Understanding 529s
Share This
A friend asked me how he should save for his daughter’s college education. (His daughter was born in 2009, which means probably I should be asking him the personal finance questions, but whatever.) “A 529 college savings plan,” I said.
529s are great, I explained: you put in after-tax money and it grows tax-free. You can put a lot of money into them; the money can be used for tuition, room, board, textbooks, and other fees; there are no age or income limits; and you can change the beneficiary if your kid decides to attend the school of hard knocks instead of college. (Although, heck, these things are so flexible, the School of Hard Knocks is probably a qualified educational expense.) If you have a child, you should have a 529.
“Okay, but which 529?” asked my friend, who lives in Vermont. “The Vermont one?”
“Uhhh,” I replied. Not only did I not have a good answer to this question, but I realized that I didn’t know whether my own six-year-old daughter’s 529 was any good. Answering my friend’s question turned out to be pretty easy. As for my own child’s future, well, I’ll tell you what I’ve figured out so far.
A messy system
You’re familiar with the Roth IRA, right? Maybe even have one of your own? Part of what makes the Roth such a handy investment vehicle is that it’s just a generic tax-advantaged box for putting your savings in. You can open a Roth with any financial institution and put any kind of investment or deposit account in it. Easy.
Now, imagine if the Roth IRA system were administered by the state governments, and each state could implement its Roth in an entirely different way. Imagine further that you didn’t have to invest with your own state’s fund, that you could choose nearly any of the 50 state Roths. Fifty states, 50 different (sometimes wildly different) plans.
Given this absurd situation, I’m guessing you’d do one of two things: go with your state’s Roth, regardless of whether it was a good investment, or throw up your hands and vow to choose a good plan someday, but not today.
Roth IRAs aren’t like that, but 529s are. The morass exists because 529s were invented by the states about 20 years ago and eventually blessed by the Internal Revenue Code in their current form in 2001.
“It does create a messy system,” says Joe Hurley, CPA and founder of savingforcollege.com.
It sure does. Choosing a 529 is harder than getting a group of friends to agree on a restaurant. So let me help narrow it down for you.
Choosing a 529: the basics
• If you pay state income tax, check whether you can get a tax credit for contributing to your own state’s plan. A list of those states can be found on FinAid.org. If you qualify, it’s like having the state drop a sack of doubloons onto your porch. “In Oregon, for example, we have a 9% state income tax rate, and so if you put $10000 into a plan, you’re going to get $900 back,” says Eric Lochner, a certified financial planner at McDonald Franceschi in Portland, Ore. “You can think of that as an immediate 9% return on your investment.” My Vermont friend gets a $250 tax credit every year for socking at least $2500 into the Vermont 529. It’s a no-brainer. Bonus: Some states, such as Pennsylvania, give you a tax deduction for contributing to any 529 plan. Check the Finaid.org page linked above.
• Otherwise, look for a plan with low fees. Some 529s have such a high expense ratio, they should be called the Cash Under the Mattress Fund. Lochner recommends the Utah or Nevada plans, which offer low-cost Vanguard funds.
• Conservative investors should consider the Montana 529, which lets you invest in a CD whose interest rate is pegged to the tuition and fees inflation rate at private colleges. You can’t lose principal, and if average tuition skyrockets, so do your earnings.
Prepaid tuition plans
This is the plan that resembles a pension, and it’s the plan my family is in right now. My wife and I both graduated from University of Washington. We would like our daughter to go there, too. It’s a good school and it’s near our home, so she could visit us anytime.
Washington’s 529 plan, which is called Guaranteed Education Tuition (GET), lets us buy credits at UW now. For every 100 GET units we buy, our daughter gets a full year at UW, guaranteed. You’re not buying the credits at today’s rate, however. Right now, a year at UW costs $7700; a year’s worth of GET units is $10,100. You can use the money to attend other schools, but it always pays out at the current UW tuition rate.
What do the experts think of prepaid plans? “In theory, they should work great, because they satisfy a need that many families have simply to put the money away now and not have to worry about tuition inflation,” says Hurley. “But they come with a lot of rules. It’s very difficult to understand exactly what you’re paying for and how much it’s costing.”
Lochner is even more skeptical. “Every time I read about them, it sounds like they’re riddled with problems,” he says. “They can run into underfunding problems and unfunded deficits in the future.”
A prepaid plan is a good idea if you want to buy exactly what it’s selling: tuition at the colleges listed on the back of the box. If my parents had expected me to attend a specific college, though, I would have told them to bite me. Since Washington has no state income tax and I have no interest in biting anyone, I’m going to invest with either the Nevada or Montana 529 in the future.
Matthew Amster-Burton, author of the book Hungry Monkey, writes on food and finance from his home in Seattle.
Organize your financial life.
Use Mint.com to see where your money goes, get bill reminders and alerts, track your investment performance, and find extra savings. It’s FREE!
Find Out MoreHow Mint Can Help
See Where You Spend
Mint.com auto-categorizes all of your transactions so you’ll always know where your money goes. Find out more »
Popular Articles
12 Comments so far
leave a commentI’m a recent transplant to WA state and investigating the WA 529 plan for our new daughter (and blogging about my research). I haven’t made an investment or a decision yet, however I find your treatment of the topic light.
Both Hurley and Lochner make generic statements about prepaid plans in general, not what appears to be considered views of the specifics of the WA plan. My research so far shows major differences between the WA plan and the other prepaid plans.
I’ve been generally considering the WA 529 plan as a low-risk component of a balanced investment portfolio, so the obvious comparison is to the MT plan. The MT plan returns a rate equivalent to tuition growth minus 3%. That’s roughly 2% a year over the last decade.
UW Tuition (the index for equivalent value outside of WA state public schools) has grown at 7% a year and may grow closer to 10% if the legislature removes the arbitrary cap on UW tuition growth.
Yes, the MT Plan is FDIC ensured. But the WA plan is backed by the full faith and credit of WA state. The real issue with the WA plan is the bid-ask spread (33%), but that still gives a 21-yr return of 5.4%.
Anyway, as someone who is considering the WA plan, I’d love to know if any of your experts actually looked at that plan.
Great, but I felt like you were just warming up. Can you do a continuation?
A 529 plan can be useful but unfortunately not enough new parents start the process of planning for their child’s tuition right after birth. We recently posted a piece on baby financial planning which also maybe helpful.
Dave, have you looked at the Independent 529? It’s pegged to tuition growth at a selection of private colleges, you don’t lose the 3%, and you can get your money out of it.
If UW tuition is deregulated, you almost certainly won’t be able to continue contributing to GET, or at least not at your current lock-in rate. Look at what happened in Texas: they had a nearly identical plan; tuition was deregulated; and the plan shut down to new contributions.
Furthermore, you can’t roll money out of GET and into another plan. I realize your GET contribution is guaranteed by the state of Washington, and they’re not going to simply confiscate it. But there are many things they can do to change the rules to make it difficult for you to use the money as you intended, especially if you intend to use it at a college other than a Washington public college or university. One thing they could do (this was threatened in Texas but hasn’t happened yet, I don’t think) is force a refund, which means you could actually lose principal because of the bid-ask spread you noted. It’s like call risk on a bond.
Yes, as a portion of a portfolio, I think GET is okay, and hey, you could . But if you want something pegged to tuition, google “Independent 529,” something I didn’t discover until after finishing the column.
Pops, what else would you like to know?
Correction: I misremembered the Texas refund issue; at stake is the refund policy on unused prepaid units. I’m not sure whether the GET program has the power to force you to take a refund in the event of a shortfall; I’m going to give them a call.
Okay, I confirmed:
http://apps.leg.wa.gov/RCW/default.aspx?cite=28B.95.090
Yes, you can lose principal in the GET program. It’s not likely, but if it happened to you, that would be little consolation.
The Independent 529 has a couple issues in my view:
1. It only includes private schools in its universe. Average annual tuition of these schools is up in the $25k+ area. There are no public schools in the plan.
2. Things wouldn’t be all so bad if we were talking about a stable of the top flight well known private schools. However, the vast majority of the 200+ schools in the program are 2nd and 3rd tier no-name schools you’ve never heard of that just charge lots of money. For them, being in the plan is just a marketing expense and a cheap way to increase applications/enrollment – since they know plan participants will most often attend a school within the plan.
3. You can withdraw your money, however, your money can lose up to 2% a year.
On the plus side, the contributions/promise is guaranteed by the schools. So there is no risk that a state legislature will leave you high and dry.
We have our money in MA U.Plan which likewise transfers risk to the schools, but has a broader swath of public/private schools. MA does also provide a guarantee with the full faith and credit of the Commonwealth, though again, since the schools bear the risk in the plan, the state should not be in a position to ever have to deliver on that guarantee.
Hi, Harold. I agree with your assessment of the Independent 529; it’s better in some ways than the Washington plan and worse in others.
The Massachusetts U.Plan looks pretty good. One risk associated with it is that if your child decides to go to school out of state, you get your investment back with interest determined by the CPI rather than tuition inflation. If tuition inflation outpaces CPI, as many people believe it will, you end up behind. But that’s not a huge risk. You’re also forced to choose a maturity date and you don’t receive any protection against inflation after that date, so you have to buy multiple certificates and ladder them. And you have a limited amount of time (six years) to use the money. Also, it is not certain that withdrawals will be free of federal income tax. They “are believed to be free of federal income tax as well,” is what the web site says; this is not technically a 529.
This reinforces what I said: you need to be very careful about what you’re buying. If you’re highly confident that your child will go to college in Massachusetts and you ladder your certificates carefully, the U.Plan is going to be great. If one of those assumptions fails to hold, you could get burned. Not badly burned, but still burned.
Facebook User – absolutely on all points.
I think the key point that people have to remember when signing up for any prepaid plan is that you are entering into a contract. A contract by definition has two sides – what the purchaser is paying and what the seller is going to provide in turn. You cannot expect that the return the purchaser is going to get will be overly slanted in the purchasers favor. How could that be? This is probably a good part of the reason most of the plans have failed – what they were promising and how they went about delivering caused a very high amount of risk to do it. The objective of the plan should be what the original intent was – a long-term low-risk savings vehicle. In that, purchaser is going to have to make concessions to get the benefit of it. You cannot have a plan which says 1. put your money in for as short a period as you like, 2. you can take all your money back at anytime and you are guaranteed to get all your money back and outsized gains, 3. we’ll let you use the money at any school you like, 4. we’ll guarantee that the money you take out is going to keep pace with the tuition increase at every school in the universe. Come on – that is not going to happen. There is a risk profile and the schools and states do risk analysis to determine how they can guarantee the return today of something being delivered in 5 to 18 years. I think that maybe the people who are looking for such a thing take an intro course on investing, what options and futures are, and maybe look at how airlines hedge their fuel purchases to gain a better understanding of what they are purchasing/protecting.
I am a very big proponent of MA U.Plan since we began participating in it 7 or 8 years ago because it is a sound program, was one of the first, very clearly states what the purpose/goal is and what the rules are, and is able to deliver because it has an extremely conservative risk profile. You can’t come along and say “well, I’m not guaranteed to get all my money back with at least 5% annual interest, when I want, to use any way I like”. If that’s the case, then don’t enter into the contract. If your first thoughts are “I don’t want my child to be locked in to this set of schools” – don’t sign up. I am continually amazed on other message boards how people so easily write off a plan or are experts because it is not meeting every single one of their criteria for the ideal plan you’d get in utopia. At the same time, they’re sitting there looking at the money they’ve thrown into their favorite 529 state plan which is worth 30% less than all the contributions they’ve made and believe they are experts on the subject.
For those looking to get into prepaid plans now, if you’re looking outside of MA or the Independent 529 I think you’re at a severe disadvantage because of premiums now being tacked on (Independent 529 in fact has a stipulation that member schools give 0.5% discount per year) and how the plans have been rejiggered (and still only a couple with a guarantee). There is definitely a follow the herd mentality, and the wave of interest now is great because all of the sheep have been led to the slaughter previously. Through 2009 the planners have flooded the media indicating people should seriously consider putting their money in prepaid plans – these are the same advisors that told everyone to buy the 529 savings plan. They and their followers have all missed the boat.
Everyone knows that tuition rates are going to be going up more/faster now because of cut budgets, reduced endowments, and reduced aid. If you cannot make the concessions needed to take full advantage of a prepaid plan, then the message is no different than in the past – don’t enter into the contract. Plain and simple. Like any other investment, you need to be in it long-term, and be in a position to take advantage of the benefits you are purchasing. The downsides are irrelevant – either you do not understand the benefits/tradeoff, or you are looking for something that doesn’t exist, nobody is going to have the ideal product you are looking for, and you are simply wasting your time – you may as well just keep your money in CDs and you’ll come out ahead for what you want.
Your last statement is the key message and it’s no different than the way things have always been – buyer beware. There’s really no “getting burned” – if you break a contract, whether here, or in any other deal, you have to pay for breaking the contract. Plain and simple. When you first enter into the contract, the plan is making room to make the guarantees to you being promised. If along the way, you change your mind, the assumptions and money/return which the plan estimated coming from you so many years into the future are eliminated and need to be compensated for. Why would anyone think they can break a contract at will, deprive the seller of what the purchaser has promised, and believe that they have no obligation or reason to pay a fee for breaking the contract and be able to get all of their money back? These are the same people who pay $175 to go and terminate a cell phone contract. It’s no different. If you buy a CD from your local bank and decide before maturity you want your money back, you pay a fee and may get less than your purchase amount back – no difference. If the purchaser cannot live up to the terms of the contract being entered, then there’s absolutely nothing wrong with paying a penalty – and it is all stated very clearly in the contract. So, again, I personally cannot understand what some people get so worked up over on the subject.
Understand what you are purchasing. If you cannot, or can’t agree to it, then why put your money in it to begin with? At the same time, don’t complain that you’re upset because no prepaid plans meet every requirement that you’ve set and you can’t get the returns needed to guarantee attendance at the school of your choice.
In Texas we don’t have State Income tax, so the tax advantages of a 529 are minimized. What I looked into for my two children (class of 2017) was the Coverdell IRA (formerly Educational IRA or ESA). It has some important distinctions from a 529 as I understand them:
- The dollars go in after tax, grow tax free
- The child owns the assets
- There is a $2,000 /yr limit per child (so contributions from multiple grandparents have to be coordinated not to exceed $2,000 for one child)
- Dollars can be used for K-12 as well as college expenses which is great for children expected to go into private school.
So My plan is to use the Coverdell IRA for each child up to $2,000 / yr and then supplement with 529 plan if needed.
Anyone else have this strategy? Comments?
Aaron, other advantages of the Coverdell ESA are that you can invest in anything you want–it’s not a state plan–and you can roll it into a 529 later if you want. The main disadvantage is the $2000 cap–but if that’s a problem for you, I guess it’s a good problem to have.
My father pointed out to me that if you’re over 59 and saving for, say, a grandchild’s college, you can also use a regular Roth IRA.
Additionally, with Coverdell, there are income limitations and phaseouts so you need to first check how much you are eligible to contribute, if you are eligible.
If the child is the owner of the asset, then for college financial aid purposes this will hurt compared to the expected contribution if it were a parental asset – 35% vs. 5.6%.
In any event, we put $2000 into a Coverdell for our daughter the year my wife was unemployed about 6 or 7 years ago because we were below the limit. We have absolutely no expectation of receiving financial aid, so we’re not concerned about ownership issues.