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College Funding: The 529 Solution

529-Plan-150x150As kids we all remember paint by numbers.  These were simple and fun.  As parents we all want to find an equally simple to use solution to paying for college.  Qualified Tuition Plans, also referred to as 529 Plans, seem to be that but are they really?

Parents have a range of choices when it comes to saving money for college.  And investment firms offering 529 plans have done the best job marketing their options as the best solution for families interested in getting an early start on the daunting task of setting aside funds for paying college later.

Merits and Drawbacks of a 529 Plan

Let’s explore the basic benefit of any 529 plan.  When used properly, you may set aside funds and take out any investment earnings for qualified educational expenses without incurring any income tax on the growth.  Using the Ninth Wonder of the World — time and compounding — parents may be able to build up a significant amount that may be used when their student goes off to college.

In some states (but not my home state of Massachusetts), there is the added bonus of getting tax deductions for this good behavior of saving early and often for your kid’s college bill.  An added benefit of investing in your state’s 529 plan is that assets are protected from bankruptcy and lawsuits — though we’re hoping that paying for college DOESN’T drive you into bankruptcy.

(Side Note:  With proper planning you may likely be able to avoid bankruptcy and even avoid eating dog food in retirement).

The Question: SAVE or INVEST for College

Shakespeare may have had a different question in mind about roses but when it comes to college funding, you’ll have to consider a more relevant near-term one:  Should you save or invest for college?

Given the vagaries of the economy and financial markets, as parents you’ll need to consider what your priority is.  There is a significant difference between saving for or investing for college.  Investing for college means that you are willing to take market risks with your money.  You may gain or you may lose your money.  Maybe not all of it but there is the risk that it may not go up or may even go down in value.  If you believe that you have sufficient time to recover any losses before needing the money – and you believe that you’re getting properly compensated for taking on market risks, then you should consider investing.

Saving for college is more about protecting what you have and your rate of return is more of an afterthought. Saving is more predictable and steady.  This is the tradeoff between participating in the market for upside potential. Given the market shocks we’ve experienced over the past decade, who’s to blame you for wanting to avoid the market turbulence?

529 Investment Plans: The Basics

A 529 plan is foremost an investment plan.  Each is sponsored by a state (though there are two plans for the District of Columbia) and is managed by a firm chosen by that state.  You’re provided with a menu of mutual fund choices.  These may be broad or narrowly focused.  Some may be invested in equities and others in fixed income and bonds.  Another option includes an age-based mutual fund which will automatically shift the allocation from riskier equities to more stable principal options like bonds and cash as your student gets nearer the date when you’ll need the funds.

Like most mutual funds you as an investor may be familiar with, these all involve different levels of risk depending on their exposure to the market.  And like any other mutual fund there are costs for running the fund.  Added to this will be the costs for administering the program imposed by the sponsor.  As in any other investment, costs are like a sea anchor weighing down your performance which your investment must overcome before you earn anything on your principal.

Tax free benefits are always good.  But if your 529 plan has not had any growth, then the value of the tax free benefit is essentially nil. And if your family has little time before your student enters college, then you may not have an opportunity to earn money and utilize the tax free benefit.  (In another blog post, I’ll explore how even late-starters may benefit from a 529 if they have other assets available without capital gains). 

Coordinating Tax Benefits of a 529

Like anything else in the tax code, there never really is a free lunch.  Although 529 plan distributions for tuition, room, board, books and other qualified educational expenses are tax free, such expenses cannot be used again when calculating the American Opportunity Tax Credit.   Since the IRS ordering rules say that credits are calculated first, you may lose out on some of the tax free benefit that the 529 account provides.  No double counting allowed here.

And disappointing to many is the simple fact that 529 plan money cannot be used to pay back student loans.  Loans are not considered a “qualified expense” though they certainly are an expense in every other way that counts to you and me.

Prepaid Tuition Plans

There are still some states that offer prepaid tuition plans under the 529 umbrella. These allow parents to purchase credits towards future college costs at today’s prices.  These were a whole lot more generous before the financial crisis and included provisions for use outside the student’s home state at a given formula.  As states wanted to find ways to reduce their future liability to cover these expenses when the time came these provisions have become less generous.

So it is important to read the fine print on these plans since you may be limiting the choices that your kids may have when it comes time to select a college.

Advice to Parents

As with anything dealing with money, funding a college education can be complicated.  There are a host of strategies that may help a family.  529 Plans are one tool in the box to help a family but each has its own nuances that need to be considered.  Get familiar with your options and work with qualified professionals who can help you sort through these nuances to determine the path that’s right for your family and if the risks are worth the rewards.