For the vast majority> of college savers, 529 plans are a great deal. Why? I've got four good reasons:
1. Gains are tax free.
2. Most people don't want to micromanage their college accounts.
3. Being able to get the money in your college fund back (if necessary) is a good thing.
4. Paralysis by analysis is the worst enemy of college savers.
If you agree with these statements, the 529 plan is probably your best bet as a college-savings vehicle. Allow me to explain.
Gains are Tax Free
You may be tempted to simply bypass 529 plans and save for your child s college education in a taxable account. What the big difference, anyway? Quite big. Gains in 529 plans are tax free, while gains in a taxable account are subject to capital gains tax rates that s better than income tax rates, but it s a tax nonetheless. Let s face facts: A 0% tax rate beats a low tax rate.
Theoretically, a taxable account or a child s UGMA or UTMA custodial account could beat a 529 plan over time, given all of the right circumstances. But that s a stretch. (More on this later.) After all, given the right assumptions, I can prove the absolute best college-savings strategy is to stuff $100 bills in empty coffee cans and bury them in your backyard. With my trusty calculator and some assumptions, I can prove just about anything.
Winner: 529 Plan
Most People Don't Want to Micromanage Their College Accounts
From a pure convenience aspect, a 529 college-savings plan allows you to basically pick your investment strategy and then go on autopilot. If you wish, however, you can generally readjust your investments once a year. The price of this convenience is fees, and the fact that you give up control of your asset allocation.
On the other hand, using a taxable account for your college-savings fund gives you a chance to generate higher returns, because tax strategies used by 529 plans aren t all that aggressive. At least that's the theory. It can even be true if you're a savvy investor and have time to micromanage your account in order to achieve optimal after-tax results.
It s theoretically possible for taxable college-savings accounts to solidly whip a 529 plan, especially if you're willing to save using your child's UGMA or UTMA custodial account. However, this assumes the rosiest scenario for the taxable accounts: (1) a significant rate of return advantage thanks to your undeniable investment smarts, (2) tax deferral until the end of the day thanks to your considerable tax planning talents, and (3) low tax rates at that time thanks to your old pals in Washington (perhaps unrealistically low). Are these reasonable assumptions given the constraints on your time and uncertainties about future tax rates? You'll have be the judge of that, but keep in mind, if you go with a taxable account and you don t get a return advantage, the 529 plan results will crush your taxable account.
Being Able to Get the Money in Your College Fund Back Is a Good Thing
Realistically, you may not be able to beat a 529 college-savings plan with a taxable account unless you're willing to save in your child's name via an UGMA or UTMA custodial account (even then, it's certainly no sure thing). The big problem with the custodial-account approach is that your child gains unfettered access to the account upon reaching the age of majority in your state (usually 18 or 21).
Yikes! If you're having visions of your kid driving off into the sunset in a brand new sports car purchased with the cash from his or her college fund, that's an appropriate reaction.
By contrast, using a 529 plan as your college-savings vehicle leaves you in control. If your child decides to become a professional body surfer, you can designate another child (or grandchild) as the new 529 account beneficiary. If the absolute worst happens and you flat out need to get your money back, you can get it back with a 529 plan. To be sure, you'll pay income taxes and a 10% penalty on the accumulated earnings, which is a much harsher treatment than if you invested in a taxable account in your own name. But at least if all hell breaks lose, the money is accessible.
Bottom line: A college-savings plan keeps the ball in your court, not your child's. And believe me, even when there's no doubt your children will go to college and it's perfectly clear you won't ever need the money in the college fund back, it's a blessing to be able to threaten the little devils with pulling the financial plug if they don't toe the line. With an UGMA or UTMA account, you lose this leverage.
Winner: 529 Plan
Paralysis by Analysis Is a Bad Thing
As if you don't already have enough variables to think about, here's another: What are the financial-aid implications of saving for college using a 529 plan versus a taxable account in your own name vs. a taxable UGMA or UTMA custodial account in your child's name? Answering this question has become so complicated that financial-aid planning is now a profession. Result: Some parents become totally paralyzed by the horrible thought that their college-savings strategy might somehow cause their child to lose out on valuable financial-aid goodies. So they do nothing, which is clearly the worst possible strategy.
Trust me: If you invest in a good Section 529 savings plan, you won't be shooting yourself in the foot. Here's why. Saving for college in your own name generally produces the best results when applying for financial aid. But the tax results aren't so great. Saving in your child's name generally produces the worst financial-aid results but better tax results. Using a 529 college-savings plan generally puts you in the middle of the financial-aid spectrum, but you get great tax results. On the other hand, having no college fund at all may qualify your child for valuable financial-aid benefits in the same way that becoming unemployed may qualify you for valuable welfare benefits.
Winner: Any College-Savings Strategy
The Final Score
According to my scorecard, 529 college-savings plans get two points out of a possible four. The taxable-account alternatives get no points. So the 529 plan wins by a technical knockout.
That said, I'd recommend you avoid plans with high fees. Also, please deal directly with the plan you select (rather than being sold a plan through a broker). I think paying a hefty sales commission to get into a 529 plan is a terrible idea when you can get into many good ones for free. (To compare plans on your own visit Savingforcollege.com.) Finally, I think you also should avoid state 529 prepaid-tuition plans. With many state schools now raising tuition and fees at double digit rates, several states have reacted by shutting down prepaid plans and/or reneging on the original deals. This is shameful behavior, but the politicians will always find somebody to punish when state budgets go in the red.