Financial planners just love 529 plans. They allow clients to pour lots of money into college savings and when we run our computer planning models, the disciplined and dedicated client who saves a ton might actually have enough saved to pay for the children’s college. Financial advisors like that kind of result—neat and taken care of. And 529 plans have that magic attribute—tax free accumulation—that’s catnip to financial planners.
But there are some good reasons NOT to invest in 529 plans. Before you do, consider the following:
You may need the money for an emergency.
You can’t take the money out (unless there’s a loss in the account) without paying a pretty hefty penalty (10% + income tax on earnings). When your child is young and your career is booming, you may see a smooth road trending uphill. But people do get sick, jobs get reorganized out of existence, and some kids (mine) suddenly need a $15,000 harp. If you have a hefty reserve elsewhere, no problem. But if you don’t, and an emergency strikes, that 529 money can look awfully good, and pretty unreachable.
You want freedom in investment choice.
You have about the same amount of restrictions and choices as many people experience in their 401ks—preselected funds and portfolios. As many people have learned, don’t believe the rosy perspective in the brochures. Lots of state plans have lost tons of money. Some portfolios charge much higher management fees than if you held the same investments individually (see below). And then there’s that pesky rule that you can only change investments once a year. Normally I’d advocate rebalancing anything only once a year, but I’m a little uncomfortable with this rule given the performance of some of these funds.
If you want individual stocks or a different asset allocation or fund company than the plan allows, no go.
You have only one child.
This is really a question of how much you save. If you have saved the entire amount of a college education, and your child actually does qualify for some merit or athletic scholarship, or wins the Intel Science Fair, you can withdraw the equivalent amount. That’s a high class problem to have. But what about the child that turns out to be Bill Gates and drops out (see my next point)? If you have other children, you can always shift the money to their accounts or use the money for your own further education, but it’s worth a thought.
Your child may not go to college.
If the child ends up not attending college or dropping out, it’s the penalty box again.
Your child is already in high school when you begin to save.
Okay, maybe you weren’t making too much when the kiddo was younger, but income has suddenly taken off. You’re not going to get much benefit from tax savings or long term accumulation unless you’re saving for grad school. If capital gains rates stay low and you’re in a higher tax bracket, you might be better off keeping the flexibility of investment choice (#1 above).
You haven’t saved enough for retirement.
Here’s where you should NOT put your child first. Your child can take a loan to pay for college, but you can’t take a loan for retirement. Particularly for older parents, this is an oxygen mask situation. Put yours on first.
You’re not going to be able to save very much.
A Coverdell may be as good for small amounts of money (currently, the contribution limit is $2,000/year) and under current rules, money can be taken out to pay K-12 expenses if necessary.
The grandparents might make a significant college contribution.
While it’s true that a grandparent owned 529 is not considered on the FAFSA, some private colleges do ask about such accounts. A planner can analyze whether it might be better for a benevolent grandparent to prepay tuition directly to the college, or pay off the child’s loans after they graduate (also, this depends on the parents’ and child’s eligibility for financial aid).
The tax savings may not be that meaningful.
If you make enough money that the tax savings might be a consideration, you’re probably also making enough money to pay for college out of investments or current salary.
You’d like investments that are consolidated in one place.
I don’t really see the need for lots of special purpose, segregated accounts beyond tax-favored and taxable. It makes rebalancing and asset allocation way harder. And how many envelopes per day do you want to receive from your investment companies?
You may be paying a lot for the “privilege” of locking up your money.
For example, let’s take a look at Vanguard’s 529 plan under the auspices of the State of Nevada. (NO INVESTMENT RECOMMENDATION INTENDED). I’ll pick their aggressive growth portfolio, designed for kids currently aged 0-5. This portfolio invests 70% in Vanguard’s Total Stock Market Index Fund (Institutional) and 30% in the Total International Stock Index. For this, they charge a .25% management fee (plus $20/year if your balance is below $3,000). Not excessively high. But wait, what if you were to buy these in your plain-vanilla Vanguard account? The management fee for the on the Total Stock Market Investor share class is .18% but you can drop that down to .07% by buying the Admiral shares ($10,000 minimum) or the ETF version. For the Total International, management fees are .26% Investor; .20% Admiral; and .20% for the ETF. Is it worth it?
Let’s say you’re able to front load your savings by putting $65,000 (the max for one contribution) into the 529. You have 70% in the Total Stock Market Institutional, for which your account will be dinged $1,137.50. Put that same amount in a plain old Total Stock Market Admiral or ETF in a regular ole’ account and you’ll be dinged $318.50. It depends on your tax bracket and a lot of personal issues and financial picture, but maybe the tax savings won’t mean as much to you as the increased fees and loss of flexibility. You can buy a bunch of hours of fee-only advice for the difference, and set your whole financial life (not only your kids’ college plans) on surer footing.
At this point you may be asking yourself why bother with a 529, or maybe, why do I hear so much about them? What’s my usual answer? Well, ask yourself who’s making money off of them? The State? Yup, a decently run one is supposed to make some money (ergo, the higher fees for the Vanguard 529). Brokers? Aw, come on. You don’t really think that brokers would see the potential for making commissions, front-loaded fees, and selling crappy mutual funds with conveniently high management expenses paid by confused and earnest parents, do ya? Well, at least 2 out of three groups win. The only one left out may be the families that didn’t stop to consider their choices.
