A month before my daughter was born, I sat down at my father-in-law’s kitchen table. The idea was to figure out how best to save for college. I haven’t always been this organized in my life, so I have to admit that I patted myself on the back for planning so far ahead. Add to this my father-in-law’s pedigree—a retired VP of a reinsurance company—and I was feeling good about the future. Reinsurance isn’t investing, per se, but I at least knew I was set in the fine print department. But after leafing through multiple 529 brochures, trying to explain what we were reading to each other, we put it all down with disgust. “This stuff is…complicated,” he said.
That was an understatement. I guess it’s apt that the best vehicle for college savings operates as a kind of SAT for parents. The core concept of 529s couldn’t be simpler: they are Roth IRAs for higher education—but with complications.
Don’t let this confuse you into avoiding 529s, because at the end of the day they are still the best way to save for college. My father-in-law and I eventually picked a plan, and hopefully what we’ve learned can help others.
- Every state offers its own 529. They don’t run them—investment companies do. Because of this, each state has different funds and fee structures, some better than others. At first we thought we were stuck with my state’s plan (Rhode Island), which would not have been our first choice. But fortunately, this wasn’t the case.
- You can sign up for (almost) any state’s 529. A few state plans have residency requirements, but most plans allow anyone to sign up. If most plans allow anyone to sign up, then why even associate them with states? Well, one reason is because…
- You only get state-specific benefits if you use one of your state’s 529s. Are you confused yet? You can use almost any state’s plan, but you only get state-specific “goodies” in your own state. This is typically a tax deduction, but some states allow tuition freezing at current rates or other complex benefits. Here, it’s important to do some cost-benefit analysis. In my case, Rhode Island’s benefit was a deduction in state taxes by up to $1,000 per year, subject to income limits, a small bonus compared to the higher fees I would pay over time. It did not factor into our decision. This means that, in my situation, I had roughly 50 plans to choose from, right? Not even close—I had many more. This is because…
- Most states have multiple plans. A lot of states separate “Direct” plans and “Broker” or “Advisor” sold plans. In Direct plans, you choose the investments from the company. In Broker/Advisor plans, an investment advisor oversees your investment for an additional fee. But some states offer even more than two plans. If you want to make your palms sweat, peruse this full list of plans. If you really want to consider each and every plan before making a decision, you have weeks of work ahead of you.
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At this point, if you’re feeling stressed by all of the information I’ve laid out, I’d like to talk you off the ledge. At the end of the day, 529s are just investment accounts run by the same cast of characters vying for your retirement dollars: Vanguard, Fidelity, T. Rowe Price, etc. It’s important to see past the fancy names and state-specific quirks. If you want to participate in pre-paid tuition plans, in-state tuition freezes, or any of the other complex plans, you will definitely have to do your homework. But if you just want to amass savings for your child, almost any plan with low fees and name brand index funds will do.
Despite their many differences, all 529s share some basic characteristics, both positive and negative.
- There are almost no loopholes for removing the money tax-free. The major benefit of a 529 is the same as a Roth IRA: once the money goes in, it will never be taxed again as long as it is used for higher education. But if the money is removed for other purposes, the government will want taxes plus a 10 percent penalty on any investment gains. One important exception regarding scholarships. If my daughter gets a merit scholarship to college, I will be able to remove the amount of the scholarship tax-free. But that’s about it. If your child chooses not to go to college, not much can be done. The account can be changed to another beneficiary, but it must be used on education or be taxed. Because of these rules, I personally do not plan on funding my 529 to the max, and will instead split investments between 529 and a traditional taxable account.
- Even though the child is the beneficiary, parents own a 529s assets. This is quite different from a custodial account where the child gains ownership at 18 and could theoretically drain the account if he or she wanted to. Until the very end, you control 529 money.
- If you’re a Vanguard person, you can have Vanguard. Lots of people love Vanguard. They have some of the lowest fees, and their investments are clear and easy to understand. Fortunately, Vanguard services Nevada’s 529, and Nevada does not enforce a residency requirement. Out of state residents, however, must open the account with a minimum initial investment of $3,000, which is hefty by 529 standards. If you can’t swing this, here’s a hack: open a 529 in Iowa. Iowa is one of the many states that offer Vanguard funds, and their minimum initial investment is just $25. You get the same investments, but they just won’t neatly show up on the Vanguard website along with your other accounts.
- 529s don’t show up on FAFSA forms. This is good news. When it comes time to apply for financial aid, money in 529s is for all intents and purposes hidden from government eyes. No catches here.
- There are some good resources out there to compare plans, as long as you don’t let the overabundance of information short circuit your decision making. Here are a few good links: Vanguard’s 529 Comparison, SavingforCollege.com 529 Comparisons (very detailed), NerdWallet’s Best 529’s of 2013.
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A final word: Planning for college the week before your first child is born is inherently a fool’s errand. There are two separate and unpredictable variables at play. We don’t know what college will be like—or what it will cost—in eighteen years. Will it continue to outpace inflation, or is higher education the next bubble waiting to pop? Will we still pack up our cars to the brim and drive to a dorm room, or will we log into campus from home?
Perhaps importantly, we have no idea what our children will be like at age eighteen. Will they need to live on a verdant private campus for four years, or will community college be a better fit for them? How much help do they need? How much debt can they bear? Choosing any savings path that locks them into a future while they’re still in diapers is the height of hubris. My daughter is a year old now, and I already know that there is no guessing her next move. I just have to prepare the best I can, listen, and be flexible.
Written by E.A. Mann. The views expressed herein are not intended to serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities by FutureAdvisor. Differences in account size, timing of transactions and market conditions prevailing at the time of investment may lead to different results, and clients may lose money. Past performance is not indicative of future results.
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