Piggy Bank

Saving for College: Is the 529 Plan Optimal?

Piggy Bank

Over the holidays, I was having a discussion with a family member about saving for college given the recent birth of their daughter. This particular family member was looking into a 529 plan, but was concerned about some of the restrictions involved with having a 529. One of the biggest concerns involving investing in 529 plans is that the assets must be used for eligible college expenses, which includes tuition, room & board, mandatory fees, and books and computers.[1] Any funds not used for these particular expenses are subject to a 10% penalty.

Some common questions from many investors include, “what if my child receives a scholarship” or “ what if my child decides that they do not want to go to college?” or "how do assets in a 529 plan affect financial aid eligibility?" These are very real questions that are making investors hesitant about putting all of their eggs in the 529 basket.

Let’s start by asking, “what’s the alternative?”

Outside of 529 plans, there are really 3 options: Coverdell ESA, regular taxable accounts, and Uniform Gifts to Minors Act (UGMA) accounts or Uniform Transfers to Minors Act (UTMA). Each of these accounts has both pros and cons, so let’s review:

  • Coverdell ESA: Similar to 529 plans, assets grow tax-free and are exempt if used for education expenses, which can also include secondary education (private high schools or charter schools). The biggest issue with these accounts is the contribution limit of $2,000 per year, which is not nearly enough to afford state universities around the country. Also, similar to 529 pans, the assets need to be earmarked for some sort of education.
  • Regular Taxable Account: The pros include unlimited contributions and complete flexibility in terms of what the funds are spent on. The obvious con are the taxes. Dividends, interest, and capital gains are taxed every year, leading to a less efficient growth of assets over time.
  • UTMA/UGMA Accounts: The pros include, to some extent, tax-deferred growth of assets. The cons include taxes on capital gains once the account is liquidated, loss of control in terms of what the money is spent on once the child reaches either 18 or 21 depending on your state of residence, as well as the “Kiddie Tax” that can be imposed on unearned income exceeding the $2,100 exemption.

100% Certainty Scenario

If you could see into the future and know with 100% certainty that your child was going to attend college, then 529 plans are the best available option for you.  The tax-exempt growth of assets as well as the tax-exemption on funds used for college makes it the most efficient vehicle for saving for college. But what if we are not 100% certain or if your child ends up receiving scholarship and doesn’t need the savings that you accumulated for them?

The Analysis

We attempt to highlight the merits of each account (regular taxable, 529, and UGMA/UTMA) in terms of their after-tax value given the uncertainty around attending college. The analysis includes 3 different accounts across 3 different savings scenarios.

The 3 accounts include:

  • Regular Taxable Account
  • 529 Plan
  • UGMA/UTMA account

The 3 different scenarios we looked at include the saving for:

  • $13,000 per year in today’s dollars (California State University)
  • $33,000 per year in today’s dollars (University of California)
  • $65,000 per year in today’s dollars (Private University)

We assume that investors are saving a monthly amount, including a 3% increase in savings per month, that gives them 90% confidence of having enough funds for the final year of college for their child. Savings rates are based on IFA’s College Savings Analyzer that runs 10,000 simulations of portfolio outcomes. Total expenses for each scenario grows at an annualized rate of 6% per year, which is consistent with recent trends.

The annualized compound return used is 8% per year. Taxes on dividends, interest, capital gains are based on the 10-year average distributions for the DFA funds used in the tax-managed version of the IFA Index Portfolios from 2006-2015 assuming the highest income and capital gains distribution rates for each of the 10 years. The average tax impact from fund distributions on returns is 0.76% per year.

The “Kiddie Tax” assumption is also based on the 10-year average distributions for the DFA funds used in the IFA Index Portfolios from 2006-2015 assuming the highest income and capital gains distribution rates for each of the 10 years. It also assumes that the $2,100 exemption increases by a 3% annualized rate per year to keep up with general inflation. For simplicity, we apply the highest income tax rate to the amount that exceeds the exemption. We also apply a Glide Path that is typical for a client that is saving for college. State taxes are not taken into account in this analysis. 

Specifically, what we are looking at is the after-tax and 10% penalty value of each account after 18 years (assumes child attends college at 18 and attends for 4 years).

It is important to note that we are using a very basic analysis to illustrate the difference in the growth of assets in each account. If we wanted to be more exact about possible ending account balances, we would run thousands of simulations that take into account the possible variation in expected outcomes given risk and return assumptions (Monte Carlo). That isn't the intended purpose of this particular article. While the median outcomes in terms of ending account values could be much different than what is presented here, the general conclusions we draw from the analysis would remain the same. 

The Results:

The table below displays the results for each account. This particular table is looking at the University of California scenario.

Account Type

Total Contributions Capital Gains Ending Value After-Tax/10% Penalty Value

Taxable Account

$237,358 $211,457 $448,815 $398,488

529 Plan

$237,358 $247,431 $484,789 $436,310

UGMA/UTMA

$237,358 $225,774 $463,131 $409,398

As you can see, the total contributions are identical across all 3 accounts. Capital gains are highest for the 529 plan ($247,431) given its tax exempt growth, then the UGMA/UTMA accounts given the tax exemption on the first $2,100 (adjusted for 3% inflation), and then finally the regular taxable account.

The after-tax value for the taxable account and the UGMA/UTMA accounts assumes a 23.8% long term capital gains tax rate (highest) and the 10% penalty is applied to the entire ending value of the 529 plan.

These results are extremely important. Even if your child decides not to attend college or receives a scholarship, the value of the 529 plan after the 10% account balance penalty is applied is still higher than the after-tax value of alternative savings vehicles.

Here are the results for the California State University and the Private University scenarios, respectively.

Account Type

Total Contributions Capital Gains Ending Value After-Tax/10% Penalty Value

Taxable Account

$94,848 $84,498 $179,346 $159,236

529 Plan

$94,848 $98,873 $193,722 $174,349

UGMA/UTMA

$94,848 $97,995 $192,843 $169,520

 

Account Type

Total Contributions Capital Gains Ending Value After-Tax/10% Penalty Value

Taxable Account

$450,980 $401,768 $852,748 $757,127

529 Plan

$450,980 $470,119 $921,098 $828,989

UGMA/UTMA

$450,980 $407,065 $858,045 $761,163

You can see that there is a similar trend in these two scenarios to what we saw in the first. The 529 plan always wins, even after a 10% penalty is applied to the entire account balance. One important item to note is that the after-tax value for both the regular taxable account and the UGMA/UTMA accounts are almost identical for the Private University scenario given the limited benefit of the $2,100 exemption when you are saving close to $19,000 per year for college. 

Depends on Taxes

In our analysis, we assumed the highest income and capital gains tax rates. The vast majority of Americans do not pay the highest tax rates, so it is not a realistic scenario for the vast majority of Americans. What if we looked at the “middle of the road” scenario, which assumes an income tax rate of 28% and a long-term capital gains rate of 15%?

Account Type

Total Contributions Capital Gains Ending Value After-Tax/10% Penalty Value

Taxable Account

$237,358 $211,457 $448,815 $417,096

529 Plan

$237,358 $247,431 $484,789 $436,310

UGMA/UTMA

$237,358 $231,928 $469,286 $434,496

Even when we relax our tax rates, the 529 plan comes out on top with the UGMA/UTMA coming in a close second place.

As we mentioned before, this analysis doesn't take into account state taxes, which would further highlight the superiority of the 529 plan when saving for college. 

Conclusion

Although there are some real concerns when it comes to saving for college through a 529 plan, you can see that the situation isn’t as dire when compared to alternative savings vehicles. If you knew for certain that your child was going to college, then the 529 plan will win, hands down. But even if your child doesn’t end up going to college or ends up getting a scholarship, you still have a high probability of coming out ahead by utilizing a 529 plan.

This analysis is dependent on the assumptions, but any change in assumptions whether it is returns, tax rates, distribution rates, etc., will mostly favor the 529 plan in all scenarios. Further, even if the UGMA/UTMA scenario comes out slightly ahead, it is important to remember that you lose control over those funds once your child reaches either 18 or 21. While we want to believe that they would do the right thing and use the money for school, they aren’t legally required to. It may be prudent to stick with the 529 plan given the control over how the assets are used. Lastly, a combination of all 3 accounts, including a Coverdell ESA, may be prudent depending on the educational goals you have for your children.

In terms of 529 plan options, IFA advises clients to utilize the SMART 529 Select Plan from the State of West Virginia and the Utah Education Savings Plan given its reasonable fees and investment options. 

We weren’t able to cover the topic of how each account affects eligibility for financial aid. For those who are seeking advice on their particular financial situation, please contact your IFA Wealth Advisor or personal financial professional.



[1] As provided by the Securities & Exchange Commission (SEC): https://www.sec.gov/investor/pubs/intro529.htm