For decades, college costs have been climbing at a faster clip than inflation. That sad fact shows little sign of changing.
So back in 1996, Congress passed Section 529 of the Internal Revenue Code, which led to the 529 college savings account, widely hailed as the most exciting savings vehicle since the piggy bank. It's an investment account that grows tax-free; withdrawals for qualified educational purposes are exempt from federal taxes, too. Since they are administered by the states, some 529s also offer extra state tax incentives.
Still, many investors are finding these plans haven't performed as expected. "The financial crisis derailed many Americans' college savings strategies," laments Jeff Coghan, assistant vice president of college savings at The Hartford in Simsbury, Conn. "Now it's time to get back on track."
But how? Are 529s still the best option? Or should the question be more nuanced: For what type of investor are they ideal? And in what situations might alternatives be better?
In short, how has the economic meltdown altered college savings strategies?
The Case For 529s
To be sure, some 529 advocates are unfazed by the recession and if anything have become more resolute. "Our recommendation doesn't change as the stock market changes," insists Joan Marshall, the executive director of the College Savings Plans of Maryland, located in Baltimore, and chair of the College Savings Plans Network (www.CollegeSavings.org), an association of state and private sector 529 administrators.
But try telling that to the parents whose college funds have gone nowhere over the past decade and whose kids are now done with their SATs. "For the ten years ending December 31, 2010, the annualized return for the S&P 500 (including dividends) was just 1.4%. Without dividends, the return was negative," notes Steven Bleiberg, president and chief investment officer at Legg Mason Global Asset Allocation and a portfolio manager for the Scholars Choice College Savings Program in New York.
Most 529s start off heavily invested in equities. That's the surest way to grow funds over the long term, but it also means the plans have recently faltered along with the market. Don't blame "some quirk of college savings plans," asserts Bleiberg. "It's not the vehicle that's the problem-it's the road it was traveling on."
Fortunately, the number and variety of roads on the 529 map keep growing. There are options for every asset class. "Many plans have even added FDIC-insured securities," says Coghan, calling this safe option a "trend [that] gets the most attention coming out of the 2008 downturn."
Investors can change 529 plans once a year. "The problem is not having too few 529 products available to choose from but not allocating funds appropriately," says Christopher Abts, president of the Cornerstone Retirement Group, a financial planning firm in Reno, Nev.
One popular 529 option features automatic, age-based rebalancing that shifts assets into less risky territory as college nears. "If an investor is not using an age-based program, he or she will need to remember to make appropriate changes ... [to stay] consistent with his or her goals," says Kara Harmon, a certified financial planner with the Moneta Group in Clayton, Mo.
529 Limitations
Yet even those who do use automatic rebalancing ought to pay attention. For instance, you don't want your account to start automatically selling equities when they're cheapest just because the schedule says it's time. "We see the concept of an age-based portfolio showing some flaws," cautions Lawrence Glazer, managing partner at Mayflower Advisors in Boston.
"You could bear the brunt of a downturn by being heavily in equities," he says. But by shifting to bonds, you would not fully participate in the recovery. "This is adding insult to injury!"
There are situations in which 529s might not make sense at all. "The tax-exempt properties of most plans are a plus, but I'm not sure that all participants are able to take advantage of the benefits," says Jay Ferrara, investment officer and economic strategist for Farmers and Merchants Trust Co. in Laguna Hills, Calif. The reason, he says, is quite simply that the goal of college savings should be "relatively low costs with above-average investment performance." That's a hurdle, he says, that few 529s are able to overcome.
Furthermore, if your client is in a low enough tax bracket, a 529's tax advantages wouldn't amount to much, and there's arguably no reason to pay the extra fees. These administrative surcharges have come down in recent years, but usually a direct investment in the underlying mutual fund carries a lower expense ratio. "For small-dollar investors, alternative [investment funds] can make sense," acknowledges Joseph Hurley, the Pittsford, N.Y.-based founder of SavingForCollege.com. "A tax-advantaged vehicle usually only makes sense if your investments are doing well. If you expect the market to tank in the future, you might not want to use a 529."
Another complaint about 529s is that withdrawals are limited to college tuition or other "qualified" expenses such as textbooks or an academic computer. But what if you have unqualified college expenses such as travel or dorm furniture? "I encourage my clients to save money outside of the 529 plans as well," says Mark VandeVelde of Hefty Wealth Partners in Auburn, Ind.
Though he's a fan of 529s, VandeVelde suggests his clients save additional funds in a custodial account under the Uniform Gift/Transfer to Minors Act, which also grows tax-free. "That way they have the tax benefits but no restrictions, as long as withdrawals are used to benefit the child," he says.
The risk with custodial accounts is that the child gains full control at "majority age"-18, in most states-and can run off with the money. If that's a concern, a 529 might offer a degree of comfort. At worst, the penalty for unqualified withdrawals is only 10%. "If funds ultimately need to be withdrawn for reasons other than qualified college costs, the 10% penalty is a reasonably small price to pay for the tax-deferred growth," notes Lisa Simonson, a financial planner at Laird Norton Tyee in Seattle.
For many, a good alternative is a trust fund. It works like a custodial account, with no restrictions on how withdrawals are used, except you get to set the age threshold.
Other Funding Sources
These are all pieces of the puzzle, potential ingredients in the stew of a robust college savings strategy. "The new approach to financial planning for college should be to establish multiple sources," says Atlanta-based Ornella Grosz, author of Moneylicious: A Financial Clue for Generation Y. "It's always best to have a Plan B."
Those sources might include student grants or Coverdell Education Savings Accounts, formerly called Education IRAs. Coverdell funds grow tax-free, but contributions are limited to $2,000 per child per year. (Next year, that cutoff shrinks to $500.) Funds can be spent on secondary schools as well as college, though that might change next year, too. When the student turns 18, remaining funds become the child's to squander. If any are left when the student is 30, they're subject to taxes and penalties.
Loans And Financial Aid
Other options are tuition loans or financial aid. Even clients who don't think they'll need them should not jeopardize their chances. They should realize that trust funds and custodial accounts can work against eligibility in a way that 529s and Coverdells don't; the former are considered the child's assets, whereas the latter are deemed the parents'. "The student's financial resources have a greater impact on financial aid than parental resources," says Kirk Okumura, adjunct professor of financial planning at the American College in Bryn Mawr, Pa. "In general, 20% of the student's assets are counted as contributable [to tuition] while only 5.6% of parental assets are currently counted."
That means you could end up spending more than necessary. "If the child has $10,000 in a UGMA or other assets, you've added 20% of that, or $2,000, to the family's contribution toward tuition," explains Thomas Casey, a financial planner at Casey Thomas & Associates in Shelton, Conn. "But if that money is in a 529, you reduce the financial aid liability to 5.6%, or $560. ... College counselors rarely tell you how to position your assets to maximize eligibility for financial assistance."
Still another way to keep assets separate from both the child and the parents is to tap grandparents. "Grandparents can set up a 529 plan so the assets don't count towards financial aid," says John Podleski, a financial planner and senior partner at Angelo Planning Group in Rochester, N.Y. When grandparents establish a 529, they name a specific grandchild as beneficiary but retain full ownership of the assets, Podleski explains.
Life Insurance
Perhaps the most surprising alternative in college savings is life insurance. "We're seeing a lot of people using the cash value of life insurance as a savings vehicle," says Thomas Henske, partner at Lenox Advisors, a wealth-management firm in New York. Slow but steady guaranteed returns with little volatility make this a compelling choice. "If the child is young enough and the client is healthy enough, this might even be one of the better options," Henske says.
Estate Tax Advantages
Whatever investment vehicle is used, there could be estate tax implications. Money given for a child or grandchild's education is money transferred to heirs without the bite of estate taxes. Annually, such gifts cannot exceed $13,000, of course. But 529s can be front-loaded with as much as five years' worth of gifts at once-that is, up to $65,000 per donor. "There's a special selection you can make to treat the 529 contribution as if it had been made over a five-year period, up to the annual gift-tax exclusion amount," explains Gregory Merlino, president and founder of Ameriway Financial Services in Voorhees, N.J.
On the other hand, 529s can also be a liability for estate tax planning. "Moderate- to high-net-worth folks might be better served using their own dollars to pay for their kid's college education," says Henske, referring to the fact that the annual gift tax limit is waived for gifts made directly to an educational institution. "If they put the maximum gift amount in a 529 every year for, say, 18 years, chances are they'll fully fund their kid's college," he says. "But when that time comes, they will have to use the 529 money for college. They'll lose the chance to reduce their estate further via the educational gifting exemption."