Don’t Forget You Are Not Restricted to Your Own State’s Program!
September 15, 2022
Don’t Forget You Are Not Restricted to Your Own State’s Program!
College has become breathtakingly expensive, but a seeming necessity if we want our children to attain at least a middle-class lifestyle. Should you save into a 529 plan? Should a kindly grandparent contribute? And which should you choose?
The basics: A 529 plan allows you to save money for college and some vocational training programs in an account where earnings and withdrawals are tax-free when used for college. You can withdraw the money for other purposes, but earnings will incur a 10% penalty and be taxed as ordinary income.
If, however, the student gets a scholarship, the equivalent amount can be withdrawn from a 529 plan with no penalty but earnings will still be taxed. The money can also be moved to other beneficiaries: For example, if one child doesn’t use it up, funds can be moved to a sibling.
The law establishing 529 plans prohibits investing in individual stocks. You’ll have some choice, however, by selecting portfolios of mutual funds as offered by the plan.
Consider several factors:
Is your state’s plan high quality?
Do you get a state tax deduction or credit for investing?
What investments are available?
What are the fees?
Every year, Morningstar evaluates all plans; some states have more than one and advisers may also sell plans. Remember that you are not required to invest in your state’s plan — you can choose any state, especially if yours is poorly rated. You can also rollover the plan to another state if you move or change your mind.
Before you choose another state’s plan, do investigate whether your state offers any incentive for residents to invest. For example, the top-rated plan (Illinois) allows residents to claim their contributions, up to $10,000 per year ($20,000 for a married couple), on their state income tax return. Note that you cannot take a deduction for 529 plans on your federal income tax. You’ll need to balance whether the deductions will outweigh fees or investment choices in a less-than-stellar plan.
During the Great Recession of 2007-2009, outcry over performance plagued many 529 plans. Families found that they had far less money available for college than they expected, while paying high fees charged by fund advisers. Plans were overhauled (including Illinois’s) and many now offer a solid lineup of low-cost investments. Many are no-brainers akin to target-date funds, a good mix of low-cost index funds.
Plans generally charge fees in addition to the management fees incorporated into the underlying investments. There’s a cost to administering these plans, especially since many of them garner very small amounts invested, but the tax-sheltered earnings usually make these plans worthwhile.
Most families should choose to invest directly with their state’s program, known as direct-sold, rather than adviser sold. It’s difficult to see why people would pay an adviser to choose exactly the same plans they could choose on their own.
Perhaps some very wealthy families would want advice on incorporating this into an overall wealth picture, but 529 plans are special purpose and offer straightforward choices. It’s pretty easy to do it yourself. If your state’s plan has a poor rating, just choose another state.
You’ll need to choose among at least two main categories of investment plans: age-based and static orn self-selected.
An age-based plan, the easiest for most investors, functions much like a target-date retirement fund. It’s a mix of (usually) index funds allocated to different asset classes. As the child gets older and nearer college age, the mix of funds becomes increasingly conservative — more bonds and cash — so that the value can be expected to be more stable.
You choose the fund option that corresponds with your child’s age when you begin investing.
In some cases, you have the further option of age-based, but also what your risk orientation would be, i.e., conservative, moderate or aggressive.
Each of these choices will usually step to the next level as the child ages. For the 0-2 age group, the aggressive will be 100% stock funds; the moderate might be 90/10; the conservative, 80/20. In the next age bracket, you’ll see 90/10, 80/20, 70/30. Michigan’s plan, rated No. 2 by Morningstar, has you choose the anticipated enrollment year, then slots you into the mix. Utah, the No. 3 rated plan, is very similar to Illinois.
Using Illinois’s plan as an example, in the age-based option you can select all Vanguard funds. Depending on the age and risk category, these include a mix of Vanguard Total Stock, Total International Stock, Real Estate, Total Bond, Hi-yield Corporate Bond, Short-Term TIPS (U.S. Treasury inflation-protected securities), Short-Term Bond and Total International Bond. Or you can choose multi-company funds.
But just like target retirement funds, these may get too conservative for you. If you are completely dependent on the 529 to fund college, you’ll need money to be there in a secure mix. If you’re looking tonget relief from out of pocket, but could fund more from income or other investments if necessary, then you might want to gamble that a more aggressive mix, or a fixed balance, may result in a larger account.
Some states will allow you to choose a fixed portfolio, or even select individual mutual funds from their lineup. In Illinois, these fixed-balance funds are, ironically, called target funds — not because they target a date, but because they have a target risk allocation. These three targets (100% stock, 60/40, and 50/50) offer funds from a number of investment firms. Michigan has a similar option to choose risk, then get a portfolio selection.
Finally, if you really want to wade into the weeds, some plans offer you the ability to choose your specific mutual funds and mix (Illinois offers 16 from six different fund companies). Michigan offers only a single U.S. Equity fund, but also has a guaranteed option, for investors who are very conservative or perhaps have a short time horizon.
In general, the more no-brainer, the lower the fees. Age-based index fees,which usually include both a
program management fee and underlying fund fees, can range from about 0.12% to under 0.20%. Move into more fund families and fees can move up to 0.46%, still acceptably low but you’d better be really sure it’s worthwhile to you.
This is uniquely difficult to evaluate, because of the short band of time, especially in the age-based portfolios. You’re only evaluating a few years and the specific market conditions in those years. In order to estimate how you might do with an age-based fund, it’s useful to look at the annualized performance of the two oldest age groups. For multi-funds or fixed blends, check the 10 years or lifetime performance. As might be expected, you’re going to see returns parallel risk, with the highest return from the most stock-oriented, and the lowest from fixed income. You’ll see a general range of mid 4% to mid 6%.
It’s a kind and loving act to put away funds to help a grandchild, particularly since you may not be around by the time they enter college. My clients who have received such a gift are in the main very grateful and have fond memories of grandparents.
If you are certain that you’ve made plans for needing long-term care and have sufficient income from pensions, Social Security and portfolio withdrawals (even in a down market), you can move on to considering this.
As with anything that ties up money for a long time, however, grandparents need to carefully consider long-term possibilities.
Are the parents and family likely to be eligible for financial aid? A 529 plan owned by a grandparent with the grandchild as beneficiary is considered 100% available as an asset of the child. A 529 plan owned by a parent is an asset of the parent and only 5.64% is factored into eligibility for financial aid.
While none of us can know how this will be assessed 10 or 18 years in the future, you don’t want to do something that kicks the family out of aid — you’d only be saving the college, not the family, money.
What will the grandchild be like at 18? If your grandchild is already a teenager, you can make a judgment on this. But if they’re young children, you really have no idea. Carefully raised children can grow into drug addicts, or spendthrifts, or become disabled or have no inclination to college.
A 529 plan can be tapped for any other purpose, provided the spender is willing to pay taxes and penalties. Some kids just won’t care; after all, they didn’t work for the money.
It can allow a parent to duck responsibility for college. In the case of a divorce, a parent can argue that the child already has significant college funding and therefore they won’t negotiate paying any more.
College funding may change significantly in the future. We can hope. But if state colleges become free, or other credits or assistance become available to students, a 529 plan might be superfluous.
It can preserve money for grandchildren who have spendthrift parents. If you don’t have confidence that the parents will save for their kids, or might spend any money on themselves, or the marriage seems rocky, a 529 plan does ensure that the grandchildren will actually get the money.
These funds are mentioned for educational purposes only; no investment recommendations are intended. The author and some of her clients may have positions in some of the funds mentioned in this article.
Danielle L. Schultz, CFP, CDFA, is a fee only financial adviser with Haven Financial Solutions, Inc., based in Evanston, Illinois. Contact her at www.HavenFinancialSolutions.com