Are 529 plans the best way to save for college?
Estimated total costs at private colleges are nearly $63,000 in the 2014-15 school year, with more than $40,000 going for tuition, according to scholarshipworkshop.com. Two years from now, the total is projected to top $70,000. “Increases in college costs, especially for tuition, have been outpacing overall inflation,” says James Sanford, founder of Sag Harbor Advisors in New York.
Indeed, the College Board reports that private college costs have exceeded the CPI rate by 2.3 percentage points a year over the past decade. Soaring college expenses are expected to continue so financial planning clients, who may not qualify for significant need-based financial aid, could view paying for children’s higher education as a crucial concern.
“I’ve seen people who have had to reassess their choice of school for their children because of the cost,” says Sanford. “In some cases, the children have gone to a public instead of a private university.” Scholarshipworkshop.com estimates total costs at public universities at around $29,000 for in-state students in 2014-15, less than half the charges at private institutions.
TAX SAVINGS VS. FEES
Faced with the prospect of soaring bills for higher education, some parents might be tempted to take more investment risk with their college funds, in search of higher returns, but Sanford believes that’s not a prudent plan. “If parents don’t want be limited to a less expensive school,” he says, “they should put more money aside.”
Such advice is unlikely to raise eyebrows, but Sanford’s opinion as to where college money should be invested might be surprising. “I don’t recommend 529 plans,” he says. “The investment options are limited, they lack flexibility, and the fees can be high. Those factors outweigh the tax advantages.”
The major benefits of 529 plans are untaxed investment earnings and untaxed distributions for higher education, a parlay that Sanford finds underwhelming. “I give clients the example of investments earning 7% a year,” he says. “Assuming an effective tax rate of 25%, from a combination of ordinary income and long-term capital gains, investors’ savings would be 1.75% (25% of 7%) a year. The fees involved in using a 529 plan can be that much or higher.”
Therefore, Sanford recommends saving for college in a regular investment account. Choices will be greater and clients will have more room to maneuver, if necessary. As Sanford points out, federal tax rules limit investment switches inside a 529 plan to once per calendar year, or when the account beneficiary is changed.
Moreover, a regular account offers parents a full range of investment options. “Rather than take more risk to try for higher returns,” he says, “I believe that investors should be using some of the newer alternative strategies. There are long-short vehicles that may work for college funds.”
Sanford suggests having a designated higher education fund, rather than commingling college money with other investment accounts. “Clients may need the optical reminder,” he says. Seeing regular statements from a specific higher education account might help to keep parents from dipping into their children’s college money for other purposes.
Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.