Section 529 plans have been getting a lot of heat lately, but here's why they're still the best way for most families to save.
Section 529 plans, which allow tax-free savings for college costs, have taken a beating lately. Poor investment performance, increasing fees and — thanks to the Bush tax cut — a reduction in the tax hit on alternative savings vehicles have some financial planners saying that these plans are obsolete.
I respectfully disagree.
For the vast majority of college savers, 529 plans remain a great deal. Why? I've got four good reasons:
1. No tax is better than low tax.
2. Most people don't want to micromanage their college accounts.
3. Being able to get the money in your college fund back (if necessary) is a good thing.
4. Paralysis by analysis is the worst enemy of college savers.
If you agree with these statements, the 529 plan is probably your best bet as a college-savings vehicle. This was true before the Jobs and Growth Tax Relief Reconciliation Act of 2003, and it remains true today. Allow me to explain.
No Tax Is Better Than Low Tax
As you recall, the 2003 Act reduced the maximum federal-income-tax rate on long-term capital gains and dividends to a mere 15% between now and the end of 2008. Even better, long-term gains and dividends that fall within the 10% or 15% ordinary income rate brackets are taxed at only 5% between now and the end of 2007, and at 0% in 2008. By all accounts, this is a great improvement, offering significant tax savings to investors across the board.
These historically low tax rates on long-term gains and dividends have given rise to the notion that perhaps all of your college-savings funds should now be held in taxable accounts at your friendly brokerage firm. Specifically, you could buy and hold stocks and equity-index (or some other type of tax-efficient) mutual funds. That way, you'll never pay more than 15% of the resulting long-term gains and dividends to the U.S. Treasury. And if you pursue the same investment strategy with money contributed to your child's UGMA or UTMA custodial account, the tax rate might never be higher than 5%.
The combination of high rates of return (which you should get from equity investments over the long haul) and low tax rates could put you way ahead of folks who save for college using lower-yielding 529 accounts. In other words, the high rate of return earned in a taxable account would overwhelm the tax-free advantage of the lower-yielding 529 account. Given the right assumptions, this is true. (More on this later.) Of course, given the right assumptions, I can prove the absolute best college-savings strategy is to stuff $100 bills in empty coffee cans and bury them in your backyard. With my trusty calculator and some assumptions, I can prove just about anything.
Let's face facts: A 0% tax rate beats any other tax rate known to humankind. With a 529 plan, the law says you'll get that 0% rate through at least 2010. What will happen in 2011 and beyond is unknowable. I'd bet, however, that Congress allows the 0% rate to continue for as long as you're likely to care about saving for college. By contrast, the current low rates on long-term gains and dividends are scheduled to expire after 2008. What happens in 2009 and beyond is equally unknowable. Personally, I suspect these rates are more likely to go up than to stay the same or go down.
Winner: 529 Plan
Most People Don't Want to Micromanage Their College Accounts
From a pure convenience aspect, a 529 college-savings plan allows you to basically pick your investment strategy and then go on autopilot. If you wish, however, you can generally readjust your investments once a year. (Lots of people who overdosed on bond funds are probably doing that right now.) The price of this convenience is fees, and the probability that you won't earn the maximum rate of return (because most 529 plan investment strategies aren't overly aggressive).
On the other hand, using a taxable account for your college-savings fund gives you a chance to generate higher returns while paying minimal (but not zero) taxes. At least that's the theory. It can even be true if you're a savvy investor and have time to micromanage your account in order to achieve optimal after-tax results.
For instance, say you have $50,000 ready to plunk down right now for your five-year-old daughter's college account. You have three vehicles to choose from: (1) a 529 college-savings account, (2) a taxable account in your own name, or (3) a taxable UGMA or UTMA custodial account in your daughter's name.
Let's also assume the 529 plan would earn a rather pedestrian 6% annual rate of return after fees and expenses for the next 13 years until your daughter reaches 18 and is ready to enter college. By contrast, we assume that you have the investment acumen, tax-planning skills and time to earn 8% annually while postponing all taxes for 13 years, at which point they come due at the low rates of only 20% (15% federal + 5% state) if you save in your own name, or 8% (5% federal + 3% state) if you save in your child's name. Here's how the dollars would stack up after paying all taxes:
529 Account: $106,646*
Your Taxable Acct.: $118,785
Kid's Taxable Acct.: $129,103
As you can see, it's theoretically possible for taxable college-savings accounts to solidly whip a 529 plan, especially if you're willing to save using your child's UGMA or UTMA account. However, the preceding analysis assumes the rosiest scenario for the taxable accounts: (1) a significant rate of return advantage thanks to your undeniable investment smarts, (2) tax deferral until the end of the day thanks to your considerable tax planning talents, and (3) low tax rates at that time thanks to your old pals in Washington (perhaps unrealistically low). Are these reasonable assumptions given the constraints on your time and uncertainties about future tax rates? You'll have be the judge of that, but let me give you a little more food for thought.
Say you manage to earn only 6% after expenses on your $50,000 college stash with a taxable account (the same return as with a 529 account). Your tax planning is less than brilliant, so you wind up getting clipped at a 25% annual rate (federal and state combined) by saving in your own name or at a 13% annual rate if you save via your kid's UGMA or UTMA account. These revised assumptions produce dramatically different after-tax results after the 13 years between now and when your child reaches college age:
529 Account: $106,646*
Your Taxable Acct.: $88,610
Kid's Taxable Acct.: $96,883
Holy smokes! The tables have really turned. Now the 529 plan positively crushes the taxable accounts. See, I told you I could prove anything with my handy calculator!
* Assumes no federal or state income taxes. These days, most states do not tax 529 plan withdrawals, even if they are from an out-of-state plan. Also, many states offer additional state-tax incentives (in the form of credits or deductions) for in-state participants. This figure does not factor in any additional state-tax breaks.
Being Able to Get the Money in Your College Fund Back Is a Good Thing
Realistically, you may not be able to beat a 529 college-savings plan with a taxable account unless you're willing to save in your child's name via an UGMA or UTMA custodial account (even then, it's certainly no sure thing). The big problem with the custodial-account approach is that your child gains unfettered access to the account upon reaching the age of majority in your state (usually 18 or 21). Yikes! If you're having visions of your kid driving off into the sunset in a brand new yellow Hummer purchased with the cash from his or her college fund, that's an appropriate reaction.
By contrast, using a 529 plan as your college-savings vehicle leaves you in control. If your child decides to become a professional body surfer, you can designate another child (or grandchild) as the new 529 account beneficiary. If the absolute worst happens and you flat out need to get your money back, you can get it back with a 529 plan. To be sure, you'll pay income taxes and a 10% penalty on the accumulated earnings, which is a much harsher treatment than if you invested in a taxable account in your own name. But at least if all hell breaks lose, the money is accessible.
Bottom line: A college-savings plan keeps the ball in your court, not your child's. And believe me, even when there's no doubt your children will go to college and it's perfectly clear you won't ever need the money in the college fund back, it's a blessing to be able to threaten the little devils with pulling the financial plug if they don't toe the line. (Take it from me as a parent with two kids in college right now.) With an UGMA or UTMA account, you lose this leverage.
Winner: 529 Plan
Paralysis by Analysis Is a Bad thing
As if you don't already have enough variables to think about, here's another: What are the financial-aid implications of saving for college using a 529 plan versus a taxable account in your own name vs. a taxable UGMA or UTMA custodial account in your child's name? Answering this question has become so complicated that financial-aid planning is now a profession. Result: Some parents become totally paralyzed by the horrible thought that their college-savings strategy might somehow cause their child to lose out on valuable financial-aid goodies. So they do nothing, which is clearly the worst possible strategy.
Trust me: If you invest in a good Section 529 savings plan, you won't be shooting yourself in the foot. Here's why. Saving for college in your own name generally produces the best results when applying for financial aid. But the tax results aren't so great. Saving in your child's name generally produces the worst financial-aid results but better tax results. Using a 529 college-savings plan generally puts you in the middle of the financial-aid spectrum, but you get great tax results. On the other hand, having no college fund at all may qualify your child for valuable financial-aid benefits in the same way that becoming unemployed may qualify you for valuable welfare benefits.
Winner: Any College-Savings Strategy
The Final Score
According to my scorecard, 529 college-savings plans get two points out of a possible four. The taxable-account alternatives get no points. So the 529 plan wins by a technical knockout. While the 2003 Tax Act does make taxable accounts more competitive, the 529 plan remains superior.
That said, I'd recommend you avoid plans with high fees. Also, please deal directly with the plan you select (rather than being sold a plan through a broker). I think paying a hefty sales commission to get into a 529 plan is a terrible idea when you can get into many good ones for free. (To compare plans on your own visit Savingforcollege.com.) Finally, I think you also should avoid state 529 prepaid-tuition plans. With many state schools now raising tuition and fees at double digit rates, several states have reacted by shutting down prepaid plans and/or reneging on the original deals. This is shameful behavior, but the politicians will always find somebody to punish when state budgets go in the red.