15 Nov 2019 Is Saving to a 529 Plan Worth It?
A few weeks ago, Geoff and I were discussing whether it made sense for a potential client to contribute to a 529 plan (“college savings plan”) for their kids who were entering college in a few years. Yes, the gains would be tax-free, provided the funds were used for qualified expenses, but the short timeframe made it imprudent to invest any contributions in stocks. If growth was minimal, did it still make sense to contribute?
That, of course, sparked a larger debate about whether there is any real benefit in contributing to a 529 plan. The gains are tax-free, sure, but there’s always a trade-off: limited investment choices and restrictions on how the funds can be used, not to mention the relatively short amount of time before the funds are used (relative to retirement, for example). Was there a chance, we wondered, you’d be better of saving to an after-tax brokerage account?
So, you can imagine our excitement when just last week, mere days after our initial conversation, the current edition of the Journal of Financial Planning arrived with an article titled “College Savers: What Is The Expected Tax Alpha of 529 Plans?” Shouts of rejoicing echoed off the walls of the Beacon house.
(A quick, but important, note: “Alpha” is an investment term that means “additional return.” The article is quantifying the additional return of a 529 plan due its tax-free nature.)
Before reviewing the study’s finding, here’s a quick refresher on 529 plans. They are education savings accounts where you contribute and invest after-tax dollars. As an incentive to save, some states, though North Carolina is not one of them, allow for a state income-tax deduction on a portion of your contributions. As long as the money is used for qualified education expenses, withdrawals are completely tax-free. The 2017 Tax Cut and Jobs Act expanded the usefulness of 529 plans by allowing annual withdrawals up to $10,000 for K-12 tuition; prior to this, funds were restricted to college and post-college programs.
Because of the provision that funds in a 529 must be used for qualified education expenses, some parents are hesitant to use them and opt to either save for their child’s education in a Roth IRA (provided they are eligible) or an after-tax brokerage account.
Both of these options have their shortcomings. With the Roth IRA, if you withdraw any of the growth before age 59 ½, it is taxed as ordinary income and assessed a 10% penalty. Contributions can be withdrawn tax-free, but then you are sacrificing the growth, thereby limiting their usefulness in college planning.
With the after-tax brokerage account, the main concerns are year-to-year taxable activity plus capital gains when investments are liquidated to pay tuition. Neither of these are disqualifiers, but they do reduce your gains.
The study in the Journal of Financial Planning sought to answer the following question: does a 529 plan offer any benefit over a brokerage account and, if so, how much? (The Roth IRA is excluded from the study. My assumption is because of the inability to utilize any of the growth without incurring penalties.)
To answer this question, the study’s authors imagined a married couple who file their taxes jointly, have taxable income of $100,000, and save $3,000 per year for 10 years.
What’s the excess return provided by the 529 account over the brokerage account? As you can see below, in the state of North Carolina, it’s 1.07% per year and results in almost $2,500 extra dollars saved over 10 years.
While extra money is always good, relative to other states, North Carolina’s results aren’t great. Other states that offer more tax incentives have a much higher Tax Alpha. Montana, for example, the second state listed above, has a Tax Alpha of 2.32% and ranks #9 because it offers a state income tax deduction against a pretty high state income tax.
So, the answer to whether a 529 plan offers any real benefit is a clear “Yes!” but how much of a benefit depends on a few things:
First, does your state offer an income-tax deduction? If so, your Tax Alpha will be higher. It’s almost a no-brainer to use a 529 plan for education costs in a state that gives an income-tax deduction.
Second, how long until your child attends college? The longer you invest in a 529, the greater the benefit in dollars but the smaller the Tax Alpha in percentages. You can thank compound interest, the time value of money, and our tax code for this oddity.
Third, what’s your tax bracket? Generally, the higher your income, the greater the benefit of a 529.
Fourth, will you contribute in a lump-sum or annually? The lump sum results in a higher account balance. But, if your state offers an income tax deduction, annual contributions can provide a higher Tax Alpha.
Here are some additional thoughts I have on the benefits of 529s versus brokerage accounts:
Mental accounting: 529s give you an easily identifiable, segregated account whose primary purpose is paying for education.
Limited creditor protection: North Carolina offers $25,000 of creditor protection, per spouse, for 529 accounts.
More favorable financial aid treatment: Compared to brokerage accounts, 529 plans can be treated more favorably for financial aid purposes.
Your child’s college tuition, if a goal of yours, is one of the largest expenses you will incur, so you want to be as efficient as possible in saving towards it. It’s clear that a 529 plan is the best way to go about saving and investing, provided you are aware of and comfortable with the trade-offs. Let us know if you want to have a more in-depth conversation about your situation and, as always, thanks for reading!