Saving for College: 529 Tax Benefits Versus Plan Fees

Do the tax benefits of a 529 college savings plan outweigh the typical program’s costs?  This is an important question since many parents are bombarded by marketing messages telling them the best way to save for college is through the tax-favored and tax-free 529 plans sponsored by every state and two in the District of Columbia.

And the answer?  Well, like most things in finance, it depends.  But generally, families in higher income tax brackets tend to do better because of federal tax treatment of things like investment gains inside the account and the tax free withdrawals to pay for college.  And for those who live in states where there are state income tax deductions, they have an added bonus.  The case studies prepared on three fictional families with different income and tax situations are useful guides.

Morningstar® analyst Kalin Liu recently explored the issue of 529 tax benefits weighed against plan fees.  Read the full Morningstar® article here.

More Families Saving for College

Recent industry surveys show that more families are using 529 plans to save for college.  A report released by Fidelity and quoted by Joe Hurley, CPA of noted that one-third of families are saving with a 529 plan in 2013, up from 28% in 2012. A separate College Savings Foundation survey confirmed the trend reporting more than thirty-seven percent of families were saving, up from 29%.

As a quick reminder, a 529 College Savings Plan is a state-sponsored, tax-advantaged savings plan that can help families and individuals save for higher education expenses.  Funds may be distributed tax-free for qualified higher education expenses.

The creators of the 529 plans envisioned them as a way for all families to save for college.  Yet the reality is that despite the increased levels of participation shown in the Fidelity and College Savings Foundation studies, most families do not save for college and most have relatively low balances accumulated.  Most families in fact tend to save on average less than one year’s worth of tuition costs in all types of investment vehicles.

529 Benefits Higher Income Families

And the folks who tend to really take advantage of these plans tend to be those in the higher income tax brackets.  They tend to have higher-than median income. According to a study by the Minnesota House of Representatives about two-thirds of 529-plan assets ended up being held by people with median income of nearly $200,000 per year. The case is not much different in other states.  Those with the income and assets and the access to savvy financial planners or tax accountants use the plans.

It is in some states “free” money after all.  Some states (though not Massachusetts) offer income tax deductions for socking away money for college.  New York offers a credit on state income taxes up to $5,000 or $10,000 if filing jointly.  Arizona recently increased their state income tax deduction limit from $750 for an individual to $2,000 for a couple.  In Nebraska the limit has gone up from $5,000 to $10,000.

So these plans tend to favor the better-off.  (And on a separate note, at the expense of the public treasury because these tax loopholes do cost the state in the form of lost revenues).  For a more in depth commentary from a higher ed insider, check out this from The Chronicle of Higher Education.

College Savings Options for the Real America

My belief is that for most of Middle America who are not going to or are not able to stash away more than $2,000 per year per child in a 529 plan that they should look to alternatives like a Coverdell Education Savings Account.  It offers more flexibility in fund choices and lower fees.  Another is to consider the lower cost CD-like 529 options offered  by The College Savings Bank of New Jersey. While you cannot control much in investing, much less the rampant inflation in higher education, you can control your known costs.

And until the public and public officials find a more sensible public policy way of dealing with the ever-increasing burden of college, families need to take advantage of every strategy available to them.  But before you do, you need to know what works in your particular situation. Navigating this on your own can be difficult for most.  As in this case where a 529 Plan works for some, there are numerous other strategies to consider. So this is where families need to get an advocate on their side – a college financial planner – who will help them even out the playing field.