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Market rout, new tax hurt college savings

Updated: May 3, 2013 12:14PM



Originally published: August 1, 2002

While everyone’s been agonizing over stock market losses in 401(k) plans, the bear market has also taken its toll on college investment accounts. Even worse, just as stocks have gone down, tuition has been rising.

And, adding insult to injury, a new state law taxes money that is withdrawn from out-of-state plans.

Time to rethink your college-savings plan

In recent years, Section 529 College Savings Plans have become the most popular way to build a college fund because of the promise of tax-free withdrawals of all gains when the money is used to pay for tuition, room and board and other college expenses. Total assets in all state 529 plans is now an estimated $20 billion.

These plans--like Illinois’ Bright Start--don’t make any promises. The end result depends on how well your investments perform. Of course, most 529 plan investments are specifically designed to mitigate investment risk: more risk for younger children, but moving assets into less-risky options, including short-term bond funds, as college approaches.

There’s another more conservative savings approach: pre-paid tuition plans, like CollegeIllinois. They guarantee full tuition payment, but only at in-state schools. Section 529 plans are more flexibile since withdrawals can be used at any school in any state. And, of course, there’s the attraction of tax-free withdrawals.

But what if there aren’t any gains to withdraw? What if that hard-earned money turns into losses? How will you find the money to pay for college? Should you continue investing in plans like Illinois Bright Start? And on a more practical basis, can you deduct those losses?

Experts like Joe Hurley of www.SavingforCollege.com say it’s a gray area. Since the IRS hasn’t been faced with this situation, no ruling exists on the treatment of withdrawals that reflect losing investments.

Jay Stillman, an analyst at SavingforCollege.com, says that after reviewing the performance records of state plans for the first six months of this year, the age-based plans for the youngest investors have posted losses in the range of 10 to 15 percent. Some programs have losses of only 5 percent, while others have lost as much as 22 percent in this category.

Illinois Bright Start for the youngest age-based group, the most aggressive investment, is down 10 percent. The funds designed for older children are down proportionately less.

That was an expensive lesson, but don’t give up. The idea is to keep investing.

There are two choices here: which state plan, and which investment. You can change your answer every year.

When considering investment choices, Illinois’ Bright Start plan gives you some very conservative choices, along with the age-based or mutual fund options. For example, the plan has a Fixed Income Portfolio funded with bank CDs. It has a year-to-date return of 2.26 percent--nothing to snicker at these days.

The second question is far more taxing: Which state plan should you use?

Illinois kills a tax break for college savers

A new state law eliminates the state income tax break on 529 plan withdrawals except for participants in the Illinois Bright Start plan. Yes, withdrawals from other popular state plans are free from federal taxes, but Illinois is the first state to eliminate that benefit on state income taxes.

The goal is to drive money into the Illinois plan--which reaps a small (.05 percent) fee on all assets in the plan, now over $320 million. With big money at stake for the state treasury, Illinois hopes its citizens’ college savings will stay in Bright Start instead of going elsewhere. And with BrightStart’s annual fees at just about 1 percent annually, that might be a good idea. But financial planners who reap as much as 4.25 percent commission on selling out-of-state plans are upset.

The debate over taxes and fees is a reminder that when the stock market isn’t posting double-digit gains, these issues are important ones. But the most important point is to keep saving for college, and not let a bear market deter you. After all, a college education is one of the best investments you can make. And that’s The Savage Truth.

Terry Savage is a registered investment adviser and is on the board of directors of McDonald’s Corp. and Pennzoil-Quaker State Co. Send questions via e-mail to savage@suntimes.com.



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