The Pros and Cons of 529 Plans

According to the College Board, the cost of higher education has been steadily increasing by a rate of 6% annually.  Have you considered what the college cost for you child or children might be?  There are various college costing calculators online, I like using both the US News Net Price calculator as well as the savingforcollege.com online college cost calculator.  Both will give you a quick general sense of what you can expect to shell out for your child's college education.  Let's do a quick analysis using my oldest son as an example.   

The calculator asks for my son's age, 2.  It asks for the current price of tuition at my selected school, 39,122 (I'm using the current out of state tuition cost from my alma mater, the University of Michigan - Ann Arbor).  You can use the following link to look up a specific school and find a breakdown of relevant tuition costs.  It also asks how long my child will be attending, 4 years, and on a full time basis.  

There are some other inputs this particular calculator asks, and for this example, I'm going to assume that I wish to cover 100% of the total college cost by the time my son finishes school, that I have $0 currently saved for this goal, that college costs will continue to rise at 6% annually, and that I am able to earn a 6% after-tax per year.

The result: my oldest son's college education will cost $434,765.  Quite the expense!

So what is a 529 and does it make sense for me?

A 529 plan is a tax advantaged investment vehicle in the United States, operated by a state or educational institution, and designed to encourage and help families set aside funds for future college costs.  It is named after Section 529 of the Internal Revenue Code, which created these types of savings plans in 1996.  There are two types of 529 plans, prepaid and savings plan. The prepaid plans allow you to pay tuition at the current price and attend in the future. The saving plans invest in stock and bond funds.  The big flaw with the pre-paid plan is that one never truly knows what school their child will attend.  By contrast, the savings plan is far more flexible.

What are the key 529 benefits?

1. State tax benefit:  Many states offer tax deductions for 529 contributions, you can see what your state offers here.  In New York, where I reside, contributions to a New York 529 plan of up to $5,000 per year by an individual, and up to $10,000 per year by a married couple filing jointly, are deductible in computing New York taxable income. 
2. Federal tax benefit: The actual distribution of funds to pay for college costs are tax-free.  This assumes that the government will keep it this way.
3. Transferability: If your child declines to go to college, the fund can be transferred to other qualified members in your family, even to the parents.
4. Estate planning considerations:  Grandparents looking to contribute to their grandchildren's education can contribute up to $14,000 ($28,000 for married couples) per child, tax free, every year.  Additionally, a grandparent can contribute a lump sum in one year and elect to treat the contributions as if they were made ratably over five years instead of all in one year.  This strategy enables the contributed money to benefit from additional years of compounding.
5. Financial aid calculation benefits:  A 529 saving accounts held in the child's name is treated as the parent’s asset, similar to the way a custodial account is treated.  Since only 5.6 percent (or less) of the 529 is used in the expected contribution calculation used in financial aid decisions, this is particularly good news for families seeking financial aid.
6. Automatic investment options: This is actually a pro and a con.  You can set up automatic contributions and investments so you don’t have to worry about them annually, but they are often paired with sub-par age-based funds.  This feature provides added convenience, but at the cost of higher fees and inferior performance. 

What are the problems with 529 plans?

1. Limits on reallocations: You are only allowed to reallocate funds once per year in a 529 plan.  While this may not be a huge problem for individuals with long-term horizons, it does present limitations in active management of these funds.
2. Limited investment options:  Depending on your state, you may be limited to only a few investment choices in the particular 529 plan, including age-based or target-date funds.
3. Restrictions and penalties for improper withdrawal:  The earning portion of money withdrawn from the 529 that is not spent on college expenses will be taxed at ordinary  income rates, an additional 10% federal tax penalty will be assessed, and there may be the possible recapture of any state tax deduction at the time of withdrawal. 
4. Suitability: Depending on your financial circumstance, you and your advisor may have other and often more sophisticated planning tactics in mind.  A 529 plan is not a one-size fits all answer to college savings.  

Be sure to speak with your financial advisor about whether a 529 would be suitable for you.  In general, I recommend that individuals max out their retirement contributions first before contributing money to a 529 plan.  I also suggest that these plans tend to get the "most bang for the buck," when large initial deposits are made to the account (ex: a grandparent makes a lump sum deposit as party of their estate planning).  This front-loaded outlay enables the 529 account to benefit from maximum compounded interest, as discussed above.

I hope this information is helpful to you.  Please contact me with any questions or to discuss how a 529 plan might fit into your own financial plan.

Best regards,

Jason M. Gilbert, CPA/PFS, CFF
T: 516-665-1940
E: [email protected]