Pros and cons of 529 plans

While a 529 plan is commonly considered the “best college savings vehicle”, this option does have some downsides.

Reasons to use a 529 plan:

Investments in 529 plans grow tax-deferred and withdrawals are tax-free when used for qualified college expenses.  Also, most states offer income tax deductions on contributions.  Even if funds are not needed for the intended beneficiary, there are other options that let the owner escape tax penalties.

Reasons against using a 529 plan:

•  The earnings portion of withdrawals not used for qualified expenses is subject to ordinary income taxes and a 10% penalty.

•  It’s not  for the short term.

… one instance where the benefits of a 529 college-savings plan may not have time to accrue is for those that are looking at very short investment horizons—such as one year—before beginning to take withdrawals. The benefit of tax-free growth is very limited over such a short period of time in low-return, no-risk investments, and could be offset by investment expenses or plan fees in the short run.

•  Requires extra research.

Plans will vary from state to state, which is a little more challenging for families. Therefore, you need to do your due diligence on the sales charges, fees, and investment choices by the plan administrator.

•  Limited investment options and higher fees.

•  Restrictions in moving funds between accounts.

 

Some families may simply prefer to maintain more flexibility and control over their college savings, and therefore are willing to forego the tax benefits that 529 plans offer.  There are no absolute right or wrong choices since investing is a highly personalized undertaking.  Here’s a good resource for learning more about 529 plans:

Understanding 529 Plans

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“The Experts: Are 529 Plans the Right Choice for All Families Saving to Send Their Kids to College?”, Wall Street Journal,  June 5, 2013.

Poor timing of 529 withdrawals can cancel tax benefits

529 funds must be withdrawn and used within the same year that expenses are incurred to preserve tax benefits.

Question: My daughter’s college is offering a discount if you prepay in year one for all four years. Can we use 529 funds to pay all of her tuition up front even though she’ll still be in school for another few years?

Answer: In general, 529 distributions must be used to cover qualified college expenses incurred in the same tax year in which the distribution is made; otherwise, taxes and a penalty apply. The scenario you describe falls into something of a gray area given that you would be using 529 assets to pay for tuition–a qualified expense–but paying for services to be provided not only during the current tax year but in future tax years as well.

Such a scenario isn’t specifically addressed in the IRS rules governing 529 expenditures, but Mark Kantrowitz, publisher of the college-planning siteEdvisors.com, says the way the rules are written suggests that it is not just when qualified expenses are paid that matters but when those expenses are incurred. “In general, the IRS interprets tax law as applying to income and expenses during the tax year except if explicitly stated otherwise,” Kantrowitz says.

The bottom line is you’d be wise to consult a tax professional before prepaying all four years. Even if he or she recommends only counting the current year’s tuition payment as a qualified expense, you could still pay all four years at once to take advantage of the discount. Just keep in mind that if doing so requires using additional 529 funds, you may end up owing taxes on the earnings portion of any nonqualified distributions plus a 10% penalty, and those costs could eat into–or erode entirely–the prepayment discount.

Morningstar offers more advice about avoiding the pitfalls in timing your 529 withdrawals.

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Adam Zoll, “529 Owners, You Must Remember This”, Morningstar, February 3, 2015.

How the ‘middle class’ saved 529 plans

Why did President Obama do such a quick about-face on 529 plans, first proposing to eliminate them and then a few days later dropping that proposal?  Although it was widely believed that this initiative had zero chance of getting through Congress, it appears Obama’s actions were due to the efforts of the elusive “middle class”.

Several news sources have pointed out how poorly this proposal polled, notably with Democratic voters.  It seems the administration could have predicted this reaction, but apparently they were blindsided.  Obama’s proposal would have penalized wealthy families the most, since 70% of 529 “tax benefits go to households earning more than $200,000”.  As such, “middle class” families would not be seriously hurt by this change.  But here’s the rub.  The vast majority of Americans consider themselves middle class, including many with household incomes well into the six-figure range.

Don’t tax me, tax that rich guy over there.

The first rule of modern tax policy is raise taxes only on the rich. The second rule is that your family isn’t rich, even if you make a lot of money.

President Obama’s State of the Union proposal to end the tax benefits for college savings accounts ran afoul of these rules, which is why he abandoned it, under intense pressure from both political parties, within a week.

Tax-free college savings accounts, like the mortgage interest deduction and the state and local tax deduction, principally benefit people who range from affluent to wealthy. In pushing its proposal, the White House pointed to Federal Reserve data showing that 70 percent of balances in the college accounts were held by families making at least $200,000 a year. In theory, tax reform is supposed to be built around cutting back preferences like these, in order to pay for some combination of lower tax rates and tax preferences aimed at people with lower incomes.

Politicians have met with strong resistance to increasing taxes on the “merely affluent”.

But in practice, politicians from both parties have made a point of holding the group you might call the “merely affluent” harmless from tax increases. If you make $150,000 to $225,000, you make about two to three times the national median income for a married couple. The list of occupations that can get you into this income bracket — government official, academic, lobbyist, journalist — can sometimes make it hard for people in political circles to remember that 92 percent of American married couples make less than $200,000 a year.

A lot of people in this category don’t think of themselves as rich, and they benefit from tax provisions like college savings accounts.

So how can politicians raise more tax revenue?  It’s a challenge.

… If you can’t go after tax provisions for the merely affluent, you are exempting almost everyone from tax increases. And if you can’t broaden the tax base, then you are very limited in how much you can finance tax reform.

Where else can they find the money?

Raising taxes on the very rich won’t raise enough revenue to balance the budget, and the bottom 50% of income earners — who only pay about 2% of all federal taxes — are not a likely source.

Peter Suderman of Reason believes the 529 debacle shows that the “existing welfare state is unaffordable”.  On the other hand, Reihan Salam of Slate laments that the upper middle class is ruining all that is great about America.  In essence, both may be saying the same thing.  It’s hard to finance expansive government programs because “eventually you run out of other people’s money”.

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Josh Barro, “A ‘Rich’ Person Is Someone Who Makes 50 Percent More Than You”, New York Times, January 29, 2015.

What is the maximum 529 plan contribution limit?

So you want to contribute the maximum amount to your child’s 529 plan?  Maybe you received a generous inheritance, and want to set aside enough funds to assure your child will be able to attend any college he chooses.

Here’s what the IRS says:

Q. Are there contribution limits?

A. Yes. Contributions can not exceed the amount necessary to provide for the qualified education expenses of the beneficiary. If you contribute to a 529 plan, however, be aware that there may be gift tax consequences if your contributions, plus any other gifts, to a particular beneficiary exceed $14,000 during the year. For information on a special rule that applies to contributions to 529 plans, see the instructions for Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return.

In practice, “the amount necessary” varies and is determined by each state-sponsored plan, with amounts ranging from about $335,000 to $400,000.  Check out Savingforcollege.com for a complete list of state maximum amounts.

Here is how the New York 529 Advisor-Guided College Savings Plan explains the maximum contribution.

How much can I contribute to my account?

You can contribute on behalf of a beneficiary until the total balance of all Program accounts held for the same beneficiary reaches an aggregate maximum balance, currently $375,000. If there’s more than one account owner contributing for the beneficiary, this is the total for all accounts. Once this limit is reached, you can no longer make additional contributions, but you can continue to accumulate earnings.

Gift and estate tax implications

Since a 529 contribution is treated as a gift to the beneficiary for tax purposes, another consideration for donors is to understand how amounts greater than $14,000 could trigger tax liabilities.

… your contribution qualifies for the $14,000 annual gift tax exclusion and so most people can make fairly large contributions without incurring the gift tax.

For contributions greater than $14,000, 529 plans offer a unique gift-tax exclusion feature.

… Specifically, you can make a lump-sum contribution to a 529 plan of up to $70,000, elect to spread the gift evenly over five years, and completely avoid federal gift tax, provided no other gifts are made to the same beneficiary during the five-year period. A married couple can gift up to $140,000.

A good explanation of the details on how this works can be found at the Ameriprise website.

Related:  “Most families are not taking advantage of 529 plans for college savings” (Cost of College)

Most families are not taking advantage of 529 plans for college savings

Only 29% of families choose 529 plans for college savings.

A 529 plan is the “best college savings vehicle”.

… By far the most popular college savings vehicle is the general savings account (nearly half of families with children under 18 use this to save for college). But Foss says that the best college savings vehicle is the 529 plan (less than one-third of parents are using this to save). “There aren’t many reasons not to use it,” she says. One of the major reasons these plans are better than general savings accounts is that your investments in 529 plans grow tax-deferred and distributions come out tax-free on the federal level; plus 34 states and Washington, D.C. offer state income-tax deductions, so there’s a “double tax advantage” in these cases.

Furthermore, you can transfer the funds in these accounts to another child if one of your kids opts out of school and 529 plans are treated favorably with colleges’ financial aid offices. General savings accounts can’t compete with the benefits of the 529 when it comes to saving for college, Foss says. However, if you do not use the 529 plan for college expenses, you will likely have to pay a 10% penalty and income tax on the earnings when you withdraw the money.

Related: What you may not know about 529 plans (Cost of College)

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Catey Hill, Parents: “You’re saving for college all wrong”, MarketWatch, April 12, 2014.

A special day to remind us about the benefits of 529 plans

Darn! I missed 529 day.

The College Savings Plans Network sponsored National 529 College Savings Day this past Wednesday, 5/29/13.  Many states sponsored promotions for their 529 plans, with some offering special incentives that are still in effect.

Florida, for instance, is waiving the $50 enrollment fee for plans opened from May 20 through June 30.

You can check out individual states’ events and promotions by clicking on this map.

…

In general, 529 plans are college savings and investment accounts sponsored by state governments. Money deposited in the accounts grows tax free, as long as the funds are used for educational purposes when withdrawn. You don’t have to be a resident of a particular state to use its plan, although some states offer additional tax benefits to in-state plan participants.

Most 529s are designed as traditional savings-and-investment vehicles, but some states offer prepaid 529 plans, which allow savers to pay tuition at certain schools in advance at current rates.

Related:  What you may not know about 529 plans (Cost of College)

 

Private College 529 Plan is a unique option for locking in tuition costs

The Private College 529 Plan is “a relatively little-known program that lets participants prepay tuition at private colleges and universities, at today’s rates”.  This plan is unusual in that prepaid 529 plans are typically designed for enrollment in public colleges.

How it works

… Families contribute to a trust and get a certificate representing a share of tuition at current rates, a proportion that remains constant even as tuition rises. So, for instance, if you were to pay in $10,000, and the tuition at a given college were $40,000, the certificate you bought would be worth a quarter of one year’s tuition at that college. If, in 10 years, the tuition is $60,000, your certificate would be worth a fourth of that amount, or $15,000. Money must be in the plan for at least three years before it can be used. The plan covers tuition and mandatory fees, but not room and board and other expenses, like books.

The private plan includes more than 270 participating colleges and universities, but what happens if your child doesn’t want to attend one on their list?

If your child chooses a college that is not in the plan, you can change the beneficiary of the account, so another family member or relative can use it. Or you can request a refund. But you will earn only 2 percent maximum on your savings in the plan, and you could be subject to a loss of as much as 2 percent, depending on the performance of the trust’s investments. (While the value of the tuition certificates are guaranteed, plan documents caution that refunds aren’t assured, if the trust lacks funds to pay them. But Ms. Farmer says it’s “hard to imagine a scenario” in which that would happen. Refunds have averaged about 1 percent of plan assets for the last five years.)

Both the private and state prepaid 529 plans guarantee parents a locked-in tuition cost that can mean substantial savings, but there are some risks involved.

Because the emotional draw of the plan is strong, it is important that families carefully consider possible risks. For instance, to benefit from the plan, students must be accepted at a member college, and they do not get extra points in the admissions office for participating. The savings are greatest when families join early, but making such a commitment for a baby is a gamble. A student may later feel financial pressure to choose a college that participates in the plan.

What if college costs stabilize?  These prepaid plans may not turn out to be such a good value if college costs stagnate or even drop after their meteoric increases over the last few decades.

Related:  Average 529 savings reach all-time high

Quick Links – Middle school mess; hypergamy and single-parent families; bipartisan cuts to higher ed; and more

◊◊◊  The middle school debate

Various views on the middle school model were presented in the New York Times last year.

You don’t have to have to read all the studies to know that the ages between 10 and 13 are socially awkward ones. But they are also important ones academically, crucial in determining college and career outcomes. Would these preteens be better off staying in an elementary school that covers kindergarten through eighth grade? Or is there a reason why this age group needs to be sectioned off into a separate middle school?

Another observation on the Middle School Mess:

American middle schools have become the places “where academic achievement goes to die.”  — Cheri Pierson Yecke

◊◊◊  Fewer college-educated men are reason for rise in single parent families?

The effects of a low sex ratio

As this column has repeatedly noted, women are hypergamous, which means that their instinct is to be attracted to men of higher status than themselves. When the societywide status of women increases relative to men, the effect is to diminish the pool of suitable men for any given woman. If most women reject most men as not good enough for them, the effect is no different from that of a low sex ratio. High-status men, being in short supply, set the terms of relationships, resulting in libertine sexual mores and higher illegitimacy.

I rarely see the term “illegitimacy” used these days.

◊◊◊  ‘Bipartisan Support for Cutting Higher-Ed‘

The national trend is marked: between 2009 and 2012, 47 states cut higher education spending per FTE. The median (mean) reduction was just over 23 percent (22 percent). Just three states saw increases: Illinois (unified Democratic government), North Dakota (unified Republican government), and Rhode Island (divided government with Republican governor).

When they have had unified government, both Democrats and Republicans have cut higher education funding. If we look at the seven states with unified Democratic control over this period, six reduced funding. Those six (excluding Illinois’s 2.8 percent increase) reduced funding by between 19 and 31 percent (West Virginia and Washington respectively) for an average reduction of 22.9 percent.

Of the nine states under unified Republican control, eight reduced funding by an average of 25.2 percent, ranging from a 0.2 percent decline in South Dakota to 42.8 percent reduction in Idaho. Texas, one of Leonard’s great villains, reduced funding by 9.2 percent (less than any of the Democratically-controlled states). Florida cut funding by 27 percent, which outranked all but one unified Democratic state. So while Republican-controlled states did cut higher education spending, they were not alone; unified Democratic governments more than held their own. (Of the 17 states with divided government, 16 reduced higher ed spending by an average of 25 percent during the period)….

These data suggest a bipartisan national trend, not a conservative conspiracy. The vast majority of states–whether controlled by Republicans or Democrats–have cut higher education funding in response to budget deficits.

◊◊◊  Grandparents’ contribution make up about 9.5 percent of the total 529 assets

By all accounts, Grandma and Grandpa are more active than ever in funding their grandkids’ educations, including sinking money into 529 college savings plans….

By the end of 2012, American families had a record $190.7 billion socked away in 529 college savings plans, according to a March 13 report from the College Savings Plans Network. …

Parents still contribute the lion’s share of funds invested in 529 accounts. But contributions from grandparents now make up about 9.5 percent of the total, according to the most recent data from the Financial Research Corp, which tracks 529 investments. It was a substantial enough increase that FRC started keeping track of which types of relatives were funding 529s for the first time last year.

Average 529 savings reach all-time high

Average balances for 529 college savings and prepaid tuition plans grew to a record $17,174 in 2012 — up 12% from an average of $15,349 in 2011, according to a report from the College Savings Plans Network, a nonprofit and affiliate of the National Association of State Treasurers.

In December 2012, the number of existing 529 accounts increased by about 4% to 11.1 million, up from 10.7 million in December 2011. Total 529 investments reached a record $190.7 billion, up from $165 billion in 2011.

Those numbers were also helped by a strong stock market last year. In 2012, the S&P 500 soared 13%.

Is the college savings situation improving or not?

The picture painted by these numbers is rosier than the one depicted by another report of fewer families saving for college.  The discrepancy between the this story and previous one could be due to what was measured (only 529 plans vs. total college savings), source of information (plan administrators vs. parents), and focus on different years (2012 vs. 2011).  Even with this latest positive indication for college savings, there are valid reasons why many parents still “feel overwhelmed, annoyed, angry, or frustrated”.

Yet, students and their families are still struggling to keep up with rapid increases in tuition….

Average tuition paid at public community colleges and four-year colleges and universities rose by 8.3% last year, according to a recent report by the State Higher Education Executive Officers Association.

For the 2012-13 school year, the average prices for tuition, fees, room and board for in-state students at public four-year colleges and universities is $17,860, according to the College Board. And the average bill at private institutions is nearly $40,000.

College savings hits all-time high (CNNMoney)

College Savings Plans Network 2012 Year-End 529 Report

Did your 529 plan earn a gold metal?

In their annual evaluation of 529 plans, Morningstar awarded its top Gold rating to four plans.

In an annual review of the largest 529 college-savings plans, Morningstar analysts identified 27 plans that are likely to outperform their peers on a risk-adjusted basis over a full market cycle. These plans earned Gold, Silver, or Bronze Morningstar Analyst Ratings, which are forward-looking, qualitative ratings.

The 529 plans earning medals are a diverse group of direct-sold and advisor-sold plans, but all have a strong menu of investment options, solid management, and reasonable fees. The relatively large number of plans earning medals reflects meaningful improvements across the 529 industry in recent years. Very few plans still include options that have performed poorly due to weak management or extremely high fees. As such, only four of the 64 plans rated earned Negative ratings, with 33 plans earning Neutral ratings. Morningstar did not rate 22 of the industry’s smallest plans….

Gold Medalists
Among the plans earning Morningstar’s highest rating, two,  Maryland College Investment Plan and Alaska’s  T. Rowe Price College Savings Plan, feature T. Rowe Price’s topnotch investments. Morningstar has identified these plans as industry leaders for several years running because they offer high-quality active strategies at a reasonable price. The plans were largely unchanged in the past year, though each plan’s single age-based track now features more international equity and real-assets exposure, which should further diversify the plan’s returns.

The other two plans earning Gold medals from Morningstar feature passive investments from Vanguard. To be sure, indexing is increasingly common in direct-sold 529 plans like these, but fees vary dramatically from plan to plan.  Utah Educational Savings Plan and  The Vanguard 529 College Savings Plan of Nevada are well-established leaders at keeping costs low. In these plans, college savers have a number of low-cost age-based tracks to choose from that vary their asset allocation based on the savers’ risk profiles. A primary difference between these two Gold-rated plans is their respective minimum investment. While Vanguard requires $3,000 to get going in its namesake plan, Utah’s offering has no enrollment minimum.

You can start small.
If you or your child want to start saving for college but you only have a small amount to invest initially, the Utah 529 plan may be a good option.  Remember that in some cases there are tax benefits if you use your own state’s plan, but wherever you start your plan you can later exercise the option to move funds tax-free between 529 plans.

Related:  What you may not know about 529 plans (costofcollege.wordpress.com)