Readers’ tips: Using Pa.’s ‘unique’ college-savings tax breaks and guarantee -- and why home-equity loans are now less helpful to students (Update)

(New material and an important change in tax law marked “3/20” below) Readers responded eagerly to last Sunday’s column on state tax-free college savings plans (IRS Section 529), and gave useful tips.

Pennsylvania’s unusually generous college savings tax break -- up to $15,000 per parent, for contributions to any state’s 529 investment program -- shielded $814 million in Pennsylvanians’ contributions to college savings plans last year.

That includes $277 million in tax savings that went to users of “out of state 529 plans," says Mike Connolly, spokesman for state Treasurer Joe Torsella. Torsella thinks we ought to end the out-of-state break and direct more investments to the Pennsylvania plans, “which would allow us to lower fees.”

Pennsylvania has two 529 options. Last Sunday, “you give real short shrift to Pennsylvania’s unique pre-paid program, the Guaranteed Savings Program,” complained reader Lee Bender.

It’s not exactly a popular program. Still, Pennsylvania invested about $1.9 billion as of Dec. 31 for college savers under the GSP, which sells tuition credits whose value rises as colleges jack up their prices. Pennsylvanians saved more -- $2.7 billion -- in the state’s regular 529 college savings account, whose value, like a 401(k) plan, rises and falls with stocks and bonds in plan choices, including Vanguard investment funds. Such plans in all 50 states now hold more than $30 billion in parent savings.

Bender and fellow reader Frank Farina say GSP was a big help in paying for their kids’ colleges: “I just put my two boys through college using the GSP plan very successfully,” Bender told me. GSP saved his family from annual college tuition increases as well as from “the vagaries of the market," which he suffered earlier in the 2001 dot.com stock-market bust. His earlier tax-protected savings accounts that lacked a guarantee "took years to recover” from that downturn

Bender also praises the “extreme ease of use of the GSP program to pay tuition to Penn State." Just “a few clicks” and the money went right to Happy Valley. Compared with Pennsylvania’s standard 529 plan, “the Guaranteed Savings Program is the far superior plan," he concludes. "Otherwise you are playing the market, and I do not want to play with my kids’ college funds.”

Farina also bought into GSP after the stock market plunged in 2001, when he had three kids facing college. He suggests that anyone saving for college today look into doing the same “in light of where the stock market might be heading after the extended bull market ends with the inevitable crash."

Farina appreciated that GSP offered Penn State tuition as a benchmark guarantee. He figured that Penn State would keep boosting its price -- making early GSP savings a bargain -- given the state’s declining support for college funding, as well as the school’s sturdy academic reputation. Add the program’s lack of broker fees and protection from market drops, and Farina was sold.

His kids didn’t even end up going to Penn State, but the benchmark guarantee helped him fund their studies at Cornell, the University of Vermont, and James Madison -- three undergraduate degrees plus two MBAs and a law school program.

Farina shared what he set aside for his youngest child -- $65,900, in 2001 to 2003 -- and what he got back -- $79,600 for undergraduate tuition (2005 to 2008), plus $27,700 for graduate school (2017 to 2018) -- add that together and Farina calculates his total return at more than 60 percent over that period.

He might have grossed more than that by investing the money in the S&P 500 -- but this was “tax free and risk free. And I got a decent return, and was able to sleep at night knowing their accounts were not wiped out by the vagaries of the stock market,” Farina concluded. He has since retired to North Carolina.

Reader Bernie McGorrey says he didn’t tie up his money in savings programs: “We went a different route to finance our three boys’ education.” Here is McGorrey’s five-step program:

1. “Pay off the house early. (I worked two and three jobs.)” That frees you to help the kids, as needed.

2. "Encourage them to go to state colleges.” He got partway there. His kids picked state-run Kutztown University, private Moravian College (with a half-scholarship), and a trade school.

3. “Expect children to work over the summer, to have some ‘skin in the game.’”

4. Use a home equity loan, instead of federal student loans: “Home equity rates were lower than for student loans.” (3/20: But the Trump tax reform has cut off the tax benefits of using this option for today’s savers, see David Zalles’ comments below.)

5. Rely on families, not federal student loans, as lenders of last resort: "Kids pay the parents back with a zero-interest loan over four to eight years.”

Of course, there was a “bump in the road,” McGorrey adds, when then-Gov. Tom Corbett cut funding at state colleges in 2010, raising tuition at Kutztown. The family tightened their belts and moved forward.

McGorrey’s full program can work -- if you own a house and can scare up some cash to lend your kids. (Our own program for the six college kids in our house was similar, though our mortgage payments were low enough that I saw no point in paying it off early, and most of our kids did tap federal direct student loans. And besides state-backed schools, we also encouraged them to apply to elite schools, which have a lot of money for academic scholarships.)

Reader Saul Katz sees another advantage to using the state savings programs: Assets in a Pennsylvania 529 plan (but not out-of-state plans) are exempt from the state’s inheritance tax.

John Burnes asks: “If one has an existing 529, can those assets be readily moved to a more attractive 529?” (Yes, with some conditions, says Connolly. If the two plans are for one person, money can be shifted once a year. Or more often, if the accounts are for different people in the same family.)

Will the state treasurer get his wish and persuade the state to trim the tax break for out-of state plans? I expect that will be resisted, in Harrisburg lobbying, because it won’t be popular among financial advisers who sell out-of-state plans, or with money managers such as Vanguard and American whose funds are sold to Pennsylvanians by 529 plans in other states. Colleges may not like it, either, because most of them face a declining applicant pool and welcome all the tax breaks their student families can get.

ADDED 3/20: Writes Tony Ghizori: “My youngest graduated from college a few years ago. We didn’t do the 529 plan. We got a home equity line of credit instead of loan. With a loan you get all the money at once, but you also pay interest on all the money even though you are only using a portion if it to pay each years tuition. With a line of credit, you still have the same amount of money available to you, but you only pay interest on what you have used so far.” (But tax benefits on home-equity loans are no longer available for non-home-related uses -- see Zalles below.)

"My daughter also got student loans each year. I felt this was an important lesson for her to have, as (reader McGorrey, above) said, some skin in the game, but it also would leave her with some debt to payoff when she graduated, a good way to begin building a credit score for herself because as you know kids in college typically have no to minimal credit history.

"This worked well for us along with the internship she was able to get her sophomore year which helped her put away some money but more importantly gave her some insight into how the ‘real world’ actually works.

"Despite all of the above I feel the most important thing we did happened after college. By then her internship had turned into a full time position...

"We sat down and went over all of the 8 student loans she had. Four were subsidized loans and the other 4 were unsubsidized.

We prioritized these loans, from worst to best, based on principal balance, interest rate and length the loan had been in existence,.. (With her new wages) she would attack her worst loan first, throwing at it as much as she could above the standard minimum monthly payment... She slowly knocked off each loan. one at a time, while at the same time establishing a credit history. It took her three years to completely wipe them all out, and at the end she had a good enough credit history, she was able to purchase a car on her own without us having to cosign."

Philadelphia tax accountant David Zalles adds a few sobering tax points: "In 2017 and prior years, the home equity interest was deductible regardless of the use of the proceeds. But, starting Jan. 1, 2018, they are deductible only for house purchase and improvements.

“Other state 529s are exempt from PA Inheritance Taxes only if death is (a year after contributions.)” Zalles cites the case of an 85-year-old childless widow who avoided the problem by splitting $1.8 million into Pennsylvania 529 plans, which, he says, were instantly tax exempt -- saving the prospect of $200,000 in Pennsylvania inheritance taxes when she went to her reward earlier than expected."