Why You Might Want To Think Twice About 529 College Savings
May 29, 2018As a financial planner, I meet with people far too often who have a child who is just entering their sophomore year of high school and they have yet to start planning for college expenses. I don’t often recommend waiting until there are only two years before the funds are needed to pay for what may be a gigantic expense — the best recommendation I have for people who want to save for college is to start as early as possible.
However, I’m not sure that the most popular way to save for college, which is the Section 529 College Savings Plan, is the best way. Everything I read and what we often teach as planners is to start a 529 plan as soon as a child is born, make ongoing contributions and have family members add to them at birthdays and holidays. In spite of that, I’m personally not a huge fan of the 529 and don’t think the conventional wisdom surrounding 529’s is all that wise.
What I don’t like about 529 plans
Lack of flexibility
If your kid decides not to seek higher education after high school, getting the money that is inside the plan out for other uses has a cost. All of the growth of the funds becomes taxable along with a 10 percent penalty. If, alternatively, the assets were held in a brokerage account, capital gains would usually be taxed at a lower rate. Converting capital gains into ordinary income for the purposes of taxation is usually a horrible idea, and it’s even worse when a penalty is attached.
One of my favorite ways to see college funded is with the use of low cost index funds in the name of a parent. The upside is that it is truly an asset of the parent and is treated as such in the FAFSA formula. And, if the child opts for a path other than college, BONUS! You have an extra pot of money to fund retirement, pay down debt or check a few items off the bucket list.
Fees
Fees in many 529 plans are higher than you might be able to find with a low cost index fund. While we’ve all heard “past performance is not an indication of future results” a million times, we hear less about what has a higher correlation with future performance: low fees. If a 529 plan is a part of your college funding plan, do a quick fee analysis to make sure that you are not paying multiple layers of fees that drag down your performance. The savingforcollege.com website has information on any 529 I’ve ever tried to review and is a great resource to help evaluate your alternatives.
Other ways to plan, save and pay for college
Choosing a lower cost school
Without question, the single biggest factor to consider regarding the funding of your child’s education is school selection. I’ve talked to too many parents who don’t want to tell their children “no” when it comes to their dream school, even if it creates a financial nightmare for the family. I’ve also talked to a lot of recent grads, suffering under the weight of crushing student loan debt, who wish that someone in their life had questioned why their “dream school” made sense.
There is some merit to kids doing two years at a community college or a low priced university before transferring to their #1 choice of school for the final two years. School choice is by far the best way to manage education costs, so make sure you are having those difficult but needed conversations with children about the economics of college. Does it make sense to pay $250k for a degree that results in a $35,000 starting salary?
Home equity line of credit
Another way I’ve seen people fund college costs is with a home equity line of credit. It usually beats the interest rate on Parent Plus loans and private student loan interest rates. It provides a lot of flexibility, given that you can pull money from it any time and pay interest only while the loan is in force.
After the last graduation, when flexibility isn’t needed, it can be converted to a fixed rate, fixed term loan or the payments can get accelerated. And while the interest is no longer tax deductible for this type of credit, it still might make sense. For homeowners with significant equity, this is a fabulous option and those who have smaller children can put themselves in position to use this pool of funds later in life by paying additional principal with each mortgage payment and trying to drive the principal balance as close to $0 as possible prior to needing to write a tuition check. Just remember that your home is on the line if you can’t make the payments though.
With as many options as there are for ways to fund college expenses, if your game plan involves a 529 plan perhaps it’s time to re-think your assumptions and strategy. What pools of money could you use instead of a 529? How can you reduce the overall need for funds? What happens if a child opts to not pursue college? There are a lot of variables in this equation and talking with a financial professional who has your interests first and a product sale last on the priority list could be a way to build the right plan for you and your children.