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529 College Savings Plans
Air Line Pilot, July/August 2002, p.22
By Thomas J. Goebel and Robert D. Lipsey, CFA
One of the best things to come along in the financial planning arena since the 401(k) plan is the "529 Plan" or College Savings Plan. All pilots should consider whether this great new financial planning vehicle makes sense as a way to save money for education for themselves, their spouse, their children, their grandchildren, or other possible beneficiaries.
College Savings Plans, which are also known as 529 Plans because they are maintained under Section 529 of the Internal Revenue Code, must be sponsored by individual states, which often hire financial partners, such as Fidelity, Vanguard, T. Rowe Price, etc., to manage, administer, and market all or a part of their programs; for instance, the state of Minnesota is partnered with TIAA-CREF for its 529 Plan.
The plans constitute legal vehicles for an "account holder" (such as a parent), and in some cases with additional deposits from a "contributor" other than the account holder (such as a grandparent), to deposit and invest funds as a way to save for and pay college expenses for a "beneficiary" (such as a child).
Features of these plans include the following:
• An account holder may contribute high amounts (set by each individual state and currently ranging from about $175,000 to $300,000) regardless of income level. Contributors may contribute up to $55,000 (married couples, $110,000) in the first year of a 5-year period without triggering gift taxes. These amounts are no longer considered a part of the contributor’s estate, although if the contributor is also the account holder, he or she retains control.
• The account holder maintains control over the account and may transfer it to another qualified beneficiary at any time.
• Contributions may be deductible for state tax purposes in some states.
• Earnings grow tax-deferred.
• Withdrawals for qualified distributions (tuition, room and board, books, supplies, etc.) are currently free from both federal and state taxes. (The federal tax exemption expires in 2010 under current legislation, but Congress is already considering extending it indefinitely). Beneficiaries may use withdrawals at any institution accredited by the U.S. Department of Education, including technical schools, junior colleges, and most vocational schools, in addition to most undergraduate and graduate institutions here and abroad.
• Withdrawals for nonqualified distributions will incur a 10 percent federal penalty, and regular income taxes will be due on investment earnings accrued to date. No penalty, however, is due if the beneficiary dies, becomes disabled, or obtains a scholarship.
Investment options for the state plans are generally those of the financial partner (e.g., Vanguard or Fidelity), although in some cases, states manage investments in-house.
The plans have two basic asset-allocation arrangements:
• First are age-based portfolios—in which the investment mix changes with the age of the beneficiary, usually becoming more conservative as the beneficiary approaches college age.
• The second are static portfolios, which maintain the same asset allocation mix over time (e.g., 60 percent stocks and 40 percent bonds). The account holder chooses the investment option and, by federal law, may change the mix only once per year or when the beneficiary is changed.
Expenses associated with the state plans vary widely. Some states market through brokerage firms and may charge loads (commissions). Some may also charge enrollment fees. Annual fees may include maintenance fees (these are often waived if ongoing contributions are made, through payroll deductions or from a bank or credit union account) and asset-based fees.
These expenses can constitute a significant drag on investment return and should be thoroughly investigated before deciding on a state plan. Home state incentives can make an expensive program cheaper than a less expensive out-of-state program, but this is not necessarily the case (see the sidebar for how to figure expenses).
An account holder (or contributor) does not have to use the state plan in the state in which he, she, or the beneficiary resides. In selecting a state plan, a potential account holder (or contributor) should take into account the following:
• state subsidies, such as matching contributions or deductibility of state tax,
• costs (expense ratios, loads, etc.),
• the investment and administrative capabilities of the financial partners,
• residency requirements,
• investment options (some programs use an active-management approach while others use a passive or index-based approach),
• contribution limits, and
• availability of direct deposit.
Anyone interested in saving for education should learn more about 529 Plans, as they are a great tax-advantaged way to save for education, in much the same way that a 401(k) can be used to save for retirement in a tax-advantaged way. These plans are flexible and universally accessible without regard to income level, and the account owner maintains control over the funds until they are used for qualified education expenses. An excellent website, www.savingforcollege.com, is useful as a resource for more information on 529 Plans.
This article, a collaborative effort between Bob Lipsey and Northwest R&I Committee members Tom Goebel, Steve Wilson, Greg Averill, and Bill Johnston, as well as Benefits Specialist Elaine Grittner, is based on an investigation that the Northwest MEC R&I Committee conducted and during which they interviewed 529 Plan providers TIAA-CREF, Vanguard, Fidelity, T. Rowe Price, and others.
Perceptions regarding the capabilities of various financial partners are of course subjective in nature. Tradeoffs between expenses, loads, matching contributions, and state tax deductibility, however, can be quantified to some extent. If a state offers matching contributions or state income tax deductions for 529 Plan contributions, that might make a compelling argument for a resident to use his or her state plan. This argument may not hold up, however, if the Plan has high annual expense ratios. The following table was developed to permit comparisons between an account holder’s state-of-residence plan involving state tax deductibility or matching contributions, and any other state plan from the perspective of expenses and taxes.
To use the table
1. If contributions are state-tax deductible, determine marginal state tax rate (TR) that would apply to the deduction.
2. If the state matches contributions, convert the matching formula to a dollar amount and divide by size of annual contribution to determine matching contribution percentage (MC).
3. Determine load percentage (LP) if any.
4. Apply to the following formula:
$1,000 (1+MC) (1+TR) (1-LP) = Adjustment Factor
5. On the table, find the final expense ratio column that most closely matches the total annual fee percentage (asset-based + underlying fund expense ratios) that most closely matches your state plan.
6. Read down column to the cell that intersects with the number of years until qualified distributions begin.
7. Multiply the Adjustment Factor by the amount in the intersecting cell.
8. Read across to left. If the amount in any cell to the left is greater than that of the adjusted intersecting cell, read up to expense ratio. Any state program that involves an expense ratio of that percentage or less will be as effective from a tax/match/load perspective as that of the state of residence.
Expense/Tax Decision Table
Assumptions: $1,000 contribution
Pre-expense ratio annual return of 8%