Planning For 'Pomp'

College costs are rising fast, but tax-advantaged savings plans can help buffer the sticker shock.

by Mary Rowland

Photo collage: Comstock Images

It's 2027, and little Janie is strutting down the lawn at State U to the strains of "Pomp and Circumstance."

Well, maybe.

Janie and her friends, all born this year, are due to invade the freshmen dorms in 2023 and will likely face college costs approaching $100,000 for a four-year education at a public institution and far more at private colleges. With college costs outpacing inflation most years, anyone with a little Janie at home can't hear it too many times: Think seriously about starting (or beefing up) a college savings fund.

Fortunately, several tax-advantaged investments have been introduced over the past decade to help families cope with rising costs. The best of them is probably the so-called "529" plan, named for Section 529 of the Internal Revenue Code. The 529 plan is a tax-advantaged college savings account available in every state. Money you put into the plan grows tax-deferred, and withdrawals to pay for college expenses come out free of federal tax (at least until 2010—after that, distributions will be taxed at the student's tax rate unless Congress extends the benefit). The tax savings, combined with the power of compounding interest earned on the investments, give your college fund a better chance at keeping up with rising tuition and fees. (Although, as always, nothing is guaranteed in investing!)

The 529 plans have several advantages over older college savings vehicles. There is no income limit on contributors to a 529 account. The amount you can put in is substantial—exceeding $200,000 in some states. You remain in control of the account, and there are no age limits. Your child could use it for graduate school—or you could even withdraw the money to fund continuing education for yourself. The money need not be spent by any particular deadline, and you need not send your child to any particular school.

Unlike the Uniform Gift to Minors Accounts (UGMA) and the Uniform Transfer to Minors Accounts (UTMA), where your child gains control of the money at the age of majority, 529 plans allow the donor to decide when money will be taken out and for what purpose. In most cases, you could even take the money back or transfer it to another beneficiary, although you must pay tax and a 10-percent penalty if you do not use the money for education.

Although you need not invest in your own state's plan, there may be an advantage to doing so if you live in a high-tax state that provides you with a tax break.

With all these benefits, what's the downside? Chief among them is widely varying fees. Some of the vendors chosen by states provide very low-cost plans. Others charge 529 plan participants higher fees, which erode your return on investment—and may leave Janie and her classmates a few books or courses shy.

One other college savings option deserves mention. A Coverdell Education Savings Account, with a non-deductible contribution limit of $2,000 a year, also helps you save for college, with earnings growing tax free. Money goes to the child beneficiary whether or not he or she uses it for college, and it must be used by the time the child is 30. Money is free from federal tax when withdrawn for education. To receive a full deduction, the taxpayer must have modified gross income of no more than $190,000 for a couple or $95,000 for a single.

One pitfall: record keeping for the Coverdell can be substantial. The IRS estimates a time of more than six hours to read instructions and figure out filing. There is also a penalty for "double dipping" or using Coverdell withdrawals at the same time a student claims a Hope or Lifetime Learning Credit. Finally, if your account remains small, fees will likely to eat up much of the proceeds.

Our best advice: Take the time to shop for a 529 plan. An excellent source for comparing 529 plans is the Web site www.savingforcollege.com. As you compare plans, make sure you understand the fees and investigate the performance of the investment option you choose. An automatic monthly withdrawal from a paycheck or savings account can make this a nearly painless way to conquer rising college costs.

Bye Bye Clunker

Photo: Image 100

This year, you might hear fewer of those radio jingles asking you to donate your old clunker to charity in exchange for a tax deduction. That's because, as of January 1, 2005, the IRS has imposed strict new limits on the amount you may deduct when you donate your used car.

Over the past few years, increasing numbers of charities raised money through car donations, pitching the ease with which you can get rid of your aging ride—and the tax deduction you'll gain. Until December 31, 2004, you could deduct the fair market value of the car. If the value was more than $5,000, you needed an appraisal. If the value was $5,000 or less, the rules required only an estimate of value, based on a chat with a used-car dealer or a Web site like Kelley Blue Book.

But beginning in January 2005, the taxpayer is limited to deducting the price that the charity receives when it sells your old car. That might not be much. Many charities use middlemen to pick up, spruce up, and auction off the cars, looking for a quick turnaround rather than top dollar.

Donating your car to a worthy charity is fine—as long as you don't harbor unrealistic ideas about the tax break. Stay informed and you won't be taken for a ride at tax time.

Don't Play With Fire

Insuring your crib makes sense—even if you rent.

A friend returned to her apartment one recent afternoon to find the hallway filled with smoke. One of her neighbor's apartments had been practically gutted by a fire. Her own apartment seemed intact. Sort of. A fine soot covered books, pictures, bed, couch, and stove. In short, everything.

My friend's next-door neighbor called her renter's insurance company. The insurer sent workers right over to clean and scrub the apartment, to send sweaters and drapes out to the dry cleaners, shampoo carpets, and arrange for the insured tenant to stay in a hotel until the apartment was clean and ready. My friend, who had no renter's insurance, spent the next three months at her mother-in-law's house with breaks on the weekends to clean up her damaged apartment.

The moral? Anyone who rents an apartment or house needs renter's insurance. Even more important than covering the contents, the insurance provides liability coverage. That means if someone trips on your rug and sues you, the insurer will cover damages up to the limit on your policy.

When shopping for a policy, look for one that would cover the contents of your apartment and provide at least $100,000 in liability coverage. Such a policy is relatively inexpensive, perhaps around $300 a year.

One point to consider is whether you should choose coverage for replacement value or appraised value of your possessions. Replacement value costs more—if an item were destroyed, the insurer would pay to replace it. Appraised value coverage means you'll be reimbursed only for the appraised value of the damaged item. So the insurance check for your battered old couch won't pay for a new one.

Climbing Out of Debt

When you buy a car or take out a mortgage on a home, you have a specified time to repay the debt, perhaps five years for a car and 30 years for a mortgage. But credit card debt has no term limit, and that presents a real challenge for those of us who charge beyond our means. Simply put: If you pay the minimum amount each month, you will be in debt for eternity.

The only way to get out of credit card debt is to pay off more than the monthly minimums, says Marc Eisenson, the author of several books including Invest in Yourself (Wiley 1998). Some of his tips for climbing out of credit card debt:

Declare a one-month freeze on using your credit card for discretionary purchases. Don't open your wallet unless you have to pay the plumber, the car repair shop, or someone else essential to your daily living.

Take a look at the terms on each of your credit cards. Pick the two with the lowest interest rate, no annual fee, and the longest grace period (the time that you are allowed to make a payment before interest is charged). Put the others into a drawer (or, better yet, cut them up).

Put one of the low-interest cards in your wallet to be used for emergencies only.

Figure out how much you can afford to pay on credit card debt every month. Stretch a bit. Let's say it's $300. Pick the card with the highest interest rate. Pay the minimum payment on the others and put the rest of your credit card budget on the highest rate card. When you pay off that card, close the account and focus on the next highest rate card.

When you've paid off the cards and closed the accounts, continue to use your two remaining cards sparingly. Pay off the balances each month.