My thoughts on 529 College Savings Plans

I’m not in love with 529 plans. I think they are really fabulous in a few settings, but most of the time they’d be my third or fourth choice for ways to save for college. (Update on 12-22-2017: they can also be used for private school now. It doesn’t change any of this advice.)

First: when SHOULD you use a 529 plan? When you’re trying to create a trust fund on the cheap. If a grandparent or aunt or family friend wants to give money towards a child’s education but doesn’t want it to screw up the kid’s chances for financial aid and/or they don’t want the money to be available to the parents (for spendthrift issues or being accessible in lawsuits or divorces) then a 529 plan is a good choice. The money is hoseyed for the child and sometimes that’s exactly what you want.

Related to this, when a grandparent is trying to move money out of their estate, one of the first places I’d start is to set up a 529 plan for everyone who could conceivably use it and gift them $70,000 each. A married couple can put $140,000 into each of their grandchildren’s plans with no estate, gift or generation-skipping transfer taxes: a handy way to try to shave estate taxes if they anticipate leaving an estate in Massachusetts worth more than a million.

But if this doesn’t describe you, then I’d start in a few other places.  Is your income under $196,000 married filing joint/ $133,000 single? Then the first thing you should do is max out your Roth IRA. If you are already maxing out the Roth, the  second thing you should do is invest some money in an after-tax account until you fill out the 0% tax bracket for long-term capital gains and dividends, which hits when families have taxable income of over $75K (that’s TAXABLE income, so after all exemptions and deductions.) The third strategy to save for college while strategizing for financial aid is to pay down your home equity while concurrently putting a Home Equity Line of Credit into place. Basically, any family making less than $100,000 shouldn’t be rushing to put money into a 529.

If your income is in the top quartile in the United States, and you aren’t strategizing for financial aid, and you’re trying to hosey the money for your kid (not attachable as one of your assets) then it starts to make sense to do a 529 plan. But watch out for the downsides: it still may not be worth the bother.

Here are the downsides to 529 plans.

  • Be aware that the fund expense ratios tend not to be great. You can hunt for index funds and use those, but the default age-based funds aren’t particularly attractive. Chances are the place you have the money now gets a better investment return.
  • The way 529 plans interact with education credits isn’t lovely: you can only use one tax attribute for each tuition dollar, so if you have a choice between using a tuition dollar against a 529 distribution (letting the earnings be tax-free) OR using a tuition dollar to get a 100% tax credit, you’ll choose the tax credit.
  • It is complex to use 529 plans at tax time: tax returns need to be coordinated between owner and recipient, and you’ll probably want a CPA to do the tax returns that year. I typically charge $50 extra for returns that have distributions from 529 plans because of the added complexity.
  • The nice part about 529 plans is that the money is hoseyed for the kid, but that’s also a downside: life can throw you surprises and having the money tied up can cause unnecessary aggravation. A Roth has all the benefits (plus more) with none of the lack of flexibility.
  • A 529 plan is still considered a parent’s asset for financial aid calculations. The expected family contribution could be reduced if you put the money into home equity (which you can tap with a HELOC) or into paying off car loans instead.
  • A 529 plan’s big benefit is that the earnings on the investments will grow tax-free and then be forever tax-free when you use the money for education. But that’s a really tiny benefit for most people! Capital gains and dividends are already taxed at either 0% or 15% at the Federal level for most of us: only people with income over $415K will pay taxes at a rate of 24%. But if you choose to use the 529 plan for something other than education you convert all those potentially tax-free investment earnings into earnings at ordinary rates that quickly hit 35% including the penalty if you are making as little as $55,000. Plus, if it turns out to be a loss instead of a gain you can’t get any tax benefit for that at all! Itty bitty potential benefit combined with massive non-unlikely downsides. See why I don’t love it?
  • There’s good news and bad news about 529 plans in Massachusetts right now. The good news is, if you are interested in setting one up there’s a new tax deduction in MA that will save you up to $100 if you contribute $2000 into a 529 plan. The bad news is that somehow Fidelity, a privately-owned corporation, just got Massachusetts taxpayers to pay for a marketing campaign for Fidelity. The 529 plan they offer will cost you roughly $5 more in investment fees EVERY YEAR for every $1000 you have there than if you’d set up an after-tax account in an index fund at Vanguard. After the tax break you come out about even over the life of the 529 plan, but there is no compelling social reason the state should support this. Basically, it just gets people in the door to Fidelity so they’re more likely to use them for Rollover IRAs and the upselling into expensive mutual funds they’re doing with their “free advisors”.

Now, after reading all this, if your take-away is “that sounds terrible, I won’t do a 529 plan” then I’ve probably steered you wrong. I’d rather you saved in an imperfect plan that not saved at all. If you heard “529 plans aren’t the best place for my savings, I’ll put that savings into a Roth or after-tax account instead” then you’re on the right track. What really works for you? If you ALREADY have a 529 plan AND you are ALREADY saving into it, the harm of stopping if you don’t really restart needs to be factored in, too. My motto is “progress, not perfection.” Also, “forewarned is forearmed.”

Updated December, 2017