Why No One Should Have a 529 Plan … or Should They?
Marin Mommies presents a guest article by Marin mom and financial planner Katy Song, CFP®. This article was updated September 2020.
Back in 2011, I wrote, "Why Nobody Should Have a 529 Plan". I argued that the benefits of these IRS created plans were not worth locking your money up to use for college for several reasons. In 2011, the original account beneficiaries were starting to go to college and withdraw money. Plan performance was mediocre at a ~3% annual rate of return, investment options were few and expensive, and the plans carried account and administrative fees. I argued it was better to invest the money yourself in a brokerage account so that you could have unlimited investment options, lower/no fees and complete control over the use of your money.
Fast forward to 2020, and things have changed. Let’s look at the 3 main advantages of a 529 Plan.
Advantage #1: Tax-free growth when used for qualified education expenses. First, you have to have some growth to make this an actual benefit. In 2011, people thought a rate of return around 3% for a 529 plan was amazing. Since 2011, the S&P’s compounded annual growth rate (CAGR) is ~12% from June 2011 to June 2020. That is a lot more tax-free growth than the 3% account owners got back in 2011. Over a nine-year period, a $10,000 investment growing at 3% would give you tax free growth of ~$3,048 (less account fees and maintenance fees charge back then on 529 Plans). Over that same period, a 12% CAGR would give you tax free growth of $17,731. Tax-free growth on a much higher rate of return is significantly more compelling!
Also, there used to be management fees and other hidden costs that eroded those gains. Today, Plan administrators have eliminated account and maintenance fees, and even expense ratios are greatly reduced (0.25% in 2011 to 0.13% in 2020 same plan… same fund).
Finally, the list of qualified expenses has grown. Now you can use up to $10,000 per year for private primary and secondary school, and even apprentice programs.
Advantage #2: Donor maintains control of the money. While the account is for the benefit of your child, you write the checks to the school and your child doesn’t have access to the money. Nothing has changed on this front since 2011. If you had a regular brokerage account, you maintain control as well, so this does not appear to provide much benefit.
Advantage #3: Low maintenance option. When you invest in a 529 plan, the plan professionals handle your investments, and you do not have to worry about how to invest your money. This benefit assumes that the plan professionals are looking out for your best interest and maximizing your return on investment. In the beginning of 529 Plans, the investments were bad. With increased competition, transparency and alternatives, 529 Plans offer many more investment options than before and continue to improve their offerings to compete with other plans.
For example, Savingforcollege.com ranks New York’s Vanguard 529 Plan #1 right now. It was #1 back in 2011 and it is again in 2020. They used to offer 3 age based investment options and 13 other investment options. Today this plan has 9 age groups with three portfolio options (Conservative, Moderate and Aggressive) plus 13 static portfolio options.
Passive, well-diversified index funds and robo-advisors are everywhere now. So, I don’t see managed investments in a 529 Plan has an advantage over a passive well-diversified ETF.
So, the ONLY compelling reason to have a 529 Plan is for tax-free growth. If you want to maximize this benefit, then you should do the following:
- Frontload. Put in as much as you can as early as you can to take advantage of the power of compounding. The IRS allows an individual to frontload 5 years’ worth of gifts (5 x $15,000) in one year. If you can afford it, do it. This method is much better than trickling in $250 per month over 18 years.
- Be aggressive with those investments. The age-based funds don’t change a whole lot in the early years. Once beneficiary is 10 years old, the age-based funds get conservative very quickly. Instead, pick the Static Aggressive Growth option and let the money compound until middle school. Then, you can change the investments to be more conservative.
Approximately 70% of the cost of college is “qualified expenses”, which leaves 30% of soft costs for which 529 plan money cannot be used without a penalty and taxes. Once you have funded the 529 Plan or around middle school, whichever comes first, start saving for the soft costs in a brokerage account in your name (not your child’s). By this age, the power of compounding is starting to diminish in the 529 plans, and you want to make sure you don’t have all your eggs in the 529 basket.
Katy Song, CFP, focuses on comprehensive financial planning for families with young children and couples starting their lives together. You can contact Katy at email@example.com, visit her website katysong.com, or follow her on Twitter @katydavissong. She lives in Mill Valley with her husband and children.
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