The Case for 529s
The Case for 529s
Throughout the years I have asked many affluent, intelligent and informed investors as to why they had not opened 529 accounts for their children. They have cited many different reasons; hidden imbedded costs, lack of investment choice, inability to use the funds prior to college, the possibility that their child doesn’t go on to college or may receive scholarships and even the detrimental effect that 529s may have on possible financial aid awards. While these are all valid concerns, none, separately or together, can overcome the immense power that tax free compound growth can deliver to your doorstep.
The Case For
I think it’s first wise to reexamine the law of 72. For those of you not familiar with this concept, allow me to explain. The law allows us to discern how long it will take a given sum of money to double given a rate of return. It assumes no future contributions nor any taxes. Take 72 and simply divide it by the rate of return for which you believe is reasonable.
72 / 10 (% which is not a reasonable rate of return) = 7.2 years to double
72 / 7 (% much more historically reasonable) = 10 years to double.
When you take the rule of 72 and add continuing contributions, the math gets crazy in a hurry. Take for example the following…
Immediately after their child is born, Mr. And Mrs. Bueno open a 529 account and fund it with $1000. They make a commitment to fund the account with $1000 per quarter or $4000 per year for the next 18 years. In addition, grandparents and other relatives are informed of the account and the ability to gift up to $15,000, tax free, per year to the newborn (this is the annual gift tax exclusion). Let us assume that these additions at birthdays and other holidays add up to another $1000 per year.
Now for the math. For a $5000 per year investment and assuming a 6% rate of return over the next 18 years, when their daughter is about to graduate from high school, her 529 will be worth $163,135.21 of which $91,000 was principal contributed and $72,135.21 was growth. The cherry on top is that the entire amount, as long as it is spent on qualified items (room and board, books, supplies, and anything the accredited college or university requires) is TAX FREE.
The Case Against
There has been quite a bit of negative press regarding expensive, hidden, embedded fees within the 529 industry. As with all investment choices, this is a cost that while unavoidable must be monitored and compared with other 529 plans. As California does not offer a tax deduction for using its own state sponsored plan, there is no reason not to shop around. At Charles Schwab and Co. Inc., costs for their 529 program range from 0.25% to 1%. At Vanguard, their 529 plan costs between 0.16% and 0.44%. Finally, Fidelity charges between 0.11% and 0.20%. Fees at or below 1% per year are entirely reasonable and you can see that there are three options listed above that are significantly lower than that benchmark.
Limited Investment Choices
That brings us to the next criticism, limited choice of investments. There is no denying that this is the case. All 529 providers will offer a range of active and passive mutual funds or ETFs from which to choose. You cannot purchase individual stocks, bonds, or alternative assets. This drives many investors away from 529s because they wish to buy their favorite stocks for their college bound child. However, there is a plethora of research that demonstrates that self-directed investors fare much worse than if they had simply indexed their investments:
Studies have shown the track record for individual investors is not encouraging. DALBAR, a leading financial services marketing research firm, released a study that showed from 1990 to 2010, the unmanaged S&P 500 Index earned an average of 7.81% annually. Over that same period, the average equity investor earned a paltry 3.49% annually.
However, for the sake of the argument let’s assume that the family in the above example was able to generate the same net 6% return over their daughter’s 18 year elementary and secondary school career. At graduation, the account would be worth $163,135.21. Now the kicker, taxes! Assuming a 15% capital gains tax rate, the account is now worth $163,135.21 – $24,470.28 = $138,664.93. Thus, for the pleasure of trading their own account and assuming they were able to match the market, which is doubtful at best in most cases, the family has given up $24,470.28 in taxes that could have been avoided had they employed a 529 account. Obviously, the math is a bit simplified as you would not liquidate the account and pay capital gains on the entire amount in year 18, but the point is that for every sale, the family is obligated to pay 15% taxes on the earnings.
Inability to use Funds Prior to Postsecondary School
Many people have bemoaned the inability to use the 529 prior to college. Thanks to the passage of the Tax Cuts and Jobs Act of 2017, clients may use up to $10,000 per year for tuition expenses at elementary or secondary, public, private or parochial schools. Thus, this criticism while not eliminated, as you can only access $10,000 per year, has been muted to some extent.
College is not in the Cards / My Kid Got a Free Ride
In the first case, your child decides that college, nor trade, nor vocational schools are for him or her. There is an account with $163,135.21 in it. What do you do now? Let’s take the most extreme example of withdrawing the money in a lump sum and paying the penalties and taxes.
$163,135.21 Total Account Value
$ 16,313.52 Less 10% penalty on the earnings
$ 25,247.32 Less 35% marginal tax rate on the earnings
While your child is not going to college, you still have a pot of gold that was allocated to college that is now freed up to the tune of $121,000 for a $91,000 investment.
Less extreme options include changing the beneficiary to another family member who would be able to take advantage of the tax free savings for qualified expenses. You could also change the beneficiary to yourself should you decide to pursue that long sought after masters degree or your child may ultimately decide to pursue his or her education after all. The point is that there are many options for dealing with the 529 should your child not go to college.
In the event that your child receives a full scholarship to the school of his or her choice, the 10% penalty is waived and you would only pay taxes on the earnings.
Impact on Financial Aid
One of the many criticisms I hear regarding 529s is their detrimental impact on a student’s ability to access financial aid. Let’s examine the worst case scenario again, using the example from above. From the example above, the family owns their daughter’s 529 worth $163,125.21. The FAFSA allows them to deduct around $20,000.00 of 529 savings from their calculation (the Parent’s Education and Savings Allowance Deduction https://studentaid.ed.gov/sa/sites/default/files/2017-18-efc-formula.pdf). That leaves us with $143,125.21 to declare. Their total financial aid package is then reduced by a maximum of 5.41% of this amount which is $7156.26 in reduced aid. However, if the parents had eschewed the 529 in favor of a custodial UGMA/UTMA account that they had funded and allocated over the years, the account is treated as a student asset and reduces aid by 20% of that account value (https://www.savingforcollege.com/article/yes-your-529-plan-will-affect-financial-aid). Thus, the argument against 529s really boils down to the following statement “I would rather borrow and hope for grants rather than have a tax free dedicated source of college funding for my student.”
The 529 despite all of its restrictions, is one of most powerful savings tools available to you and your family to plan for your child’s education. The ability to compound contributions and disburse monies tax free in my opinion, overrides any of the various criticisms of the account structure. I would advise all of my clients to carefully consider using a 529 as part of their education funding plans.
At Marin Wealth Advisors we can help you with education funding as well as holistic wealth management including but not limited to, investment allocation, financial planning, estate planning, tax planning, stock compensation and social security optimization.
For additional resources on 529s please see the following…
https://studentaid.ed.gov/sa/sites/default/files/2017-18-efc-formula.pdf for the Expected Family Contibution (EFC) formula.