Saving For College The Wrong Way
The standard recommendation for college savings is to open a 529 plan. Rarely do you see important limitations explained and, in some cases, you can over allocate to 529 plans. Let’s review.
First, what is a 529? These are plans that are run as state programs and each state has its own plan(s). Contributions are deductible at the state level (in some cases), investments grow tax deferred, and can be withdrawn tax free for qualified education expenses at accredited institutions in the US and abroad. This includes community colleges and technical training programs. Broadly speaking, these are generous tax benefits and for any parent starting their savings journey, 529s are probably the best starting point. However, we often see people who have focused solely on the benefits of these plans and are not aware of the drawbacks.
Spending limitations
The IRS defines qualified education expenses as amounts paid for tuition, fees and other related expenses for an eligible student that are required for enrollment or attendance at an eligible educational institution. Sounds pretty straightforward. However, many other expenses that most people associate with sending a child off to college are not eligible. The new laptop? Only if it is explicitly required for a class. Furniture for the dorm room? Not eligible. Plane ticket home for the holidays? Also not eligible. If all of your savings is tied up in a 529, you are setting yourself up for some unexpected college expenses that will need to be paid out of pocket.
Age based allocations
While you can select your own investments, most people opt for an age-based allocation that gets progressively more conservative as college approaches. That is appropriate but many plans reduce risk dramatically - as early as age 15 - dropping stock exposure to 20% or less in some cases. For a 15-year-old whose final tuition payment is not due for 7 more years, that could be overly conservative. If you are directing savings into a 529 for a high schooler, be aware of the underlying allocation. Tax free growth is attractive. However, you are not going to see much growth on a portfolio that is largely invested in cash and bonds.
Fees and expenses
Understandably, people seek college planning advice from financial professionals. Unfortunately, 529s are sold as a product and most advisors take a commission on the investment in the plan. What’s the problem? The commissions on the plans can be significant (5.5% up front or 1% ongoing plus additional administrative fees). For an account that requires no management (the target date funds rebalance themselves), and little more than a few minutes of paperwork, that is expensive. Conversely, all states have plans that are available direct to consumer. In virtually all cases, the administrative fees are lower or non-existent and there are no commissions. We have always recommended the consumer direct plans but we are in the minority. We often see new clients from other advisors with expensive plans that involve thousands of dollars a year in unnecessary fees.
What if you do not use it?
What if your child is a gifted entrepreneur, obtains scholarships, or simply does not pursue a college education? While there are exceptions, if you distribute the funds for non-education purposes you will pay ordinary income tax plus a 10% penalty on the gains.
529s do offer some flexibility for certain situations but it is limited. First, you can change the beneficiary so conceivably you can shift the fund from one child to another (or even to yourself). There is also an exception for scholarships but it only waives the 10% penalty. While you don’t forfeit the money, the taxes and penalties can be significant. Thankfully, a recent change to the law called SECURE Act 2.0 provides more flexibility for 529 plan assets. Beginning in 2024, account owners will have the ability to move unused funds from the 529 to the plan beneficiary's Roth IRA. This is an excellent new feature but it is not a panacea. It has a number of limitations one needs to consider, which are outlined here. Bottom line; it is an improvement but it does not fully address the issue.
Let’s review an actual client scenario. A couple saved aggressively for their five children with the help of their parents (the children’s grandparents). Though we eventually stopped saving into the 529s, they made contributions early and often. As a result, each child had roughly $150,000 set aside for their respective educations. Their oldest is a skilled computer programmer and was determined to pay his own way. He graduated without using any of his college savings. His next three younger siblings have either received full scholarships or significant partial scholarships. None withdrew a material amount from their accounts. We are hoping the youngest attends Stanford for undergrad, pursues an MBA, and then goes to medical school. Joking aside, this client has close to $700,000 in 529 accounts (they have continued to grow while the kids are in school). Even if their youngest does spend a large amount, they have at least $500,000 that is somewhat trapped in the 529 accounts. It could be earmarked for grandkids that are not yet born and are roughly 30 years off from college, or it could be withdrawn. If they were to withdraw the funds, the current state and federal tax rate is approximately 41% plus any applicable penalties. This is not what they had in mind when they started saving for college many years ago.
What should you do?
- If you work with an advisor, determine what kind of fees you are paying on your 529 accounts. An easy way to determine that is to look at a statement. If your investments have an A or C next to them you are paying a commission (i.e., Investment is labeled ABC US Growth Fund – A).
- Consider shifting a portion of your savings to a brokerage account as your children get older. You can invest in broad based, tax efficient index funds that generate limited current year tax obligations. Moreover, funds can be used for any purpose (education, retirement, other spending). You pay capital gains when investments are sold. That rate is between 0% and 23.3% but is 15% for the majority of consumers. Far less than the cost of exiting an unused 529.
- Keep in mind that paying for college costs is a multifaceted solution. Most parents take 529 distributions, pay bills from their regular cash flow, tap other investments, and have a range of other options including student loans, work study, scholarships, and grants. The 529 does not have to be the only tool in the tool box.
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This is not a recommendation and is not intended to be taken as a recommendation. This material was prepared for general distribution and is not directed to a specific individual.
LPWM LLC does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisers.
