Thursday, July 5, 2012

Trying to figure out 529 plans

I’ve been trying to figure out whether we should set up a 529 plan for our son. It’s a particular type of investment account for saving for college education. Federal taxes on the earnings are deferred, and as long as you spend the money on college expenses, you don’t pay federal taxes when you take the money out.

What if it’s a mistake? What if you need the money for something else? You can take the money out, but you pay federal taxes on the earnings and a 10% tax penalty as well. But the 10% tax penalty is only on the earnings, not the principal, so if you had any significant amount of compounding tax-free then the additional compounding will largely offset the 10% penalty. I tried running scenarios of 4 years, 10 years, and 17 years with a compounding calculator, assuming 4% earnings or 10% earnings. That gave me a range of possibilities, and the tax penalty was just not that bad. For example, put $1000 into a 529 and grow it tax-free for 10 years at 4%, and you have $1480.24. Pull that out and pay the 10% penalty and 15% tax on the $480.24 of earnings, and you’re left with $1360.18. But if you had used a regular investment account instead and paid 15% federal taxes each year, you’d be compounding at 3.4% (earn 4% and pay 0.6% in taxes each year), and your $1000 would turn into $1397.03. That’s not a whole lot better, so the mistake scenario doesn’t look too costly. The higher the compounding rate, the less important the 10% penalty is. It’s certainly a smaller penalty than the bonus on the flip side of not having to pay taxes on the money spent on college.

The tax penalty is larger if you compare it to an investment strategy that defers the federal taxes, such as buying and holding stocks for many years. But the variation in earnings from different investments seems much larger than the variation due to tax strategy. And that’s the biggest difference with a 529 plan—in a 529 plan, someone else makes essentially all the investment decisions. Each plan is essentially a mutual fund. I don’t know anything about choosing mutual funds, and this is a way not to have to worry about the choice repeatedly over time. Just pick a 529 plan, and call it a day. That appeals to me.

But you still have to choose a plan, and that’s annoying. Every state has one or more plans, and they’re all a little different. If your state doesn’t offer you any specific advantage for choosing your own state’s plan, then there’s no reason to choose your own state’s plan. New York has one direct-sold plan, but a bunch of options within that plan. You can just let the plan choose an option based on how old the child is (and let the plan automatically adjust to more conservative options as college draws closer), which is what we are likely to do. I no longer kid myself that I have an investment philosophy, so I like the idea of letting someone else make the decisions, at least with this.

So a 529 is a Roth IRA with really limited options, where the money is used for college instead of retirement.

A lot of other questions about 529s were pretty well answered for me at since apparently I think more like a grandparent than like a parent. You can change the beneficiary to another family member of the original beneficiary. Other people can contribute money if they want. You can use the money for trade school or grad school, but not for private high school. And this is different from a tuition prepayment program, which is an entirely different proposition.

I’m still hesitant to set this up, because I don’t think college financing will look anything like it does today when my son is old enough to go to college. The current system is not sustainable. But I suspect there will still be higher education options, and those options will still cost money, so money will still be helpful. And if it’s not, or if my son doesn’t want a higher education, or if he finds a free ride somehow, then the 10% penalty isn’t so bad. That’s something of a comfort.


Amy said...

We've done ours through Vanguard, because we have the rest of our similar stuff there (Roths and whatnot) and it's super easy and you can do the whole thing online. It's probably not the ultimate perfect thing, but ease of use means we actually use it, at least.


I have to say after all the analysi, the long term benefits outweighs the short term savings issue. Everyone should have 3-6 mints of expenses on hand anyway for emergency, so a raid drawdown shouldn't be an issue


Anonymous said...

There is also the private college independent 529 plan, which works a little differently. Instead of relying on investments, you are just buying tuition certificates based on today's tuition rates for select private colleges. It's only good for colleges in the plan though (or you can get a refund, but with only nominal interest accrued).