The 529 plan world consistently promotes the benefits of a 529 college savings plan. There are some very appealing benefits, but you should clearly understand what those benefits cost and how they work.

Certainly, there are trillions of reasons to save for your child’s college expenses since it is so costly to get an education today. A statistic that most advisors will point out to you is the magnitude of student debt. It has reached $1.53 trillion. Therefore, the more you can pay out of pocket with the least amount of cost the better. 529 college savings plans are an option that is becoming more and more popular. There is over $320 billion in college savings plans currently. And congratulations to those who have had the foresight to put that money away. Just make sure you read to the end of this article to have a clear understanding of the cost/benefit analysis of using a 529 college saving plan.

Structure of a 529 Plan

First, we should review how 529 plans are structured. Then we look at how those structures should be evaluated as to the true benefits that they would provide. They should also be evaluated based on the risks associated with the typical 529 plan.

529 College Savings Plans Structured By State

529 plans are structured under each individual state. You might ask why a state gets involved when the main benefit is the federal income tax savings. The main reason is because the mutual funds that are the investment options within a state 529 plan have an added expense to the management of the mutual fund. Those extra fees go to the state that you choose to use for your 529 plan. Therefore, the same mutual fund that you could purchase on a retail basis is less expensive because of the added fees for the state that sponsors the 529 plan. For clarification, you do not need to use the state 529 plan for your college student where your student will attend to achieve the tax savings you seek.

Higher Education Expenses

529 college savings plans

Secondly, a 529 plan under federal tax guidelines offers that any funds that are used to pay for “qualified” higher education expenses of the child that you have established the 529 college saving plan for will not have to pay any taxes on the gains of the mutual funds purchased. There could be some benefit tax-wise at the state level as well for states with an income tax. A calculation of what that really means will follow later. Recently, some changes even allow you to use the 529 plans tax-free for private tuition paid for K through 12th grade.

Fund Ownership & Control

Additionally, the owner of the funds is actually the parent or grandparent and not the child. This offers the parent or grandparent control of the funds rather than the child. This is different than setting up an UGMA (Uniform Gift to Minor Act account). In UGMA, when the child reaches the age of 18 (or legal age in the state of residence) they become the legal owner of the account. This means they can do anything they want with the funds. We will outline later the challenges that parents or grandparents face with this. However, advisors who want to get more of your funds under management or in commissionable format for them use it as a selling point.

For one example of the control benefit, you would be told that if the child does not go to school, you can change the beneficiary of the funds to a different child/grandchild. Ultimately, if you run out of children you can use the funds yourself for schooling or just for retirement. Using the funds for a purpose other than education triggers the federal income tax plus a penalty on the gains as they are used or pulled out of the 529 plan. It can be argued that this becomes a tax deferral instrument. However, the same funds in an IRA would have lower expense fees on the same funds used outside of a 529 plan.

Opportunity to Invest in Mutual Funds

It is also a selling point that is used to have the opportunity to invest your money in mutual funds. Typically, you would be shown a mountain chart where stock and bond mutual funds have outperformed savings accounts. This may or may not be true based on the year of investment and the year(s) you access the funds to pay for your children’s college education.

Time is the most critical component of return. To generate a large gain in a 529 plan, it typically takes a good deal of time versus the calculation of how well the fund or funds have performed. What a tragedy it would be to count on funds you had saved for your child or grandchild when 9/11 hit or 2008 when the stock market went down almost 40%. A loss like that would most likely wipe out any gains and probably a part of your hard-earned contributions. Most 529 plan fund managers allow for age-based investing. This is where the closer your child gets to college, the more conservative the funds are invested in. It should be noted that bond funds are not exempt from losses in a rising interest rate environment.

Cost/Benefit Analysis of 529 Plans

529 college savings plans

Carefully consider the state sponsor of the 529 plan you choose. This is especially true in light of what is called the expense ratio or cost of having your money in a mutual fund. This expense includes fees for the manager for management, trading expenses and the fee to the state. Not all mutual funds are created equal so consider the mutual funds based on cost plus performance. The higher the cost the lower your results are going to be. 

Contributions to 529 plans are done with after-tax funds. The tax benefit is calculated by how much of the gain is used for “qualified educational expenses”. So, let’s take a look at some numbers:

Investment $10,000

  • Value at college time $20,000 (if you are so lucky to double your investment)
  • Gain (tax free distributions) $10,000
  • Tax Savings (Assume 40% bracket) $ 4,000

What most advisors don’t tell you is that the $20,000 in accumulated value counts against you in calculating needs-based aid. The $20,000 in the first year could cost you $1,128 in potential needs-based aid. Year 2 (assuming you used a quarter of your money) with $15,000 left could cost you $864 in potential needs-based aid. Year 3 with $10,000 left could cost you $564. And Year 4 with $5000 left in the 529 plan could cost you $282. So, IF you are in a 40% tax bracket and IF you have sizeable gains in the example above, your net tax advantage over lost needs-based aid would have only been $1162 in tax savings over needs based aid lost.

Let’s look at a more realistic example because most people in a 40% tax bracket won’t qualify for needs based aid anyway. We should also look at some more realistic gain possibilities because most people save in a 529 plan by contributing monthly rather than putting in a large lump sum up front. Example #2:

Investment $15,000

  • Value at college time $20,000
  • Gain (tax free distributions) $ 5,000
  • Tax Savings (Assume 22% bracket) $ 1,100

The needs-based calculation would not change. Therefore, your 529 plan in this example would have cost you $1738 more than you have gained by having a 529 plan.

Tax Savings vs Need-based Aid

One item to note is a grandparent-owned 529 plan. It doesn’t affect the needs-based aid for the student until the second year. In year two, the student would have to show the money distributed as income to them and that counts against needs-based aid at the rate of 20% of income instead of 5.64% of the asset on 529 plans owned by a parent.

What this should hopefully point out to you is the need to carefully consider the tax savings versus need-based aid available before blindly contributing to a 529 plan. College expenses continue to rise at a higher than normal inflation rate. That’s why you should be prepared to contribute more (if it makes sense) to keep up with the rising costs.

Fund Control Issue

The control issue is an important one. Not all kids go to college. It is difficult to tell whether your two-year-old is going to have what it takes to go to college let alone finish. This is not to cheer you on to have more kids. However, the more you have, the more you can pass onto the younger ones if the oldest don’t decide to go to college or finish college. Even if none of your children go, saving the money for college is important. In worst cases, you could ultimately use the money for your own retirement (taxes due on gains) or a grand child’s college education.

How to Invest

529 college savings plans

Finally, one of the more important issues is to decide how to invest your hard-earned savings. No one knows the future of how your investments are going to perform. Once again you should carefully consider the risk profile of the funds that you are considering investing in or that you have your funds currently in.

I would highly recommend that you check your statement and determine how much gain you currently have in your 529 plan(s). Also determine what the benefit would be if your child started college today. I would then make sure I assess my risk tolerance and determine if the way the funds are invested lines up with the risk tolerance. I would also look at the time horizon you have left in order to accumulate the funds you desire to have set aside and then determine again if the risk in the funds will get you there.

In conclusion, it is extremely important to understand how a 529 college savings plan works and how the benefits stack up compared to the potential benefits lost. It is also really important to stack up the investment vehicles against the risk and timing of the market at the time you are going to need the funds in the future.

There are alternatives to 529 plans in the market place that offer tax savings, control and market risk mitigation strategies. One of the alternatives also allows for the funds not to count on the FAFSA or CSS Profile calculations. To find out about these seek out a qualified college planning specialist to see if you qualify.

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