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Over the last 17 years, I have been saving a modest amount each month in a 529 plan. I have been doing the same for my daughter for the past 14 years. Given the market performance and our steady contributions over time, these modest monthly contributions have grown to be a sizable amount. While I am thrilled that we should have most of our college cost covered, I’ve often wondered if the 529 plan was the best bet in saving for college.
I have done much thinking on this topic, and I’m sure many others have as well. I am creating this forum to share some analysis/thinking on this subject and to hear what others have to say.
I have one final semester of payments for tuition using the 529 plan that we funded for both kids, and it will use up all that we put aside. I think it was a fantastic thing to have, not just for the tax free growth, but more to simply have it there to pay for college and thus not pull it from our other taxable savings. Like was mentioned earlier I found that to be a comforting feature. It has been extremely easy to pull the money out to pay the bills, and our fund was a very low fee fund through California’s Scholarshare (TIAA-CREF). Although we moved to Minnesota we still get a tax credit for contributing to the 529, which has been nice also. It was great for us.
As an aunt and uncle to several nieces and nephews soon college-bound, we have used front-loaded 529s to help lower our estate value below the federal (and state if it applies) estate tax boundary. Our plan is to make more front-loaded gifts to their 529s every 5 years so the funds can be used for their children, or for future graduate education.
We had not thought about the “save it for later” approach just paying the college directly which is a good way to channel more money to the kids without the extra IRS reporting for front-loaded gifts. A useful idea provided we live long enough to see them through all their education years.
As mentioned in an earlier post, I was relieved to find that it should be easy to access the funds that are in the 529 plan. I tell Schwab what I’ve spent and they will send the money from the 529 plan to cover the cost. The 529 plan can also cover the college costs directly (i.e. send the funds to the college), but that sounded like a trickier route to take. By the end of four years, the balance should be down to zero. I am good with that.
I am well aware there are other schools of thought on how to approach 529 balances. Many have an eye towards preserving the balances for the future. In one case, I have a friend who is funding college without tapping his child’s substantial 529 account. His thinking: the 529 plan is an efficient vehicle to pass money to his child who can use the funds to fund college costs for his grandchildren. While generous and forward-thinking, this approach does not work for me.
First off, as mentioned in prior posts, 529 plans carry fees that can offset the tax deferral benefit. If you have your 529 plan with a low cost provider, then the tax benefit math may work. If you have your plan with a company – like Schwab – who levies about 1% per year, you may find that the tax benefit is offset by the fees.
My second argument against this “save it for later” approach is that you don’t know what tax changes and financial aid rules will be in the future. While unlikely, it could be that withdrawals from 529 plans are taxed in the future. It could also be that there is a change in the student aid formula that makes 529 plan accounts unfavorable to hold.
A final argument against such a “hold on to it” approach is that there is no certainty you will have grandkids. And if you do, it could be they will not need money for college as they choose to enter a trade or they end up earning a scholarship. In a case where the funds are never used, you will certainly pay a hefty tax to access the funds.
Another benefit I see with the 529 plans is that it’s easy to pull money from the account to reimburse yourself for college-related costs you incur. About a year ago, I talked to a 529 specialist at Schwab. Given that my balance had grown quite a bit, I started to worry about how to access the funds. In past lives, I’d found it challenging to access dependent care flex spending and HSA accounts. So as college for my oldest was drawing near, I figured I’d check in to understand the process to access funds.
To my surprise, it will be relatively easy to access the funds. I will simply communicate to Schwab the qualified costs I’ve incurred and they will cover it accordingly. The qualified costs include tuition, room, board, books and technology costs. For the latter two costs, it’s my understanding that they are covered so long as the costs are paid directly to the school.
The key costs not covered would be travel to the school, any health fees levied by the school, and fees for extracurricular activities.
With the cost of college these days, I am fairly confident it will be no problem for us to drain our 529 balances.
I started saving for college for my first two children using Uniform Transfer to Minors Accounts (UTMA) because the Coverdell ESA wasn’t yet available. Then I switched to the Coverdell for two of my kids, then the last two rolled into 529s. The key is to get started early, when they are born, and the 529 is a great resource. That said, I also set aside money in a taxable account, in the name of my wife and I, just in case it wasn’t needed for college. As it turned out, one of my sons got a tuition, room, board, books, fees scholarship, which was great because the Great Financial Crisis of 2008 decimated his college fund. I gave him money from the taxable account, after he graduated, to defray some of his costs during medical school. Again, get started early and you’ll do fine.
We used a Vanguard 529 plan for our son and don’t regret it. Low cost and tax free compounding worked great. Only downside is that there will be left over money after he graduates. However, there are options to avoid penalties and taxes. You can transfer the money to a new beneficiary such as grandchildren, nieces and nephews. Also, after 15 years some can be rolled over tax free into an IRA for the beneficiary if they have earned income.
I’m funding 529s for my two grandsons, and actions speak louder than words. Still, I wonder whether a dedicated education fund is the right strategy today, given the potential changes to the whole system of paying for college. Will we see more colleges digging deep into their endowments to offer free tuition to all? Will the college borrowing system get radically revised, given that so many students seem to end up over their head in debt? Will some colleges take steps to roll back the huge cost increases of recent decades, perhaps spurring a price war? If we see a radical revamp of college funding, parents may be happy if they saved money in, say, a regular taxable account, rather than 529s, because they’ll have greater financial flexibility.
In addition to the 529 plans, some states (including my state) also offer a prepaid tuition option for state schools. Basicly, you can buy a plan and prepay tuition (either lump sum or payments) and then tuition has literally been prepaid at the set price at the time of plan purchase. My daughter preferred that approach to “investing” in a more flexible 529 plan. We did this back about 15 years ago when the stock market has just had 2 pretty severe and recent bear market drops. While I think the more general 529 investment plan would clearly have turned out better financially (thanks to bull market of the last 15 years), we’re still happy with what we did and the surety it provided (ie. no dependence on investment returns or the rate of future tuition inflation). So while it probably wasn’t the smartest investment, there is something to be said for peace of mind. I only mention this so folks can be aware that some states do offer other options in addition to the typical 529 plan. I’m not saying a prepaid tuition plan is a better option; but rather it’s just another option to consider.
Tax free compounding of income for education inside of a 529 is a major tax benefit of each 529 plan which are established by individual state governments under federal law (IRC 529). Some brokers affiliate with a state to run their plan. The Schwab plan you note in the comment below is a plan for the State of Kansas. The amount of time funds contributed to the 529 have to compound is key to the ultimate benefit of this source of education funding.
Some states offer state residents a state tax credit or deduction for eligible 529 contributions. Morningstar can give you a summary of your available potential state tax benefit for contributing to a 529 plan. The state benefit, if any, really depends on state under which the plan is established.
I gave my grandson’s parents a modest gift when he was born to start the funding for a 529 plan and we gift a even more modest contribution directly online monthly to the 529 plan. I get to think nice thoughts about how this contribution will benefit my grandson every month and how the 529 will jump start his college funding even if I am no longer around to see him go to or finish college. When my grandson will be college age I would be over age 90 and even if I am alive then I want my daughter and son-in-law to take the lead in the administrative matters on properly distributing funding the 529 benefit to the appropriate chosen college. I consider this arrangement a win-win for me and my wife. We get to help with funding an expected goal of education for our grandson and have none of the headaches.
Our grandson lives in Illinois. The Illinois 529 is named Bright Start. There is no annual account fee. The portfolios have a 0.07% program management fee and 0.025% state fee, plus each portfolio also indirectly bears its pro-rata share of the fees and expenses of each of the underlying investments. Typical available investments at Bright Start are a mixture of low cost index funds and many are beneficiary aged based that become more cash investment like as the beneficiary approaches and reaches college age. Just as you would review the expense ratios of your 401(k) the investment expense ratios of a 529 plan can be low or crazy high. Buyer beware! There are both federal and plan requirements on investment options which seem to me to meet a prudent investor standard.
The following link is a recent article on how having the 529 might impact financial aid. Key take away to me is if you expect the 529 beneficiary to attend a university with a large endowment then that university may request additional parent or student financial information including 529 balances which could limit institutional grants compared with a state university that requests just a FAFSA.
https://www.savingforcollege.com/article/yes-your-529-plan-will-affect-financial-aid
I believe the best part of establishing a 529 and sharing it’s existence with the beneficiary at the appropriate time is the creation of the expectation and the importance of education and learning in the mind of the beneficiary from the family that loves him or her.
There are many benefits that we can list about a 529 plan. The key benefit most cite is that earnings will grow tax free. Based on my analysis, the benefit of the tax deferral may not be there for everyone.
Some data to consider:
A few final thoughts on this analysis:
We have used 529 plans for our grandchildren for many years. I think it was a good choice as the money is isolated and investments get more conservative as the children age. Plus a portion if unused may be eligible to roll into a Roth IRA.
I see the top benefit of the 529 plan as having money that’s specifically set aside for college. Assuming that my son does not get offered a large academic scholarship, we are within about a year of needing to write large checks to a university. For several friends with older kids, they have been pained to write checks from their bank or brokerage accounts as they did not have the funds earmarked for college. I believe it will be much easier for us to part with the 5-figure sums each year given that we have this money set aside and we have always intended it for school for our children.