Benjamin Beck, CFP®One of the keys to 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 are you putting those hard-earned savings? Many families turn to 529 plans.
How Do 529 Plans Work?
A 529 plan is a state-sponsored plan that allows you to put aside money (tax-free within specific and restrictive rules) for educational expenses in the future such as your child’s college tuition. Making poor decisions in this area can cause shortfalls and directly affect your own retirement savings.
A 529 college savings account may seem like a good idea 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!
Disadvantages 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 a 529 plan, your portfolio actually becomes over-diversified — a phenomenon where you own too many securities — and your returns become diluted over the long term. The average mutual fund has over 100 securities inside of it, whereas here at Beck Bode, 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).
One of the greatest disadvantages of 529 plans is the related expenses parents end up paying. These costs can include asset-based, program management, and underlying investment fees, and they may not be justified given the alternatives out there.
Better Alternatives to 529 Plans
We recommend a plan with flexibility and efficiency. Two avenues to consider include:
The 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 particularly advantageous over a 529 plan is you can always withdraw your regular contributions, for any purpose, without incurring taxes or penalties. Since you made contributions with money that has already been taxed, you are allowed to withdraw these contributions (known as “basis”) anytime, tax-free.
A Roth IRA 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 ($500 below the limit for 2022) 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). This is a nice chunk of change to help cover tuition and fees (or for anything else you choose, for that matter).
A 529 Plan Scenario:
If you were saving in a 529 plan, this withdrawal can only be used for college expenses. Otherwise, IRS taxes and penalties apply. There are several instances in which you would end up paying taxes and penalties such as:
- Your child decides not to pursue a college education.
- You decide to use the money to help with a down payment on your child’s first home (or for any other major purpose).
- Your child receives a scholarship or other means to pay for college.
The Flexibility and Tax Benefits of the Roth IRA
With Roth contributions, you get 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. It is important to remember that if you withdraw any of the earnings prior to age 59 ½ and own 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 — a crucial factor when calculating eligibility.
Another Choice? A Standard Brokerage Account (Meaning, Not a Qualified Retirement Account)
Another option is to open a standard brokerage account. Here, you will pay taxes when you take disbursements from the account, but it does come with other advantages. A key consideration here is that a 529 plan is managed by someone who doesn’t know you. Even with a simple brokerage account, you’ll get the guidance of your trusted advisor.
There are many assumptions made when someone puts money away for a purpose later down the road. And then, we go through years like 2022 — where inflation skyrockets and the market experiences huge volatility, and perhaps the parents decide to move money away from the 529 plan. Doubt creeps in. Maybe you will return to putting money back into the 529, maybe you won’t. Disrupting the savings plan, however, will likely result in lower appreciation of your principal. A financial advisor monitoring your brokerage account would strongly advise you from moving money out of fear. The manager of your 529 plan, on the other hand, wouldn't bat an eye if you made that decision.
Start Building Toward Your Child’s Future
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. Schedule a discovery call to begin your financial planning strategy today!