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Is the 529 really necessary for college savings?

There's been a lot of talk recently about 529 plans. This leads me to wonder... are these things really necessary? There are already provisions in the IRC that allow parents to use IRA funds to pay for college tuition. Some 401k plans allow hardship withdrawals to pay for tuition, but you pay a 10% penalty. So I'll focus on using IRA funds to pay for college. Of course you can buff up your IRA balance with a

401k rollover.

First, there's the Roth option. Suppose you put $8K per year (self + spouse) in a Roth IRA for 18 years. Assuming 7.22% return, you'll end up with $296K. Of that, $144K is contributions. You can withdraw the contributions without tax or penalty to pay for junior's education. Assuming the contributions are enough, you've still got a nice chunk of change ($152K + left-over contributions) in the Roth. If the contributions aren't enough, you can start to use the earnings. If you're under 59.5, you have to pay ordinary income taxes on the earnings, but not the 10% penalty.

Then there's the traditional option. If the contributions are deductible, you'll realize a tax benefit every year you contribute. But then, when you go to make a withdrawal to pay for college, you will pay ordinary income taxes on the money. However, since you're using the money to pay for education expenses, you're exempt from the 10% penalty, even if you're under 59.5.

OK, that stuff is pretty standard knowledge. But I believe there are other advantages to using your IRAs to save for college:

1) Flexibility. If your child gets a scholarship or decides not to go to college, that's fine. If you decide that you can't afford to finance junior's education, that's OK, too. You can do whatever you like with the money. 2) More tax benefits. The IRC specifically bans double benefits for college incentives. Money taken from a 529 or ESA cannot deducted or applied to the Hope or Lifetime Learning credits. As far as I can tell, the same is not true of money taken from IRAs. 3) Control. As opposed to a UGMA/UTMA account, you retain complete control over the money. So junior can't take it and buy a Corvette.

To be fair, there are some disadvantages, too:

1) Scalability. The amount of money you can contribute does not scale with the number of children you have. I believe the limits on the 529 plans are per child. 2) Eligibility. If your AGI is too high, you start to lose IRA benefits (though this may change in 2010 when the Roth conversion income limit goes away). There is no income limit for 529 plans. 3) State benefits. Some states provide nice tax breaks for participating in their 529 plan. Unfortunately, if you live in a state with a crappy 529 plan, this would be meaningless if you opt for another state's plan. 4) Lower limits. It's not uncommon for people to max out their 401k and IRA. In that case, a 529 or ESA can provide another tax shelter.

OK, there's my analysis. Anyone else have thoughts on the matter?

--Bill

Reply to
woessner
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You're dead on as near as I can tell on everything up to this point.

529's remain an asset or the parent on in the paren't scontrol. So junior can't go buy a Corvette.

Correct. And benefits can be shifted to other children, I believe, though I haven't tested this mechanism with my own state's plan.

This is the compelling point for me, in a state with a 3% income tax rate--I can deduct the contribution from income. Being free of federal and state income tax in most cases on the gains (guaranteed to

2010 federally at least, IIRC) and deductible in many cases on state income tax starts your earnings 3% ahead straight away.

You seem to have a good handle on it based on my past months of research into the subject. I'm curious what folks have to say as well.

Best Regards,

-- Todd H.

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Reply to
Todd H.

question -> if we contribute to a 529 plan, where is that "deducted" ?

Reply to
P.Schuman

This is my understanding. Contributions are not deductible from your federal taxes. According to this web page

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28 states and DC allow you to deduct 529 contributions from your state taxes. Only Pennsylvania allows you to deduct contributions made to other states' plans.

--Bill

Reply to
woessner

If your state provides for this deduction when investing in your home state's plan, it'd be on your state tax form somewhere.

Contributions to 529's are not deductible from federal taxes to the best of my knowledge.

-- Todd H.

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Reply to
Todd H.

Aside from the state tax deduction, the benefit (if it survives 2010) is the tax-free growth. Not deferred, tax free. You'd have to compare that benefit to the expenses within the 529, because it would seem that proper gifting to the child and having them pay long term gains at 5% would quickly negate the tax savings.

The rest of your analysis mostly compares the 529 to using one's retirement account to fund their child's college. For some, the 401(k) and IRA limits are high enough to save for their retirement, for others, that could make sense, and straddle the fence in that if the child doesn't go to school, the money can just stay in the retirement account(s).

FWIW, the Fidelity 529 fees ranges from .50 (for their S&P index fund) to over 1% for managed funds. I suppose, given the limited choices within a 529, that can be motivation enough to avoid them.

JOE

Reply to
joetaxpayer

I'm having mixed feelings about the whole 529 world. We have a Fidelity 529 that was setup by our son's grandparents, and it has a 3.5% front end (that I believe is being waived) along with the annual fee (forgot the %). But - it's very conservative, and only earning about 5-6%. So... we'll see -

Reply to
P.Schuman

I believe the "tax-free withdrawals if used to pay for qualified educational expenses" was made permanent (well as permanent as any law can be) by one of the tax laws that passed in 2006.

Reply to
Rich Carreiro

Reply to
wyu
[...]

One thing to be careful of is the "kiddie tax", under which higher amount's of child's investment earnings are taxed at parents' rate. This wasn't so bad when the cut-off age was 14, but now it's 18. Even with long-term investment in mutual funds, there can still be annual capital gains distributions and dividends that are taxed at parent's rate.

Plus, a conservative approach would dictate that money you need for tuition shouldn't be in the stock market within 3-5 years of when you are going to need it (too risky).

So, you can still put maybe $10-20K in the kid's name and benefit from lower tax rates on the earnings, but more than that and the new kiddie tax rules really push you toward the 529 plan.

I'm old fashioned and have a chip on my shoulder from having to earn my own way through college and beyond, so I say: let the kids work or borrow to pay for college, you can always help them pay back the loan later if you choose.

-Mark Bole

Reply to
Mark Bole

Your point is well taken, I forgot to mention about the kiddie tax. Which, if one follows your advice to move from stocks as school approaches (which I agree with, BTW), then the 529 scores points in that regard. While the choices within the 529 are limited, there's 100% equity all the way to a Money Market equivalent in most offerings. And the transactions remain tax free in the account. JOE

Reply to
joetaxpayer

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Reply to
clay

I wonder if there are safeguards against abusing this benefit. For example, you could open up an account for yourself and contribute just enough money to get the full match. When the match is credited to your account (and you're vested in it, if there's such a concept), you withdraw the money. You'll have to pay taxes and the 10% penalty, but who cares? You just got a 100% return on your investment. I'll take that and a 10% penalty every day of the week and twice on Friday.

I am so going to Hell... :-)

--Bill

Reply to
woessner

Here's the detail for Kansas;

(May 22, 2006) - Kansas has enacted a matching contribution program for a limited number of Kansas residents participating in the state's Learning Quest 529 plan. Under a 3-year pilot program beginning July 1,

2006, the match is dollar-for-dollar up to $600 per year. The program is limited to 400 applications each year from individuals or families with incomes below 200% of the federal poverty level.

I'd imagine any matching plans are similar. But your logic is why I am a broken record stuck on "deposit to your 401(k) to get the full company match". Even after tax and penalty, if you lose your job, it's worth doing.

JOE

Reply to
joetaxpayer

A 529 plan is plausible for those who have contributed the maximum to

401(k) and IRA contributions. Since it is the gains in the 529 plan that are untaxed, the benefits are largest when contributions are made long before they are withdrawn.

There is a philosophical problem with putting too much money in children's college savings accounts when they are very young -- how do you know they are college material? I think too many Americans who go to 4-year colleges are not smart enough and motivated enough to benefit from the experience. Most 4-year college degrees does not certify more than what a high school diploma ought to. I don't want my children to think of the freshman year of college as being the "13th grade" -- their should attend if their track record by the end of high school demonstrates that they can handle the intellectual challenges of a real college education and that they want to. Society needs skilled workers (plumbers, electricians, nurses, etc.) whose occupations do not require

4-year college degrees. Even for medicine, 6-year college+medical-school programs exist, and for law, I think people could enroll just after high school -- the current obstacles to this are artificial. I program at my job, and I know that somone with the knack can pick up computer programming by reading and experimenting.

To forecast the probability that one's kids will be smart enough for college, one should consider the intelligence of the parents. I think I have read that rate of mean reversion is about 0.5, so that if the average IQ of the parents is 130, the predicted IQ of the children is

100 + 0.5*30 = 115 . One can get a reasonable estimate of IQ from SAT scores, and I think there are web sites that provide conversion tables. Charles Murray estimates that an IQ of 110 is needed for college. Two of his articles -- "What's Wrong With Vocational School?" and "Intelligence in the Classroom" and his book "The Bell Curve" provide the basis of what I have written.

To sum up, I think colleges today are a grossly inefficient credentialing machine, and I hope that in 20 years time the education sector will be rationalized, with less money spent in real terms. I have 3 kids and have put about 5% of the expected costs of 4-year colleges for all of them in 529 plans, but I intend to do further saving in retirement and general taxable accounts, until I have a better idea of their talents.

It is no disgrace for a kid to just not be smart enough to attend college. Maybe his parents can better assist him with a down payment on a house at age 30 than college tuition at 20.

Reply to
beliavsky

I think we are back to a topic where the answer is specific to a given individual. I'm not a big fan of 529s, but am objective on the topic. The limited choices within the plans are a negative to me, but can be a positive as they are less overwhelming than having the entire universe of investments to choose from. I remain apprehensive of mixing one's retirement assets and college savings, yet appreciate the point that if the child doesn't go to college, then no action is required. At least a 529 isn't quite a completed gift. If the child doesn't go to college, the parents still have control of the money. I'm also hypersensitive to the gain/loss in a given type of account, as my questioning of 401(k) fees exemplifies. If we agree that the major benefit of the 529 is the tax free growth, but the cost is a minimum 40 basis points (.40%) as there are index funds at 10 basis points vs the 50 for the cheapest 529, that's about a

4% hit to the account. (say an average time invested of 10 years). This to avoid whatever cap gain rate is in place at the time of withdrawal. OTOH, we don't know the cap gain rate 10 or 18 years hence, so perhaps putting in some money, but not 'too much' is a good diversification among the tax aspect of the accounts. Some in your retirement account, some in straight UGMA, some in the 529.

Your analysis of the percent of people who go to college is noted, but I note also, that most people I run into have pitifully undersaved, and are now either paying most of their income to tuition bills, or taking equity loans. I'd make the case that the average person pondering this question is both above mean income, and above mean intelligence. (kind of like how any finance magazine can make a similar claim, the reader, by definition, isn't average)

JOE

Reply to
joetaxpayer

I have heard of a couple who's child got a scholarship and they had extra funds in a 529, and they took some classes - but the creative part was that they were held on a cruise ship! LOL

Scott

Reply to
scott

snipped-for-privacy@gmail.com,

A large number of 529 plans are set up by people other than parents.

I don't believe they get the same benefits from using IRA/401(k) that the parents do. Someone else may want to better analyze this aspect.

Reply to
kastnna

That is an excellent point. Of course, anyone can withdraw their Roth contributions for anything. For other early distributions (Roth earnings and traditional IRA), you can only avoid the penalty if the education expenses are for you, your spouse, your children or your grandchildren.

--Bill

Reply to
woessner

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