College Q&A: Should I Invest in a 529 Plan?

Welcome to MainStreet's newest series. Each week, we will answer a real question from readers on education costs and how to pay for college. If you have a question, feel free to send it to editors@mainstreet.com.

Q: "My wife and I are debating whether to take advantage of a 529 savings plan for our two-year-old son. We’ve lived in several different states, and I imagine we’ll move around more. My wife likes the 529 because of the tax benefits, but I’m skeptical. It seems the plans are operated on a state-by-state basis, plus I've read it's better for parents to save for retirement rather than their children's education.

My wife is a physician so many tax advantages we had during graduate school no longer help offset our tax burden. She thinks we're crazy for not using this one to help offset our taxes and provide for our son. I'd rather just manage the money myself in a brokerage account. So, who's in the right?"
- Jay, New York City

A: Jay, your wife is always right, even when she’s wrong. And in this case, she really is right.

You can save in any state’s 529 college savings plan; you do not have to save within your current state’s plan. And if you happen to like a particular state’s plan, you can keep the money in that state’s plan when you move. You can also roll the money over into another state’s plan at any time.

Distributions from a 529 college savings plan can be used to pay for college expenses at any accredited college in any state in the United States of America. So even though each state has its own 529 college savings plan, you are not tied to any state when you invest in its plan.

Perhaps you were thinking of a prepaid tuition plan, which is intended to pay for public college expenses at in-state public colleges. Most can be used for private and out-of-state colleges, and you can roll over a prepaid tuition plan into a 529 college savings plan, but the value of the plan may be diminished if you don’t use it to pay for an in-state public college. Also, many of the state prepaid tuition plans have been hiking the premiums they charge on top of a year’s tuition to compensate for actuarial shortfalls from recent stock market losses in the plans investments. With this in mind, it’s wise to not  invest in a prepaid tuition plan.

The 529 college savings plans, however, are a tax-advantaged way to save for college. The investment returns are tax deferred, and distributions are entirely tax-free if used to pay for qualified higher education expenses. If you take a non-qualified distribution, the earnings will be subject to income tax at the beneficiary’s rate, plus a 10% tax penalty. This will usually save you money compared with investing in a taxable brokerage account.

Some states provide a state income tax deduction on contributions to the state’s 529 plan. These deductions may be subject to recapture rules if you move the money into another state’s plan. But the availability of a state income tax deduction is not as important as the fees charged by the company that manages the 529 plan. That said, never use an advisor-sold plan, as the fees are much higher than a direct-sold plan. Focus on 529 plans that charge less than 1% in fees. For example, the direct sold plans run by Fidelity, Vanguard and TIAA-CREF offer some of the lowest fees due to an ongoing pricing war.

Unless you are a financial professional, you are unlikely to get better returns than the S&P 500 in the long run. You might beat the S&P 500 for a year or two, but not consistently for 17 years. (A note: most mutual funds do not beat the S&P 500 when the investment horizon is measured in decades.) Moreover, if you manage the money yourself, you are unlikely to properly balance risk against return. Stick with a 529 college savings plan and invest in an age-based asset allocation scheme. Age-based asset allocation schemes start off with mostly stocks when the child is young, and gradually shift the split from aggressive to conservative investments as college approaches. By the time your son’s heads off to college, less than a fifth of the 529 plan funds should be in investments where there is risk to principal. This sacrifices some returns, but minimizes the chances you might lose 40% or 50% of your investment like some stock market investors did in 2008.

Your goal in saving for retirement and for college should be to maximize your overall after-tax return on investment. Money is fungible, meaning that the money in a 529 plan and the money in a retirement plan are both green. If you save less for college, you’ll need to spend more current income when your child matriculates to pay for the college costs. If your income falls short, you’ll need to borrow more. But borrowing ultimately costs more than saving, and therefore should be avoided if at all possible.

If your employer matches contributions to your 401(k), maximize the match. That’s free money. Then you should consider whether the 529 plan or the retirement plan will provide a better return on investment, and allocate your savings accordingly. Ideally you should be saving at least 20% of your income for retirement and at least $3,000 a year for your child’s education. If you aren’t, reduce your spending so you can save more. Since your wife is a doctor, you can afford to save--for both retirement and for college.

—Mark Kantrowitz is president of MK Consulting Inc. and publisher of the FinAid.org and FastWeb.com. He has testified before Congress about student aid on several occasions and is on the editorial board of the Council on Law in Higher Education.

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