If you were trying to level a mountain with your bare hands, you’d be pretty happy when someone gave you a shovel.
And you’d be a lot happier when they brought in the heavy equipment.
Well, for anyone saving for college education, a new type of investment program could prove to be just the machinery to get the job done.
It’s called a 529 Plan, named for the section of tax code that allows its creation, and it may someday become as ubiquitous as another numerically named savings tool, the 401(k). More likely, it will be known under some other fancy name, depending upon what your state calls it.
Some version of a 529 Plan is operating in 16 states, with plans either in the legislative or startup process in several others.
The following states currently have 529 Plans: Arizona, Connecticut, Delaware, Indiana, Iowa, Kentucky, Louisiana, Massachusetts, Montana, New Hampshire, New Jersey, New York, North Carolina, Utah, Rhode Island and Wisconsin. The following states have legislation for a 529 Plan pending: California, Maine, Minnesota, Missouri, New Mexico, Oklahoma, Vermont. In addition, Florida, Ohio, Virginia and Wyoming are studying the option.
“I’d be amazed if there was any state that did not have one of these plans in place within the next three years,” says Philip C. Johnson, a Clifton Park, N.Y., financial adviser who specializes in helping clients plan for college. “This seems to be the right mix of investment return and safety and tax benefits, so that the state can really help people save.”
Adds Brian Grodman of Grodman Financial Group in Manchester, N.H.: “This is one of the few laws passed by Congress that really helps people from all income groups provide for their children’s college education.”
A 529 Plan allows parents or grandparents to set aside money in an account of which the child is the beneficiary. The money grows tax-deferred until it is withdrawn to pay for college expenses (tuition, room, board, books, etc.), and is then taxed at the child’s rate, usually much lower than the parents’. Many states are making 529 Plan investments state tax-free.
The kid can go to school anywhere, and many 529 Plans are open to non-residents, meaning that neither the giver nor the beneficiary must live in or attend college in the state. In fact, that means savers can shop around to find the best available open-enrollment plan (though they could face some tax consequences by moving money out of state).
The 529 Plans also have other positive aspects. There are no income limits for participation, and the amount that can be deposited is high. In addition, a parent or grandparent can give up to $50,000 to a child in a single year ($100,000 for a couple) without facing gift tax problems. Essentially, the gift giver is making five years worth of gifts at once, which is why they can hit this maximum just once every five years without tax complications, putting the money to work now instead of on a rolling, year-after-year basis.
State-sponsored savings plans are not new, but the 529 adds a significant twist.
Nineteen states, including Illinois, have what is known as a “prepaid tuition plan.”
In this type of program, as opposed to a 529 plan, investors essentially are buying tomorrow’s tuition at today’s prices. If you put in half of the cost of current tuition, it is guaranteed to be worth half of your kid’s tuition when he or she hits college age, regardless of what happens with tuition inflation.
Typically, however, these plans have serious limitations. Most work with only a limited number of schools; if your child goes elsewhere, you are likely to get back only your initial deposit plus inflation.
Others are limited to state residents. And most prohibit transferring money in an account for one child directly into the account for another (if, for example, one child does not use the entire account while paying for college).
Just as important, the rate of college inflation has been slowing, while the stock market has been booming.
And that’s where the 529 Plans come in. They allow stock investments, albeit with a significant catch.
The individual investor is not allowed to control where the money goes. Unlike a 401(k) plan, you don’t get a few mutual funds from which to choose, with the option to pick from a menu and be as aggressive or conservative as you please. Instead, the state picks the menu and decides what you’re going to eat.
In some cases, this has been bad. In Kentucky, for example, the 529 Plan invests entirely in Treasury securities, hardly the growth-oriented vehicle needed to amass a mountain of college savings in a tax-deferred environment.
In New Jersey, the plan has some stock investments, but is conservative, largely because it does not change asset allocations over time.
In Massachusetts, New Hampshire, Delaware and Arizona, by comparison, money is invested in a mix of mutual funds that changes as the child grows. It starts with 80 percent of the money in stocks and becomes conservative, until just 20 percent of the money is in stocks as high school graduation nears.
That is one big drawback of the 529 Plan. While tax deferrment and the lower tax bracket of the child will help, it’s not necessarily going to make up for the better returns you might get from a more aggressive portfolio.
Another concern can be the cost of the program. The expenses don’t offset the tax benefits, but they do add a layer of cost to the mutual funds, bonds or other instruments in these plans.
And the third big concern is how the money will be treated when it comes to financial aid. Currently, most experts believe 529 Plan money will be treated as if it belongs to the parents, which is more favorable from a financial aid standpoint than if it were in the name of the child.
“Unless you have problems with the allocations, where you want to be more aggressive, these plans are a can’t-miss, win-win situation,” says Barry Freedman of Freedman Financial Advisors in Peabody, Mass. “Anyone saving for college really needs to take a good look at this.”
What might be best for most investors, experts say, is a mix of plans and planning tools. While the 529 Plan has the potential for better growth than a prepaid tuition program, it does not come with a guarantee of investment performance. If education inflation starts to creep back up and the market slows down, many people might prefer the certainty of a guarantee despite the limitations of the programs.
And while the Education IRA allows only a small savings amount ($500 annually), it can be invested more aggressively, as can any other after-tax savings earmarked for college.
“These plans are best used in conjunction with your other investments,” says Johnson. “The state-sponsored plan becomes the conservative aspect of your college savings. And since you are, therefore, relieved from that conservative obligation, you can be more aggressive with the rest of your money. You marry the two sides to develop your own college savings plan.”
Stephen Mitchell, senior vice president at Fidelity Investments, which is running the plans in several states: “The news here is that there is a new tax-advantaged savings program that will allow people to pay for a loved one’s college education. Not just some of it, like most of the older plans or Education IRAs, but all of it.
“We think that’s a message that a lot of people will be very happy to hear.”
