On June 1, 2016, Wealthfront announced its new 529 College Savings Plan. This post is the first in a 3-part series updating our previous advice on saving for college using 529 plans. This post is based on an original 2012 post by Jeff Rosenberger, PhD.
For most households, the birth of a child represents a wide range of conflicting emotions and new found responsibilities. From an investment standpoint, it is at this moment that many parents confront a familiar, and yet suddenly urgent financial goal: how to save for the ever-increasing financial burden of a college education.
Saving for college can be a daunting financial goal. If you have a newborn daughter, you’ll need roughly $540,000 to pay for her engineering degree at Stanford, or $240,000 for a philosophy degree at UCLA.
College costs can rapidly overwhelm even the most optimistic saver, especially in the case that the family is saving for more than one child.
When it comes to saving for college, there are five important questions:
- How much should I save?
- On what schedule?
- In which kind of plan?
- Which state 529 plan?
- What underlying investments should I pick?
At Wealthfront, we care deeply about helping parents navigate saving and investing for college. As with most financial goals, it is best to start sooner rather than later, and the best way to start is with learning more about your options.
Questions 1 & 2: How much should I save & on what schedule?
The short answer to the first question, as you’ve guessed, is that college education will require substantial savings. However, the second question directly affects the answer to the first. The schedule you decide to use directly affects the amount you need to save for your child’s college education. To understand why requires understanding a bit more about the way compounding affects the growth of your investments over time.
When you save for college, there are two basic choices that frame the issue: either save a fixed amount every month, or put aside a large lump sum at the start. In real life, many families decide to implement some combination of the two, but looking at each individually provides a simpler way to understand why the difference in schedule matters.
The chart below gives you a sense of the different results of the two approaches.
Whether you begin with a lump sum or a monthly savings discipline, the investment accounts will start increasing 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.
The future amount required is calculated by taking this year’s tuition, fees, room & board and applying 4% annual inflation (higher education inflation on average is approximately 2% higher than the average increase in the Consumer Price Index). The lump sum required now is the amount needed to invest this year assuming 4.7% investment returns, which is the average net-of-fee annual expected return for Wealthfront 529 risk score 9.0 investment plan, to meet the future amount required at matriculation (See disclosures below). 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.
As a result, you can see the difference in the total cash required for each approach. In the example of the Stanford degree, you either need to save $1,550 over 216 months, a total of $334,704. But if you are starting with a lump sum, you can reach the same goal with $222,761 today.
Question 3: What kind of account or plan should I use?
As if the goal of saving for college wasn’t daunting enough, the answer above ignores one of the more complicated and costly issues in regards to investments: taxes. 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.
Most people find that it makes sense to take advantage of one of the three investment vehicles outlined below.
The 529 Plan
The ideal plan for college savings is usually the 529 plan because of its superior tax benefits and relative flexibility. You invest money into the plan; the money grows tax-free; when your daughter is ready for school, you sell the investments, withdraw the money tax-free, and use it to pay for tuition, fees, books, and room and board – even computers and software.
529 plans are considered assets of the parent, which means that as the owner of the account you have complete control over when and how the money is withdrawn. This classification also allows you to change beneficiaries, and can significantly reduce the potential impact on financial aid compared to accounts in a child’s name.
If you decide for any reason not to use the account for college-related expenses, you will owe taxes on the earnings, plus a 10% penalty, when the money is withdrawn.
529s must be sponsored by states, state agencies or educational institutions, which generally contract with investment companies to provide the investments. States often share in the fee revenue charged to administer 529 plans and many states of small population size generally leverage plans sold nationally to reach scale which can help ensure a low cost, high quality plan is available to its residents. For example, the Wealthfront 529 is sponsored by the State of Nevada, but if you reside in Rhode Island and wish to send your child to college in Minnesota, you can still invest in the Wealthfront 529 Plan sponsored by the State of Nevada.
Some 529 plans are classified as “prepaid tuition plans,” which allow parents to invest funds for tuition up front at the current rate at the time of investment for a specific in-state school. These plans have the advantage of allowing you to lock in today’s in-state college tuition costs, but typically cannot be used for any other expense besides tuition, so by nature are less flexible. This is why Wealthfront’s 529 College Savings Plan is a post-paid college savings plan, so the money invested can be used for Qualified Higher Education Expenses at any eligible institution, in any state – no matter which state sponsors the plan.
Some states also offer a state income tax deduction, but often only if you contribute money to a plan sponsored by that state. You should consider many factors before deciding to invest in a 529 plan such as the plan, including the plan’s investment options and its performance history, the plan’s flexibility and features, the reputation and expertise of the plan’s investment manager(s), the plan’s contribution limits, the plan’s fees and expenses, and federal and state tax benefits associated with an investment in the plan. Unfortunately, many states featuring these tax deductions may also have higher fees. For more information on various state plans, please refer to the Wealthfront 529 whitepaper.
One of the most powerful features of 529 plans is the ability to make large, tax-advantaged lump sum investments, sometimes referred to as “superfunding.” You and your spouse each can invest five times the annual gift tax limit of $14,000 (or a total of $140,000 per child, per couple), as long as you file a gift tax return to elect to treat this as a gift over five years. As a result, investors can get a significant “head start” on hitting college savings goals utilizing 529 accounts.
Coverdell Education Savings Accounts (Coverdell ESA), like 529s, can only be used for qualified tuition expenses. They lack the flexibility of custodial accounts (described below), 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 can seem low in major metropolitan regions. The earnings are subject to tax and a penalty if the money is used for something other than educational expenses.
Custodial Accounts (UGMA / UTMA)
Custodial accounts established under the 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. Unlike 529 plans and Coverdell ESAs, the assets in custodial accounts do not grow tax-free, but because the UGMA or UTMA account is in your child’s name, the earnings probably will be taxed at a lower rate. You should check with your accountant to confirm.
There are three significant downsides to these accounts. First, 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). Second, they are included in federal student aid calculations, which can lower your aid. Third, 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.
Question 4: Which 529 plan to choose?
Assuming you’re going with a 529 plan 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.
Some of the main factors you’ll want to consider 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
The Wealthfront 529 White Paper lists the 33 states plus the District of Columbia 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, but only as so far as the contribution limit that qualifies for the deduction. In most cases, those contribution limits are relatively low.
California, for example, does not offer a deduction. New York, on the other hand, offers a state income tax deduction on contributions of up to $5,000 per individual or $10,000 per couple per year. In both cases, investors who want to save with a 529 are free to survey the nation for the best combination of fees and investment choices to meet their needs.
Fees on 529 plans can vary significantly, especially between advisor-sold and direct-sold plans. The current Morningstar report states that the asset-weighted average fee is 1.13% for an advisor-sold plans and 0.39% for direct-sold plans.
Advisor-sold plans are delivered with personalized financial advice and employ portfolio strategies that often include active management. As a result, they typically charge higher fees than direct sold plans, which offer no advice or personalization and tend to offer portfolios that feature low cost funds.
There are two kinds of fees in a 529 plan:
- Administrative fees. These are charged by the states or the financial services firms hired by the states to provide the investments
- Investment fees. These can be commissions (loads) and distribution fees, which are similar to 12b-1 fees used by mutual funds
The Wealthfront 529 is unique in that it provides features normally associated with expensive, advisor-sold plans, but with fees comparable to direct-sold plans.
Question 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. We advise you to 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 many plans you’ll find age-based options that automatically adjust as your child gets closer to college, comprised of allocations to stocks, bonds and cash in varying proportions.
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.
Unfortunately, many of the direct sold 529 plans that offer index funds only offer between one and five different asset classes, and often only one to three different glide paths for different levels of risk. Worse, they tend to look only at the age of your child, instead of also taking into account your own personal financial situation and risk tolerance.
The Wealthfront 529 offers nine different asset classes and 20 different glide paths, selected for the investor based on the risk tolerance of the investor. The benefit of utilizing more asset classes is substantial and our research suggests that utilizing nine properly chosen relatively uncorrelated asset classes can result in an additional annual risk-adjusted return of approximately 0.60% over the long term compared to a three asset class portfolio.
Saving for College? Start Now.
Saving money towards a college education fund so your children can go to schools they choose is one of the best gifts you can give. Start now, keep one eye on the tax rules, choose your investments to minimize the fees and maximize the risk-adjusted return.
For more information about the Wealthfront 529 College Savings Plan (the “Plan”), download the Plan Description and Participation Agreement (to be made available on Plan launch) or request one by calling or emailing email@example.com or (650) 249-4250. Investment objectives, risks, charges, expenses, and other important information are included in the Plan Description and Participation Agreement; read and consider it carefully before investing. Wealthfront Brokerage Corporation serves as the distributor and the underwriter of the Plan.
Please Note: Before investing in any 529 plan, you should consider whether you or the beneficiary’s home state offers a 529 plan that provides its taxpayers with favorable state tax and other benefits that are only available through investment in the home state’s 529 plan. You also should consult your financial, tax, or other advisor to learn more about how state-based benefits (or any limitations) would apply to your specific circumstances. You also may wish to contact directly your home state’s 529 plan(s), or any other 529 plan, to learn more about those plans’ features, benefits and limitations. Keep in mind that state-based benefits should be one of many appropriately weighted factors to be considered when making an investment decision.
The Plan is administered by the Board of Trustees of the College Savings Plans of Nevada (the “Board”), chaired by the Nevada State Treasurer. Ascensus Broker Dealer Services, Inc. (“ABD”) serves as the Program Manager.
Earnings on nonqualified withdrawals are subject to federal income tax and may be subject to a 10 percent federal tax penalty, as well as state and local income taxes. The availability of tax and other benefits may be contingent on meeting other requirements.
The information contained is provided for general informational purposes and should not be construed as investment advice. Nothing should be construed as tax advice, solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront clients. Wealthfront does not represent in any manner that the tax consequences described here will be obtained or will result in any particular tax consequence.
Prospective investors should confer with their personal tax advisors regarding the tax consequences of investing with Wealthfront, based on their particular circumstances.
The calculation for projected returns is a hypothetical calculation base on backtested data, i.e., a retroactive application of Wealthfront’s investment methodologies. Backtesting has the inherent limitations of not representing actual trading and not reflecting the impact that material economic and market factors might have had on the Wealthfront’s decisionmaking if Wealthfront were actually managing clients’ money at that time. It also does not take into consideration the effect of changing risk profiles or future investment decisions. Several processes, assumptions and data sources were used to create one possible approximation of how a Wealthfront 529 plan might have benefited investors in the past, and a different methodology may have resulted in a different outcome. The results of this simulation should not be relied upon for predicting future performance and is not a guarantee of actual performance.
The return data presented is based on an average Wealthfront high net worth client. The average Wealthfront high net worth investor has a liquid net worth greater than $1 million and a risk score of 7.5 for a static investment plan, i.e., without a glide path. The 529 glide path investment plan with approximately equivalent risk (as measured by average expected volatility) is risk score 9.0, which has an average expected return of 4.7% over 18 years.
Actual investors in Wealthfront may experience different results from the results upon which we based our calculations. There is a potential for loss as well as gain that is not reflected in the hypothetical information portrayed. Investors evaluating this information should carefully consider the processes, data, and assumptions used by Wealthfront in creating its historical simulations.