529 Series, Part 2: The Benefits of Superfunding

On June 1, 2016, Wealthfront announced its new 529 College Savings Plan. This post is the second in a three-part series updating our previous advice on saving for college using 529 plans. This post is based on an original 2014 post by Adam Nash.

One of the largest financial obligations that many parents decide to take on is funding their child’s college education. With the current four-year cost of a California public education at UCLA at $136,000 and a private education at Stanford at $267,000, this can be a daunting task even for professionals with high-paying careers.

The 529 plan is the most popular of several deferred savings plans for college. While contributions to a 529 plan are not deductible for federal purposes, capital gains and dividends compound tax free, and no federal taxes are owed so long as funds are used to cover qualified higher education expenses, such as college tuition and room and board at any eligible institution.

Many parents choose 529 plans because of their large annual contribution limits (up to $14,000 per parent per beneficiary per year). However, there is a special feature of 529 plans that can be particularly interesting to parents deciding what to do with a large windfall.

Beyond Funding to Superfunding

Unlike retirement savings, which potentially have decades to compound and grow, parents are typically limited to at most about 18 years before their first bills come due for their child’s college education. To help compensate for this, the 529 plan supports a unique feature which allows you to pre-fund up to five years of contributions gift tax-free. This capability is commonly known as superfunding.

Superfunding dramatically increases the amount you can start a 529 plan with without incurring federal gift taxes. Instead of the $14,000 per year annual gift tax exclusion limit, each parent can pre-fund up to $70,000 (5 x $14,000). Together, that means parents can open a 529 plan with $140,000. Obviously, that’s a tremendous amount to allocate to a savings plan up front, but the benefits are numerous in situations where it’s possible. That’s why we made sure to design the Wealthfront 529 College Savings Plan with superfunding as a standard option.

Superfunding Maximizes Compounding

The key benefit of superfunding a 529 plan is the account gets the full benefit of compounding over the 18-year period.

Let’s compare the benefits of pursuing a 529 plan with $140,000 saved evenly over 18 years (starting with the day the child is born), and one where $140,000 is deposited up front with no follow-on contributions. To perform the analysis we assume the annual expected returns associated with the Wealthfront 529 College Savings Plan for a client with a 9.0 risk score, which is projected to average 4.7% over 18 years (see disclosure below).

In both cases, a total of $140,000 would be contributed to the 529 plan. However, the amounts saved for college would be dramatically different. Despite the fact that no additional contributions would be made to the superfunded 529 plan, the total amount available for college expenses at the end of 18 years could be 47% higher ($327,188 / $222,586) in this example.

Benefits from a Behavioral Finance Perspective

The superfunded 529 plan has other benefits besides taking advantage of compounding over a longer period of time. Research shows that you can increase your future wealth by taking advantage of commitment devices, which are ways to lock yourself into a good course of action today and stop your behavioral self from making poor choices in the future. If you do know you can afford it, then superfunding can be an effective commitment device because it requires making only one large deposit, avoiding the decision fatigue — and possibility of giving up altogether — implicit in trying to stick to an 18 year saving program.

As a tip, superfunding a 529 plan tends to be easier to absorb from a mental accounting perspective if you think of it as assigning a portion of a past windfall to an explicit and desirable future goal: your child’s college education. But remember that you should only contemplate superfunding if you are certain you are not going to need the cash.

Issues to Consider

There are a few additional issues to consider before superfunding a 529 plan:

• Liquidity. Can you really afford to take $140,000 and lock it away in a tax-deferred account for 18 years? This can be possible in windfall situations, but the penalties for pulling out the money for non-college expenses are significant.
• Commitment. How confident are you that your children will want to go to college? 529 plans allow you to switch beneficiaries without penalty within certain parameters, but if your child decides to take a different path post-high school, or you decide not to fund their choices, the costs could outweigh the benefits.
• Plan Selection. The Wealthfront 529 College Savings Plan has low cost investment options, but there are other 529 plans with fewer fund choices and higher fees. Superfunding a 529 plan, with fewer investment options and higher fees, can be less effective. If you are going to superfund, make sure it is into a low-cost plan that offers high quality investment options.

Windfall Planning & Superfunding

Windfall planning is the general term for making financial decisions in the face of a large, one-time gain. This is common for employees of technology companies that either go public or are acquired by a public company.

For parents who find themselves in the fortunate situation of a significant windfall event, superfunding a 529 plan offers significant benefits both in terms of objective savings results, as well as from a behavioral finance perspective. For some, the ability to know that they have made a significant contribution to their children’s future education, without the need for ongoing savings and maintenance, provides significant simplification and comfort even beyond the superior investment results.

If you have the resources, superfunding a 529 plan can be a significant boost towards reaching your college savings goal.

Disclosure

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 support@wealthfront.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.

In the event the donor does not survive the five-year superfunding gift tax period, a prorated amount of the superfunded contribution will revert to the donor’s taxable estate.

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. This article is not intended as tax advice, and 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 table and chart analyzing different 529 Plan contribution schedules do not represent the results of actual trading using client assets but were achieved by means of forward-looking analysis and back-tested models. Projected returns are not a guarantee of actual performance. There is a potential for loss as well as gain that is not reflected in the hypothetical information presented.

The calculation for projected returns is a hypothetical calculation based on back-tested data, i.e., the models assumed that Wealthfront’s investment strategy of diversified ETF portfolios was in effect for periods even before Wealthfront existed or began using such strategy. That data and those models do not take into consideration the effect changing risk profiles or future investment decisions and may not reflect the effect of material economic and market factors might have had on Wealthfront’s investment decisions during the back-tested period. 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 in the future, 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.

The return data presented is based on an average Wealthfront high net worth client with a liquid net worth greater than $1 million. Such average high net worth Wealthfront client has a risk score of 7.5 for a static, i.e., non-529 glide path, investment plan. The 529 glide path investment plan with approximately equivalent risk (as measured by average volatility) is risk score 9.0, which has an average expected return of 4.7% over 18 years, assuming the reinvestment of dividends and other earnings.

Actual Wealthfront clients may experience different results from the results upon which we based our calculations. Investors evaluating this information should carefully consider the processes, data, and assumptions used by Wealthfront in creating its projections.