The 529 Plan has long been one of the most popular vehicles to save for your children’s (or grandchildren’s) education. For many families, it is clearly the best choice – especially for those funding it with less than a few hundred dollars a month.
However, there are many little-known disadvantages of a 529 plan and these are the reasons many of my clients use a smart alternative.
529 College Savings Plans have:
1) Financial Aid: A 529 plan counts as an important asset in determining the level of need-based (FAFSA form) and even merit-based financial aid. A 529 plan can actually undermine one’s ability to get either type of financial aid. Most folks have no idea of this potential landmine.
2) Limited Investment Growth: Most plans only offer 4%-5% of average interest and capital gains per year, due to their low-risk nature and being fully subject to market losses.
3) The potential to lose money: Despite the low-risk nature, these plans’ investments are directly correlated to the stock market and create the potential for losses. Even plans structured similar to a retirement target date funds (TDF) that I wrote about last week, the market could drag the fund down… exactly when you need it!
4) Potential Penalties: Withdrawals from a 529 plan not used on eligible college expenses can trigger both an income tax and an additional 10% federal tax penalty on earnings. So if the child doesn’t go to college (or doesn’t continues to attend), gets a scholarship or something else, funds not used for educational expenses could be taxable with a 10% penalty.
Interestingly, you might recall from the President’s 2015 State of the Union Address, that Obama actually called for 529 Plans to lose their tax-free status in paying for educational costs. He thought that it would be better to collect taxes from these accounts (that responsible folks had set up in order to pay for their children’s college expenses) so that he could make college free for all people that did not save for this known expense.
He quickly backed down when a groundswell of both politicians and the general public stood up to this “idea”.
Anyway… now for the 529 Alternative:
It’s Advantages?
This college-saving asset does NOT go on the FAFSA form and therefore does not affect financial aid or eligibility.
The net returns and growth will likely be similar to most 529 plans over 10-15 years.
However, there is no potential to lose money based on the stock or bond market performance. No chance of a market-meltdown affecting your account balance right as tuition bills become due!
Much More Flexibility: If the money does not end up being used for college (for any number of reasons), Mom & Dad have a nice nest egg for retirement or other planning goals.
Here’s an Example:
Parents are both 35 years old. Diane, their daughter is 1 year old:
They want to accumulate funds for their Diane’s college tuition and they have $500 a month to put towards that financial goal.
Using conservative assumptions, when the child is 17, there will be over $167,000 in the “college fund”.
But fortunately, for Mom & Dad, Diane received a scholarship for Lacrosse so they don’t need to touch these funds. In reality this could be caused by any number of reasons. In any case, they decided to let those funds grow for use in their retirement.
If the funds were in a 529 Plan instead, any growth would be taxable since the fund wouldn’t be used for higher education. But these funds are held elsewhere.
Now, when her parents retire at age 65, they will be able to have an annual income stream of $30,000 to age 90. That’s approximately $750,000 in total income! What’s even better, is all of that income will be TAX-FREE (just like a ROTH IRA!).
Without going into a fuller explanation since many readers will not be saving for college at this point, there are other benefits that this alternative has that 529 Plans simply cannot offer.
If you, or someone that you care about is saving a good amount of money for future college costs, they may want to contact me for more information.
All the best… Mark