College Savings 101: Arguments Against 529 Plans and Alternatives That Might Work Better

In 18 years, just about when a newborn today would be ready to go to college, a four-year degree at a public university could cost about $250,000, while the average private school could run you $500,000. And that’s just for one child.

After recovering from the sticker shock, you might think it’s time to get started on a 529 college savings plan. The description says it all, right? The reality is that preparing for your kids’ future isn’t always so simple, and there are a number of short- and long-term factors that should be considered.

Put on your oxygen mask on first

It’s natural for parents to think of their children before themselves. People go out of their way to start saving for their children – sometimes to their own detriment. Earlier in my career, I’d regularly talk to clients looking to open 529 plans, despite having less than $5,000 saved for themselves. Well intentioned as that might be, if you haven’t planned properly for your own future, it won’t be helping anyone that much.

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Think of being on an airplane. Before taking off, the flight attendant directs parents, in the event of an emergency, to put your mask on first. If you’re going to help your family, you will need oxygen, too. The same concept applies to college savings: Before you start putting away funds for your child’s or grandchild’s education, make sure you’re checking these four boxes for some financial oxygen.

1. Make sure you have an emergency fund, even before you save for your own retirement. Have three months of living expenses saved if you’re in a dual-income family, or six months in a single-income family. Your living expenses should be in cash in a savings account.
2. You should have the right amount of life and disability insurance. Again, this should come before saving for retirement, because you’re trying to insure your income. You can always work longer, but if, unfortunately, you die early, you will be leaving your heirs in a tough situation.
3. Pay off any high-interest debt. Generally, high-interest debt falls under the category of credit card debt, unsecured personal loans and in some cases, student loans. Believe it or not some parents think it’s smart to save for their child's education before they’ve paid off their own!
4. Now, you can save for your retirement, but make sure you’re keeping pace with steps 1, 2 and 3. Helping your child through college is great, but the accomplishment is muted if you end up asking them for a loan once they enter the workforce.

The uncomfortable 411 on the 529

Named for its section of the tax code, the 529 can be an effective way to save for your child’s education, but its applications are limited, and the only up-front benefit is a small deduction in states with an income tax. In Pennsylvania, for example, the deduction is only 3.07%. From a federal standpoint, there are long-term advantages, as you’re getting tax-deferred growth and it’s tax-free to use as long as the funds go to qualified educational expenses. In addition to the tax benefits, it’s also worth noting that assets in a 529 plan are generally looked at more favorably from a financial aid qualification standpoint than assets in other types of accounts. Nonetheless, the restrictions of the plan can sometimes outweigh the potential tax benefits.

When considering a 529 plan it’s important to understand which expenses are “qualified.” College tuition, computers, software and books are qualified expenses. However, many other standard expenses -- such as vehicles, sports equipment, some forms of off-campus housing and even tuition for colleges that don’t accept federal aid -- are considered “non-qualified” and are subject to taxes. Imagine the beneficiary of the 529 plan is in their senior year of college and living in an apartment off-campus, can you use 529 money to pay the rent? The answer is, “maybe.” Qualified housing costs cannot exceed the room & board allowance set by the university. In this example, if the rent is more than what the university allows, the costs above the qualified housing limit would be taxed as ordinary income and would also be hit with a 10% federal penalty.

Taxes could come into play in other scenarios, too. If your child receives a full scholarship, the 10% penalty is generally waived on 529 earnings used for non-qualified school expenses up to the amount of the scholarship, but ordinary income tax would still be due. Or, perhaps you opened a 529 account for your child when they were 2 years old, but at 18, they decide they want to go to Europe instead. If you wanted to support their trip with funds from their 529, your contributions could be withdrawn without a tax penalty, but the 529 gains used would be subject to the 10% penalty in addition to ordinary income taxes.

Money contributed to a 529 is also considered a gift, so you have to pay attention to annual gifting limits too ($15,000 in 2018). In most cases, you can’t just drop $200,000 in a 529, wipe your hands, and watch the money grow. Fortunately, there is a tax provision that allows you to frontload a 529 with five years of gifts in one year. For the next five years, you would then file a gift tax return.

Alternatives to the 529

Because of these limitations, among others, I encourage people to consider all of their savings options and to not just assume a 529 is the way to go.

• An alternative vehicle parents can use to save money for their children is a custodial account. A custodial account allows an adult to control the account for the named beneficiary until the beneficiary turns 18 or 21, depending on the state. There are no income limits or withdrawal penalties, but contributions over the gifting limit will be subject to the federal gift tax. Assets placed in the account are considered an irrevocable gift to the minor and can be used for any purpose without penalty. In addition, assets can be withdrawn at any time if they are used to benefit the minor. The flexibility is high, but because their child will have full access to the funds as a young adult, many parents shy away from heavily funding them.
• A strategy that often stacks up favorably to a 529 plan is setting up a trust. As I covered in a previous article, trusts are valuable tools that allow you to maximize tax-planning opportunities within your estate plan, spell out specifically how you want to distribute your assets, and ensure that your vision for your legacy is carried out faithfully. A Trust doesn’t provide you with the tax benefits that a 529 plan would, but it does give you the ability to control access to the account and spell out what it can be used for. Most parents I’ve worked with like the idea of a trust because it provides maximum flexibility without giving the child automatic access to the funds when they become 18 or 21 years old, and the money doesn’t have to be used for “qualified education expenses.”
• Another potential savings vehicle is a Roth IRA. Roth IRAs are funded with after-tax dollars and the benefit is tax-free earnings for retirement. A unique feature of a Roth is the ability to access your contributions penalty-free at any time. Say, for instance, you contributed $5,000 for 15 years. That would equate to $75,000, which could be withdrawn to pay for your child’s education. If you’re under 59½ the earnings should stay in the account, or you could end up paying the same penalty as you would in the 529 plan scenario (ordinary income taxes plus 10%). And of course, make sure before withdrawing funds, you have your financial “mask” on.
• Cash value life insurance is another important option to consider. Purchasing a policy for a toddler is generally inexpensive, and over time, the policy can build up substantial cash value. A portion of each premium payment goes toward the cash value of the account, while rest goes to the death benefit. Many of these policies allow you to take out a loan against the cash value at a very low interest rate, if not zero percent, which can be used to pay for school. The one caveat is that you shouldn’t purchase life insurance for the sole purpose of funding college as there is certainly a cost to carry the policy, but, it can play a useful role in your education-funding strategy if planned correctly.

Class dismissed

These are just a few of the options you have when planning for your child’s future, and this is not to say that a 529 is necessarily a bad thing. In fact, over the last few years, the rules surrounding 529 plans have started to ease up by expanding the definition of what is considered a “qualified education expense.” If you opened a 529 plan shortly after your child was born, and you’ve checked the boxes mentioned earlier, the plan could pay dividends once the budding student gets to the dorms and start racking up qualifying expenses.

But it’s important to know that there is more than one route to securing solid financial footing for your kids or grandkids, especially if you’re getting off to a later start saving for their education, or if you are fairly certain that they won’t be attending college. No matter what your circumstances, it’s always a good idea to educate yourself about your options.