The Best 529 College Savings Plan
You may have heard that the cost of college tuition is rising, but did you know that the cost of tuition at a 4-year public-university could be as much as $225,000 for a child born today, under moderate assumptions? Saving for college is a big challenge for many parents, but a 529 College Savings Plan can help. However, not all 529 plans are created equal, and one I know may be better than the rest (spoiler: It is the West Virginia plan).
529 College Savings Plans have many tax and savings benefits, but few people use them.
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Few families actually save in 529 plans. While these plans have been widely publicized for years, families either do not know about them or do not have the money to set aside. According to the U.S. Government Accountability Office, only 3 percent of families contributed to a 529 plan in 2010. This is far lower than one might expect considering the need to save for rising costs. Nearly every state has at least one plan and many have more than one. There are more than 100 plans nationwide, many of which are open to residents from any state (ex. Washington parents can open a 529 account in West Virginia - no travel required).
There are behavioral and tax reasons why one should use a 529 plan, rather than keeping money in a savings or investment account. The behavioral reasons are that once the money is deposited in the plan, there are tax penalties for retrieving it, which keeps parents from doing so on a rainy day. While the penalty is relatively small (10 percent of the investment income), the deterrent works. In addition, the tax benefits to using a 529 plan are helpful to families. The investment gain on assets deposited into the plan is tax deferred and the withdrawals are exempt from federal income tax (like a Roth IRA) if used for qualified education expenses (ex. tuition and books). While contributions to a 529 plan are not deductible from the donor’s federal income tax (like the Roth), many states provide state income tax deductions for all or part of the contributions of the donor. This matters most to those in high tax states.
Not all 529 plans are created equal
Washington State's Pre-Paid Plan
There are two main types of 529 plans: “pre-paid plans” and “savings plans”. Pre-paid plans allow one to purchase tuition at today's prices to be used in the future (Washington state and Michigan have such plans). Therefore, performance is based upon tuition inflation (about 9 percent per year in Washington state for the last 30 years). The main benefit of a pre-paid plan is that the sponsor of the plan bears the investment risk. That means that if the stock market crashes right before your child is ready for college, you do not have to worry about not having saved enough. Unfortunately, only 11 states have such a plan and to cover the investment risk, sponsors have raised prices dramatically over the last decade. Furthermore, the future availability of these plans is uncertain due to state fiscal challenges.
Savings plans are more widely available than pre-paid plans, but not all are created equal and the West Virginia plan may be the best. Among all the 529 savings plans, annual fees range from about 0.3% per year to nearly 3% per year and investment options vary from low to high quality mutual funds.
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I know what you may be thinking: Why West Virginia? The reason is that the investment fees in the West Virginia plan are extremely low (think Walmart prices) and the quality of the investment options is very high (think Mercedes). Fees in the West Virginia plan are around 0.3% and the plan is open to residents from any state. The plan is named the Smart529 plan and I think that name suits the underlying investments. Those investments are mutual funds from Dimensional Fund Advisors (Dimensional). Dimensional’s mutual funds regularly rank at the top of all mutual funds, due in part to the smart management of the funds and those low fees. Dimensional was started by some of the most notable financial economists of the last century, and it shows as the popularity of Dimensional’s funds has grown significantly along with the value of the funds.
If you would like to learn more about how to maximize the benefit of your contribution to your child’s 529 plan it is wise to check-in with an investment advisor who is knowledgeable about these plans. There are other considerations besides those mentioned in this article, such as how 529 savings affect availability of tuition assistance, how to retrieve the money deposited into a plan in an emergency, and gift and estate tax implications.