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Since its creation in 1996, the 529 plan has become the most popular college savings vehicle for American families. However, many parents have become frustrated by their 529 plans’ lackluster performance while college tuition costs continue to skyrocket.
A 529 plan is an education savings account offered by a state or an educational institution as a vehicle for families to build assets to fund future college costs.
Two distinct types of 529 plans exist: prepaid plans, which permit participants to pre-pay for future college expenses, and savings plans, which allow participants to invest in mutual funds. Because savings plans are subject to the whims of the market, they have also been subject to the ire of frustrated participants.
These investment vehicles offer several benefits, but the primary appeal is tax-deferred growth. Participants can also ultimately withdraw “qualified” distributions tax-free. While your contributions are not deductible on your federal tax return, Pennsylvania residents are allowed a current deduction in calculating Pennsylvania taxable income.
Additionally, anyone can fund a 529 plan, regardless of age, income and relationship to the account beneficiary. Plan contributions are classified as gifts, so a person can make contributions of up to $13,000 a year without filing a federal gift tax return. Moreover, an exception exists that allows for the prefunding of five years of gifts ($13,000 x 5) in one lump sum.
It is important to note that there is a 10% penalty for withdrawing earnings from a 529 plan when not used for higher education expenses, in addition to paying income tax on those earnings. However, most 529 plans allow a change in beneficiaries. So, if the beneficiary decides not to attend college, one can transfer the account to a new individual who is directly related to the original beneficiary.
Despite the theoretical advantages of a 529 plan, it is tough to find a participant who has been thrilled with their results. Consider what has happened to college tuition costs versus equity market returns since the advent of 529 plans roughly 15 years ago.
The U.S. Bureau of Labor Statistics reports that college tuition and fees have increased at a rate of 5.94% from 1996 through 2009, roughly double the long-term average rate of inflation. In other words, a $10,000 college tuition bill in 1996 would cost over $22,000 today.
And according to a recent New York Times editorial by Mark C. Taylor, chairman of the religion department at Columbia University, “if recent trends continue, four years at a top-tier school will cost $330,000 in 2020, $525,000 in 2028 and $785,000 in 2035.”
Since the advent of 529 Plans, the S&P 500 index produced total returns of 6.19% through 2009, lower than the market’s long-term average return and just barely keeping pace with tuition inflation. And along the way, it was anything but a smooth ride. We experienced a tech stock bubble, two recessions, a housing bubble, and a major financial crisis.
But, as the investment disclosure statement says, “Past performance is not indicative of future returns.” The past ten years have been a “lost decade,” but the United States stock market has never endured two consecutive decades of flat or negative returns in its modern history. As contrarian investors, we see value in a stock market that most investors have largely been shunning for the past two years.
For 529 plan participants who are gun-shy about investing in equities, the most likely alternative would be fixed income. Interest rates are at all-time lows, and rising interest rates would lead to losses for bond fund investors, making it unlikely that bond returns will keep up with the rise in college expenses.
We advise 529 plan investors to focus on creating an appropriate asset allocation given the beneficiary’s time horizon and minimizing fees.
For a young child with more than ten years until college, consider a stock-heavy portfolio to allow for growth. For a young teenager with five years or less, bonds, cash and a small allocation to equities may be more appropriate in order to protect principal. Time frames in between probably call for a more balanced asset allocation. Seek the help of a fee-only investment advisor for guidance in developing an asset allocation strategy.
Next, choose a low-cost plan. According to Savingforcollege.com, a website that offers extensive information on 529 plans, you can find the lowest-cost 529 investment options in Ohio (CollegeAdvantage), Virginia (VEST) and Utah (UESP). In addition, Vanguard Group recently cut its fees for participants in New York’s College Savings Program Direct Plan to 0.25% from 0.49%, according to The Wall Street Journal. A Pennsylvania resident is free to participate in any state’s plan and still receive a Pennsylvania income tax deduction.
Although 529 Plans have discouraged many, saving for college is a wise investment regardless of the returns available in the savings vehicle. A recent report from the U.S. Census Bureau reveals that over an adult’s working life, high school graduates can expect, on average, to earn $1.2 million; those with a bachelor’s degree, $2.1 million; and people with a master’s degree, $2.5 million.
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