start plan.

Arizona's plan allows the owner to decide where the funds are to be invested among a number of choices. One program is managed by College Savings Bank, an experienced program manager that offers the CollegeSure CD, a FDIC insured variable rate certificate of deposit that matches the rate of college tuition increase, with a minimum 4% interest rate. This is the same as the Montana plan mentioned earlier. The other program is managed by Securities Management and Research, Inc., of Texas, a long-time mutual fund company. This program will offer an up-front choice to spread the contribution in any manner on a no-load basis between four mutual funds. Arizona's plan allows the owner to choose between aggressive and conservative investing.

The State of Rhode Island's §529 Plan is called the "CollegeBoundfund" (the "Fund") which is managed by Alliance Capital. There are five different investment options available, including age-based portfolio options (there are two: aggressive growth emphasis and growth emphasis); aggressive growth portfolio; growth portfolio; and balanced portfolio. All of the portfolios invest in a mixture of stock, bond and/or money market mutual funds managed by Alliance Capital and vary according to risk.

Our investment affiliate, Marc J. Lane & Company, is an authorized agent for this CollegeBoundfund.

There are many different QSTPs available. Currently, 48 of the 50 states offer a qualified state tuition program. Many of these have recently been created. Each plan has its own benefits and inherent disadvantages. Also, it is impossible to know what educational institution a young child will ultimately attend. However, residents of the State of Illinois, should consider College Illinois! because it guarantees tuition costs. Additionally, its supplement, Bright Start, offers a variety of investment strategies and can be used for non-tuition costs. It is worth repeating that Illinois residents participating in an Illinois QSTP will not be subject to Illinois income tax on distributions from the plan used for college. However, Illinois residents who participate in a similar program through another state, will be subject to Illinois income tax on income distributed from such plans.

There are many different methods for saving for college available, both in the State of Illinois and in other states. One approach that should be considered opening accounts with different plans to take advantage of the different benefits, and provide for diversification to hedge against the risk.


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The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.

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