529 Plans and Saving For College

When it comes to saving for college, there are five important questions:

  1. How much should I save?
  2. On what schedule? 
  3. In which kind of plan? 
  4. Which state 529 plan? 
  5. What underlying investments should I pick?

Based on the fact that you’re reading this blog, you likely already know how important it is to save for your kids’ college education. You may have already started the process. If you have a newborn daughter, you’ll need roughly $490,000 to pay for her engineering degree at Stanford, or $240,000 for a poli sci degree at UCLA, assuming higher education costs increase by 4% a year.

Multiply that by two or three to take into account your other (future) children, and the amount seems pretty overwhelming. You’re shaking your head no. Even if you’re growing one of those great tech careers we’ve been writing about, the amounts still loom large.

We can’t lower the totals for you, but we can give you some clear answers about a great way to reach your goal. In fact, if you want to skip the rest of this post, the bottom lines are as follows:

• If you can afford to invest a lump sum, research and the magic of compounding suggest it’s better to begin with a large amount than to invest regularly over a long period of time. (But talk to your accountant to ensure you don’t trigger gift tax problems).

• A 529 plan is the best college savings vehicle for most people because of its tax advantages and the flexible rules that govern what your child can spend the money on.

• If you are a California resident, one good 529 plan is the plan sponsored by Nevada and run by Vanguard. (We’ll explain below why Californians end up investing in a plan sponsored by Nevada and run by a national investment company).

You can take those three valuable insights and walk away now. If you’re a glutton for punishment and/or you want to better understand college savings funds, read on.

1. & 2. How much should I save…On what schedule?

You have two choices: put aside a lump sum or save a monthly amount, or some combination of the two.

The chart below gives you a sense of the different results of the two approaches. This assumes your daughter won’t get financial aid. You can play around with the costs of other colleges using this calculator.

Whether you begin with a lump sum or a monthly savings discipline, the accounts will start increasing significantly after a few years, barring a major slump in the market.  In theory, if you begin with a lump sum, the amount will grow faster, because you will have more years to compound. The latest research from Vanguard suggests there’s another reason that beginning with a lump sum is better: Markets generally trend upward over time. So if you invest in a diversified portfolio to improve your risk-adjusted returns and you have enough time to ride out the ups and downs in the market, the money that you put in earlier will multiply faster over the longer time period.

Lump Sum vs. Monthly Savings
School Type 2012-2013 Tuition + Room & Board Future Amount Required Lump sum Required Now Monthly Savings Required Over 18 Years
Stanford
(Private)
$54,506 $468,891 $164,273 $1,100
UCLA
(Public)
$26,894 $231,357 $81,054 $543
The Future Amount Required is calculated by taking this year’s tuition, room & board and applying 4% annual higher education inflation. The Lump Sum Required Now is the amount needed to invest this year assuming 6% investment returns to meet the Future Amount Required at matriculation. This compares to the Monthly Savings Required if you can’t invest via lump sum and instead contribute the same amount every month to meet the goal.

3. What kind of plan?

The problem with this analysis (sorry, there is a problem – finances are never that simple) is that it does not take taxes into account. The good news is that federal and state governments offer significant tax breaks for saving for your children’s education. The bad news is that the tax breaks are complicated, and vary depending on which type of account you use and in which state you live.

First, a little background on the gift tax rules.

You and your spouse can each give $13,000 to each child annually with no tax consequences. The $13,000 increases periodically based on inflation adjustments. You may count the amount you gift above $13,000 annually against your lifetime gift tax exclusion of $5,120,000. This lifetime allowance is scheduled to drop to $1 million, though Congress may increase it as part of this year’s tax negotiations.

As an aside: If you are wealthy enough, you can simply pay your daughter’s tuition, room and board directly to Stanford or UCLA. The amounts do not count as gifts.

Most people find that it makes sense to take advantage of one of the three investment vehicles outlined below.

529 Plan

The best plan for college savings is almost always the 529 plan because of its great tax benefits and relative flexibility. You put money into investments within the plan; the money grows tax-free; when your daughter is ready for school, you sell the investments, and she uses the money to pay for tuition, fees, books, and room and board – even computers and software. (See our previous post on situations where 529s don’t make sense).

If it turns out she doesn’t go to college, or doesn’t want to use the money for one of the other educational purposes that is permitted, she will owe taxes on the earnings, plus a 10% penalty, when the money is withdrawn.

529s can be sponsored by states, state agencies or educational institutions, which generally contract with investment companies to provide the investments. States make money by offering the plans, because they charge fees to the participants. Because it’s in their best interests to increase the amount of assets in the plans, they open them up to people nationwide. So, Californians can invest in a plan from Missouri, or Georgia or Nevada – anywhere.

There are two kinds of 529s: prepaid tuition plans and college savings plans. Prepaid tuition plans require you to use the money for a specific institution or institutions in a specific state. (If you’re dead certain your daughter will abide by your wishes and attend college in, say, Virginia, then by all means go ahead and use a prepaid tuition plan from that state.)

The money in a college savings plan can be used at any institution, in any state – no matter which state sponsors the plan. The Securities and Exchange Commission offers a good primer on 529s here.

Some states also offer a state income tax deduction, but usually only if you contribute money to a plan sponsored by that state. Some states cap the size of 529s. So if your daughter’s plan grows to $320,000, Texas, for instance, won’t allow you to make further contributions, though the plan may continue to grow.

One final note: 529s have a special tax feature to allow lump sum investing. You and your spouse each can invest five times the annual gift tax limit of $13,000 (or a total of $130,000), but must file a gift tax return to elect to treat this as a gift over five years.  You can also apply the excess over your combined annual gift amount against your lifetime gift allowance ($130,000 – 2 x $13,000).

Coverdell ESA

Coverdell Education Savings Accounts (Coverdell ESA), like 529s, can only be used for qualified tuition expenses. They lack the flexibility of UGMA/UTMAs. But they offer tax advantages where your income and capital gains accumulate tax free and can be used for qualified education expenses (i.e. tuition, fees, books, and room and board) when your child goes to college. Coverdell ESAs are generally inferior to 529s, because they have much lower contribution limits ($2,000 a year) and phase out your ability to contribute at income levels that aren’t that high in the major metro regions. The earnings are subject to tax and a penalty if the money is used for something other than educational expenses.

UGMA/UTMA

Uniform Gifts to Minors Act (UGMA) and/or Uniform Transfers to Minors Act (UTMA) provide you with a fairly straightforward way to transfer assets to your children. These accounts provide flexibility because they can be used for any purpose and not just educational expenses. The assets in them do not grow tax-free, as in 529s and Coverdell ESAs, but because the UGMA or UTMA account is in your child’s name, the earnings probably will be taxed at a lower rate, though you should check with your accountant to confirm.

Three downsides to these accounts are that they are irrevocable so the child can do whatever they want with them when the account legally becomes theirs (this age can vary by state, but typically 18); they are included in federal student aid calculations; and income on the accounts is subject to annual taxes. The benefits of these accounts are their flexibility (e.g., your child could use the funds for a down payment on a home one day) and they are easy to open.

4. Which state 529 plan?

Assuming you’re going with a 529 for your college fund – which makes sense for many people because the assets grow faster if they are growing tax-free – you next must decide which state plan to use.

This Morningstar site includes information on 529 plans from the 50 states.

You’ll want to consider three factors when making the decision: whether your state offers an income tax deduction, what the fees are in the plan, and what the underlying investments are.

Income tax deduction

Publisher FinAid offers a list of 34 states that offer state income tax deductions for contributions to 529s – but remember, generally, the deductions are only available to state residents who contribute to that state’s plan. Please check with your accountant, as state laws change frequently.

The value of a state income tax deduction typically trumps other factors, including the amount of the fees and the quality of the underlying investments.

California, where many of our clients live, does not offer a deduction. Californians who want to save with a 529 are free to survey the nation for the best combination of fees and investment choices. So if you’d like to do that, feel free. If not, consider our rationale below for choosing the Vanguard plan through the state of Nevada.

Fees

529 plans are either sold directly to the public or through brokers or investment advisors. Those sold through brokers or investment advisors have higher fees. There are two kinds of fees on a 529 plan:

• Administrative fees, charged by the states or the financial services firms hired by the states to provide the investments, and

•  Fees on the underlying investments. These could be commissions (loads) and distribution fees, which are similar to 12b-1 fees used by mutual funds.

The largest 529 plan in the country is Virginia’s, which has over $30 billion in assets. Why is the Virginia plan so big? Probably because it is administered by American Funds and distributed through motivated brokers who collect distribution fees annually from American Funds for getting you to invest. While you could do worse than the American Funds in terms of investment quality, investors in this plan will generally pay four times higher annual fees for their portfolios than the lowest cost plans that employ index funds. This is a bad tradeoff.

For Californians, we like the Vanguard 529 College Savings Plan provided direct from Vanguard and sponsored by Nevada. It has a minimum initial investment is $3,000 and a contribution limit of $370,000. It charges no enrollment, transfer or commission fees, though it has a $20 maintenance fee on balances below $3,000.

5. What underlying investments do I pick?

Once you’ve decided which 529 plan to use, you’ll face the question of how to invest money within the plan. A broker or advisor may try to steer you into actively managed mutual funds. Steer clear. Research shows actively managed funds are a bad proposition inside or outside a 529.  On average, equity index funds outperform comparable mutual funds by 2.1% per year, primarily because of the mutual funds’ high fees.

Instead, look for index funds and other low-cost, passively managed plans. Within the Vanguard plan you’ll find 22 different investment options, all managed by Vanguard: Three age-based options that automatically adjust as your child gets closer to college, and 19 portfolios that have allocations to stocks, bonds and cash in varying proportions. The fees are low, ranging from 0.25% to 0.55% depending on the investment option.

If you put money into one or more of the 19 do-it-yourself portfolios, you’ll be responsible for managing the investment mix as your child ages, to reduce the risk as college grows closer.

The age-based portfolios are constructed like target date retirement funds, in that they reduce exposure to stocks over time as you approach the drawdown period. You’ll start out with a mix of asset classes based on your child’s age. The younger the child, the higher the allocation to stocks. As your child gets older, the fund automatically adjusts, so that when your daughter is, say, 16, the portfolio will be weighted toward bonds and cash.

In other words, your portfolio is automatically rebalanced and reduces investment risk over time.

The argument for investing in one of the 19 portfolios that offers you more control is they could be used as a vehicle for investing for more than one generation or family member. (A 529 plan may be transferred tax free from one family member to another: Check out this IRS information if you’re interested.) In the Vanguard direct plan, you could assemble the risk allocations to meet your needs. For example, you could mix the Vanguard Aggressive Growth fund which is 100% stocks (US and foreign) equally with the Vanguard Growth fund which is 75% stocks and 25% bonds to get a portfolio that is 87.5% stocks and 12.5% bonds, which would be suitable for multiple generations of education.

Note that this approach only makes sense for a small part of the population that anticipates they can exceed their kid’s college tuition costs and plan to invest past that horizon for them to use their 529 for their children’s children’s college education and compound tax-free over the 30-ish years in between.

The Bottom Line

Saving money towards a college education fund so your children can go to schools they choose is one of the best gifts in your power to give. Start now, keep one eye on the tax rules, choose your investments to minimize the fees and maximize the risk-adjusted return. You and your children will be on your way.

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12 Responses to “529 Plans and Saving For College”

  1. Rick Foreman November 30, 2012 at 3:14 pm #

    Unqualified 529 distributions are actually more onerous than they may appear. If you withdraw 529 funds without using them for eligible education expenses, any withdrawn gains are subject to ordinary income tax at your individual tax rate (federal and state), regardless of when the contributions were made or how long they were held. They are not considered capital gains, even though the gains may have accumulated over years. That’s in addition to the 10% unqualified distribution penalty. To add insult to injury, if you live in a state that had a tax deduction for 529 contributions, you’ll also owe ordinary income tax on the recaptured amount.

  2. Ram December 2, 2012 at 5:41 pm #

    Great info Andy. Do you have any advice for residents of WA state?

    • Elizabeth MacBride December 2, 2012 at 10:01 pm #

      Most of the information in the post applies to everyone. To make a decision about which state 529 plan to use (if you decide to use a 529 plan) you’ll want to investigate if Washington allows you to deduct 529 contributions into its own plan. This chart is a good place to start. If you live in a state that does not allow deductions for 529 contributions, Nevada’s plan is one good option.

  3. Eytan Seidman December 18, 2012 at 6:17 am #

    Hi Jeff,

    This is a really good piece on understanding all of the ins and outs of 529 plans.

    One thing, however, that I don’t quite follow is why you recommend to California residents to use the Nevada plan rather than the New York plan?

    It seems to me that the New York plan is cheaper and better along every dimension:
    * It has a a much lower minimum initial contribution
    * On aged based options it has an expense ratio of 0.17% vs. 0.25% for Nevada
    * On static options it has an expense ratio of 0.17% vs. as high as 0.50% for Nevada

    You can see more details here: https://personal.vanguard.com/us/whatweoffer/college/finda529?Link=facet

    • Elizabeth MacBride December 18, 2012 at 10:01 am #

      Hi Eytan,

      Great question and point. We think the direct plans from Nevada and New York are both very good plans and investors should fare well with either.

      New Yorkers should benefit from the tax advantages of the New York plan in addition to the low costs of the plan.

      We recommended the Nevada plan to Californians for the reasons mentioned above and the fact that the plan is administered directly through Vanguard’s website. Could Californians or other non-New Yorkers do well in the New York plan given the really low costs and the lower minimum contribution? Definitely.

      Thanks for bringing this to the discussion.

  4. Sam Tazi December 19, 2012 at 11:21 pm #

    Great article – thank you (I am a CA resident)
    529 plans are excellent option for higher education, but do not allow to pay for private lower education (elementary and high school). My kids are 8 and 4 y.o., I am planning to open a 529 plan for them (definetly considering Nevada and New York now!), but since they are going to private school, I am considering to also open on top of that coverdell accounts for them (even if it is only $2K per year), it is still better then nothing to help pay a portion of their private schooling tax free. Do you have any recommendations on good Coverdell ESAs?

    • Kevin Peterson December 21, 2012 at 11:05 am #

      It actually looks like Coverdell ESAs may be an even poorer solution compared to 529s going forward. It turns out that most of the rules around these accounts were covered by a law that expires this year and has not been extended. From what I can gather, it looks like starting in 2013, the contribution limit will fall from $2000 to $500, there will be a 6% penalty if you contribute to both a Coverdell and a 529 in the same year, and (this is probably a dealbreaker for you) they’ll lose their additional flexibility of allowing qualified K-12 expenses. My kids have Coverdell ESAs and I’m probably going to wait and see what comes out of Congress between now and April before making any more contributions. If the change sticks, I’m going to look into rolling them over into 529 plans.

      For your googling convenience, those were part of the Economic Growth and Tax Relief Reconciliation Act of 2001 and extended through 2012 by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010

    • Elizabeth MacBride December 22, 2012 at 7:00 pm #

      Thanks! We don’t have specific recommendations for Coverdells. Many banks and brokerages offer them. As of Dec. 22, Congress had not yet acted to renew laws passed in 2001 and 2003 that made Coverdell plans appealing for K-12 saving. Vanguard offers a chart that shows what will happen if the laws aren’t renewed.

  5. Tony September 16, 2013 at 11:16 pm #

    Have you considered Roth IRA as a savings vehicle? It can be used for educational purposes within the family members as well as gives you the freedom to apply towards your own retirement if your kids do not go to school.

    However there are also some drawbacks,

    1) You can’t withdrawal more than the contribution towards education without penalty
    2) You’re capped every year by the IRA max unless you backdoor, or use an after 401k to convert to Roth every year ($50k limit)

    It’s takes a bit more thought, but can offer yet some more flexibility.

    • Andy Rachleff September 18, 2013 at 10:40 am #

      It’s not nearly as compelling as a 529 if you end up using it to fund a college education.

  6. Rich October 21, 2013 at 5:24 pm #

    The question on WA state residents is actually a bit more complicated. The WA 529 plan does not allow you to choose an investment vehicle. Returns are pegged to the price of tuition at the University of Washington. You buy “tuition credits”. The idea is that you could buy 4 years’ worth of tuition today, pay what a freshman would pay today, but enroll in 20 years.

    I live in WA, and have bought 2 years’ tuition for my kids in this program. I’m now using a different state’s 529 to fund the rest.

  7. Darin Jones November 22, 2013 at 6:41 am #

    Jeff,

    Great article. This can be a complicated topic for parents, especially the tax issues.

    I also found this. A very comprehensive and non-commercial 529 Guidebook. It is also printable. Very well done.

    http://www.affordablecollegesonline.org/financial-aid/529-college-savings-plan-online-guidebook/

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