As a chief investment officer of a successful financial firm, and also a father of “three under four,” I certainly understand how college savings and planning are tremendously important pieces of my long-term portfolio. One of the keys for effective college savings is to set aside money early in your children’s lives, to make the best use of long term compounded rates of return. The earlier you begin to invest, the better. But, while starting early is important, where you are putting those hard-earned savings is just as critical. Making poor decisions in this area can cause shortfalls and directly affect your own retirement savings. Today, it seems that the most popular method is to utilize a 529 college savings account because of its potential tax advantages. But, I’m going to give you a few reasons you might want to think otherwise. Better put: STOP PUTTING MONEY IN 529 PLANS and keep reading!
The Fine Print of 529 Plans
A 529 plan tends to offer only mutual funds and, more recently, index funds. These products are built for the masses, not the individual, and don’t allow you to properly diversify your portfolio for long-term growth. With these funds, your portfolio actually becomes over-diversified, a phenomena where you own too many securities and your returns become diluted over the longer-term. The average mutual fund has over 100 securities inside of it, whereas we recommend no more than 15 securities for proper diversification.
In addition, withdrawals tend to be inflexible. In order for them to be federally income tax free, withdrawals can only be used for “qualified educational expenses.” If you use the money for something other than a college education – if your child decides against college, for example, – you’ll be taxed on the earnings and pay a 10% penalty. (Tax treatment at the state level may vary.)
Lastly, it is important that parents take a hard look at what they’ll be paying in expenses with a 529 savings plan. These costs can include asset-based, program management, and underlying investment fees, and they really may not be justified given the alternatives out there.
So, what are the alternatives?
We recommend a plan with flexibility and efficiency, such as a Roth IRA.
A Roth IRA is primarily a retirement vehicle. You deposit after-tax money (just like a 529), and any earnings accumulate tax-deferred (just like a 529). When you attain age 59.5, your entire withdrawal is tax-free provided you have owned the account for 5 years. Where we find a Roth IRA to be especially better than a 529 is you can always withdraw your regular contributions, for any purpose, without incurring taxes or penalties. Since your contributions were made with money that has already been taxed, you are allowed to withdraw these contributions (known as “basis”) anytime, tax-free.
Here’s a reasonable scenario:
You and your spouse begin contributing to your Roth IRAs (you can each have one, subject to income limits) after the birth of your first child. You each contribute $5,500 per year (the limit for 2015) until your child reaches 18. If we assume an average annual return of the market at 8%, the combined account values would be roughly $445,000 – $198,000 of which (your contributions) would be available for you to withdraw (tax free). Certainly a nice chunk of change to help cover tuition and fees at the top colleges in the country (or for anything else you choose, for that matter).
If you were saving in a 529 plan, this withdrawal can only be used for college expenses. Otherwise IRS taxes and penalties apply. Not so for your Roth contributions. Total flexibility. It is simply your already taxed money being returned to you. And oh, don’t forget about the other $247,000. It keeps chugging away, and any earnings continue to accumulate until you decide to withdraw at retirement, tax free. Not a bad retirement/education vehicle. Now remember that if you withdraw any of the earnings prior to age 59 ½ and owning the account for 5 years, a tax penalty may apply.
A Roth IRA account is very easy to open, and more importantly, you can invest in a properly diversified mix of individual stocks (particularly advantageous for the long-term investor who is working with the right investment manager, with that particular expertise). And unlike a 529 plan, the balances in a parent’s Roth IRA are not considered an asset on the federal college financial aid forms – very important when calculating eligibility.
So, if you are on board to start saving early for college, consider setting up a Roth IRA. If your annual income is above the limit for a Roth, a regular investment account will do. Committing to making those savings early on is paramount, but putting your hard-earned money in the right places is a very close second.