Making a 529 college savings plan work for you

31 May 2015 | Author: | No comments yet »

529 balances growing — and so are college costs.

For the last four years, the financial services company has been surveying adults, gauging their awareness of 529 plans. The 529 college savings plans have been around nearly 20 years, but they got an unexpected boost this year after President Barack Obama proposed taking away the one of their core benefits. When Obama revealed his tax plan during the State of the Union address in January, he proposed no longer allowing earnings on new contributions in 529 plans to be withdrawn tax-free.

Yet even though a four-year college education — at about $100,000 — now costs roughly three times more than the average car, parents generally do little comparison shopping for the best way to amass the money they will need for college. That is just one of the drawbacks of trying to choose a college savings plan by performance alone. 529 plans are sponsored by states and run by investment management companies. If you don’t know what a 529 plan is or how it works, it’s unlikely you know that there’s a day to celebrate the tax-advantaged savings vehicle.

While there are risks involved in putting money in these vehicles, it’s smarter to save for college in any form than be scared off by the complicated terms, said Mark Kantrowitz, the publisher of Edvisors.com, a financial aid information website. The administration withdrew its proposal days later and the House passed a bipartisan bill in February that actually expanded tax benefits for 529 plans, allowing college students to use 529 funds for computers and other school-related technology. Withdrawals from the accounts can be used tax-free to pay for qualified education expenses at any college or university in the country, such as tuition, fees and books. One form of the 529 allows families to pre-pay each year for “tuition credits” at today’s rates that they can use in years to come even when tuition costs are higher. More than 70% of college graduates leave school with student debt and there’s no end in sight to the trend of debt-financed college, as tuition continues to skyrocket. “Saving for college is better than not saving for college,” Kantrowitz said. “Every dollar you save is a dollar less you’re going to have to borrow.” These programs allow parents to lock in tuition payments years in advance typically at a rate slightly higher than current prices to protect against tuition inflation.

President Obama earlier this year had proposed eliminating the tax benefits of the plan for well-off families but he withdrew it after protests from Congress, including from top Democrats. A “moderate allocation” investment gets its name by taking judicious risks with a combination of stocks and bonds, often putting close to 70 percent of a person’s savings in mutual funds that invest in stocks. And at private nonprofit four-year colleges, the average cost was more than double that: $40,917—an increase of 1.7 percent from the previous year, according to The College Board. Plan shoppers still have plenty of good choices, though, since most 529s welcome out-of-state contributors and 17 other plans made SavingForCollege.com’s performance rankings. The Great Recession squeezed funding for many of these plans, making it difficult for them to keep up with payouts to account holders that match current tuition rates. “There was a period of time when tuition was growing way faster than everybody ever predicted and the stock market crashed so suddenly these funds became underfunded overnight,” said Lochner, who is also the director of Washington state’s prepaid plan.

SavingForCollege.com created its rankings several years ago to help investors gauge how well their plans were performing relative to their peers’ — a daunting task because plans can be so different in their investment offerings and approaches, said SavingForCollege.com founder Joseph Hurley. In that environment, some states froze their payouts at levels tied to the price of tuition in a certain year, stopped accepting new investors or simply shut down. Most 529 plans have age-weighted options that grow more conservative as the beneficiary nears college age, although those “glide paths” vary considerably. He is the author of several bestselling books about scholarships and financial aid, including “Filing the FAFSA (2015-2016 Edition)” and “Secrets to Winning a Scholarship.” Dozens of tip sheets about paying for college are available for free download at www.edvisors.com/ask/tips, including a one-page tip sheet about saving for college.

Only a handful of prepaid tuition plans – Florida, Massachusetts, Mississippi and Washington – are backed by the full faith and credit of the state, which is the most ideal guarantee, according to Joe Hurley, the founder of Savingforcollege.com. Total 529 savings plan assets were at an estimated $231.9 billion as of March 31, 2015, reflecting a 3.4 percent increase from the fourth quarter of last year and a 10.1 percent rise from a year earlier, according to financial research firm Strategic Insight.

Money withdrawn from a 529 account is free from federal tax (and, in most cases, free from state and local taxes, too) when used for qualifying college costs. While assets have grown, Paul Curley, Strategic Insight’s director of college savings research, said the inflows were “extremely muted”—especially given the political spotlight on the plans. The portfolios represent asset weightings of 100 percent stock, 80 percent stock, 60 percent stock, 40 percent stock, 20 percent stock, 100 percent fixed-income and 100 percent short-term investments. Thirty-eight states give people extra benefits, usually income tax breaks, but also grants and scholarships, if they save money in their home state’s 529 plan, according to Morningstar.

Investors may prefer a passive investing approach over active, or vice versa, and may also feel more comfortable with investment managers they know well. “If your retirement funds are managed by TIAA-CREF and you think they’re doing a good job, you might want to have your college money there, too,” Hurley said. You don’t have to pick your state’s 529, although Morningstar notes that valuable home-state benefits can make it worthwhile to use a good versus an exceptional 529 plan. For my three children, my husband and I chose “age-based” investment options, which means that the younger the child, the more aggressive the investment options may be. The bottom line is that investors have a great deal to consider besides performance, said Andrea Feirstein, managing director of New York-based AKF Consulting Group, which advises 33 state plans. If the investment offers a 6 percent average annual rate of return, but charges 2 percent in annual fees, the fees will consume a third of the investment returns.

While the payouts can generally be used for tuition at colleges outside the state where the plan is offered, it may not cover the full cost of tuition at other schools. Families use after-tax dollars to put money into these plans and they can take the money out tax free as long as they use it for higher education expenses. It has similar tax benefits to 529 prepaid plans that cover the cost of state schools, but lets people lock in future tuition at today’s prices at more than 270 private schools, including Stanford University, Georgetown University and the University of Chicago.

Though funds from 529 accounts can go to tuition and books, as well as room and board, there are some other expenses, like off-campus housing or laptops that may not qualify, according to Andy Lockwood, a Long Island, N.Y.-based college consultant. Also, investment advisers have a tendency to steer investors toward 529 plans that offer the adviser the highest commission, not the lowest cost or best tax benefits. (Note that seven states – DC, LA, NJ, RI, SC, SD and WV – offer the direct-sold version only to state residents.) State income-tax benefits, however, offer another potential source of savings. Lockwood, who coaches families and students on applying for financial aid, said that he suspects schools that use their own formula for determining aid eligibility – known has institutional methodology – count 529 accounts as a child’s asset, which could severely lower an aid award. More than two-thirds of the states provide a state income tax deduction or credit on contributions to the state’s 529 plan. (Six states offer tax parity, where the tax deduction is based on contributions to any state’s 529 plan.) So, investors should always consider their own state’s 529 plan first.

Though it’s hard to say whether that’s truly the case because the schools don’t publish their formulas, Lockwood said he’s noticed a pattern in aid awards, which indicates the schools are approaching the accounts in this way. The Free Application for Federal Student Aid considers 529 plans in a parent or dependent child’s name a parental asset and they have little effect on financial aid awards. An age-based asset allocation manages this risk by starting offer with an aggressive mix of investments when the child is young and shifts it to a more conservative mix of investments as college approaches.

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