Advantages and Disadvantages of College 529 Plans

Introduction:

A college 529 plan is a tax-preferred savings vehicle that helps parents, grandparents, relatives, and a student save for college.  This post describes advantages and disadvantages of 529 plans and discusses the potential use of 529 plans in combination with other savings vehicles including Roth IRAs and Series I Savings Bonds.

The main recommendations from the analysis presented here are as follows:

·      Do not rely entirely on 529 college savings plans for college savings

·      Be aware of high fees charged by some 529 plans.

·      Contribute to a broad stock fund inside a 529 when the beneficiary of the 529 is very young

·      Avoid bond ETFS inside of college 52\9 plans.

·      Purchase Series I bonds when beneficiary is more than 5 years away from entering college.

·      Purchase short-term Treasury bonds at Treasury Direct when beneficiary nears college age.

·      Help your kid set up and fund a Roth IRA when he or she gets some reportable income.

Advantages:

·      Gains on investments in funds disbursed from a college 529 plan for qualified educational expenses are not subject to state or federal income tax while gains on many other investments are often subject to federal and state income tax.  This tax exemption includes up to $10,000 in annual expenditures for k-12 expenses.

·      Funds from IRAs and gains on Series I and Series EE Saving bonds used for higher education expenses are also exempt from state and federal income tax.  These tax exemptions do NOT appear to cover expenditures on K-12 expenses.

·      Over 30 states offer a state income tax deduction or credit for contributions to an in-state college 529 plan and nine states allow residents to claim a state income tax credit or deduction for contributions to any college 529 plan as discussed here.

·      Assets in college 529 plans, owned by either parents or students, do not count towards the FAFSA financial need calculation.  Assets in IRAs owned by either parents or children also do not count towards the aid calculation on the FAFSA limit.   The FAFSA form assesses liquid financial assets held by parents at a maximum of 5.64 percent and assets held by children at 20 percent. The student financial assistance formula discourages young adults and teenagers who are trying to save for college from accumulating liquid assets.

·      The disbursement of college 529 assets will have no effect on income.  By contrast, IRA disbursements, even when not taxed, will be reported, and could decrease financial assistance.  This impact on financial aid will be small and there are several reasons why It might be appropriate to fund an IRA instead of a 529 plan.

·      Starting in 2024. owners of a 529 plan are allowed to convert a lifetime total of $35,000 to a Roth IRA owned by the beneficiary of the account.  Conversions are only allowed for 529 plans, which have been owned by the beneficiary for 15 years.  The conversions are subject to annual Roth contribution and income limits.  Converted funds must be placed in a Roth, not a conventional, IRA.  This new feature described here should increase 529 contributions and assist young adults with future savings.   

·      A person who contributes to a broad-index equity fund in a college 529 plan at the birth of a child will usually do well because returns on broad equity funds usually outperform other assets over long periods of time. However, the withdrawal of the funds early for non-education related expenses will be subject to a 10 percent tax penalty. By contrast, the early withdrawal of contributions to a Roth IRA are not subject to tax. A person with limited liquidity would be better off contributing to a Roth IRA than a 529 plan.

·      The IRS allows the owner of a plan to change the designated beneficiary of the plan to any family member.  As noted in this article, the definition of a family member is very broad.  Conceivably, a 529-rich but cash poor person could make a trade with a cash-rich but 529-poor relative.  College 529 plans are a better option for large families than small families.

Disadvantages: 

·      529 plans have limited investment options. Typical options include several equity funds of varying degrees of risk, bond or fixed-income funds, and life cycle funds where the share of funds invested in bonds rises when the beneficiary nears college age.  These investment vehicles work far better for people who are saving for retirement when spending is spread over multiple decades.

·      This Morningstar report shows that lifecycle funds did extremely poorly in 2022 leading to a potential financial squeeze for people entering college at that time.   

·      529 plans do not generally allow the owner to invest in bonds or CDS with a fixed maturity date.  The reliance on bond funds without a maturity date creates substantial interest-rate risk for the beneficiary.  Bond funds lost a lot of money in 2022 as noted here.  People entering college in 2022, would have been far better off if their funds were is short-term CD and bond ladders than in bond ETFs.

·      Many 529 plans appear to charge high fees. Some plans offered through financial advisors charge an up-front commission fee, which will make short-term investments unattractive. Both the upfront-fees and the annual fees discussed in this CNBC article appear larger than typical ETF fees.

·      Funds withdrawn from a 529 plan that are spent on non-educational expenses are subject to a 10 percent tax penalty.  The disbursement of funds from a Series I IRA prior in the first five years leads to a loss of 90 days of interest.  A person with limited liquidity should contribute to a Roth IRA instead of a 529 or Series I because the Roth contribution can be disbursed without penalty at any time.

Recommendations:

·      Do not place all college savings inside a 529 plan.  Instead rely on a variety of savings vehicles including brokerage accounts, Treasury securities purchased through Treasury Direct, and Roth IRAs.  I agree with this article that the 529 plan is not always the best way to save for college.

·      Avoid bond ETFS in College 529 plans, especially when interest rates are low because the bond fund invariably loses money when interest rates rise, and the potential return is eaten up by fees.  Go herefor a discussion of some of the mistakes made by fixed-income investors. 

·      529 plans do not allow for investments in Series I Savings bonds, an asset that never falls in value.  Go here for a discussion of the advantages of Series I Savings bonds.  The best way to mitigate market risk associated with 529 plans is to invest in Series I Bonds.  Proceeds from Series I Bonds used for higher education may not be subject to tax depending on the income of the household.    Bonds held by the parent will have a smaller impact on financial aid to student than bonds held by the student.  However, there is a loss of 90-days of interest on Series I Savings bonds, which are held less than five years.

Potential Savings Strategy:

·      Purchase broad stock ETFs inside a 529 plan in the first five years after birth of beneficiary, if you have adequate liquidity for emergencies.

·      Purchase Series I Savings bonds in the name of the parent in years 6 to 15 after the birth of the child. Again, the amount of Series I bond purchases is determined by the amount of available liquids assets for an emergency.

·      Help child set up and fund a Roth IRA when he or she starts first part-time job.

·      Parent investments starting with age 15 of child are in Treasury bond or CD ladders with longest maturity of around two years. Short term Treasury bonds are also a good source of liquid assets at all times.