Why Nobody Should Have a 529 Plan

Once your child is born, there is a strong sense of responsibility that kicks in and most parents want to immediately start saving for college.  By far the most popular college savings vehicle is the 529 Plan, which was created by the IRS in 1996.  There are over 70 plans from which to choose and the growth is tax-free! It sounds great, right?  Not quite.  Let’s look at each of the “advantages” of using a 529 Plan to save for college and why you should NOT open one (or at least rely solely on it).

Claimed Advantage #1: Your investment grows tax free as long as it is used for qualified higher education (college, grad school). This is a heavily
marketed benefit of these plans; however, according to Gary Sipos, the founder of College Cash Solutions, “There is a lot of sizzle, but no steak.” Mr. Sipos has looked at thousands of 529 plans that are maturing (i.e. the kids are going to college now), and there is little to no growth in any of the plans. He says that most parents are thrilled to just get out their contributions and not lose money! A rate of return around 3% for a 529 plan is considered amazing.  In addition, there are management fees and other hidden costs that erode any gain you might have.

Claimed Advantage #2: Donor maintains control of the money. While the account is for the benefit of your child, you write the checks to the school and your child doesn’t have access to the money. If you had a regular brokerage account, you maintain control as well, so this does not appear to provide much benefit.

Claimed Advantage #3: Low maintenance option. When you invest in a 529 plan, the plan professionals handle your investments and you do not have to worry about how to invest your money. This benefit assumes that the plan professionals are looking out for your best interest and maximizing your return on investment. While plans now offer more investment selections, the selection is still very limited and comprised of a lot of “dogs” when it comes to mutual funds.

For example, Savingforcollege.com ranks New York’s Vanguard 529 Plan #1 right now. They offer 3 age based investment options and 13 other investment options. Let’s say you have a child under 5 and pick the Aggressive Growth option. This option has underperformed its  benchmark in every year, plus you pay 0.25% management fee each year. The underlying investment of this option is Vanguard’s Institutional Total Stock Market Index Fund.

A better option, do it yourself!  Open a brokerage account in your name and earmark it for your child’s college savings. Buy Vanguard Total Stock Market Index Fund (Ticker VTSMX), pay a one-time commission to buy the fund (~$7) and no ongoing account fee.  If you did this instead of the New York 529 plan, your investment would outperform the Aggressive Growth option and the benchmark.

Investment

1 Year Return

3 Year Return

5 Year Return

Ongoing Fee

Aggressive Growth option

0.85%

14.78%

0.06%

0.25%

DIY Alternative (Ticker: VTSMX)

4.63%

20.35%

0.97%

None

Benchmark

1.08%

15.14%

0.29%

The benefits of the DIY approach: Almost unlimited investment selection, no ongoing management fee, ultimate flexibility and control over the money, and a chance to actually grow your money!

Another great way to save for college is a Roth IRA. If you own a business there is another more tax beneficial way to save for college. Hire your kids (1099 vendors), given them work experience, pay them up to $5,000 per year, open a Roth IRA for them and invest their earned $5,000. They won’t pay any income tax and the contributions can be withdrawn (tax-free) and used for anything once the account has been open for five years. This is also an expense for your business and lowers its taxable income. This is a win, win situation! In addition, financial Aid does not take any retirement assets into consideration, so this money will not count against your child. But, remember to fire your kids in their junior year of high school. You do not want them earning any income in their junior or senior year because it will be counted against them for financial aid.

The future costs of college are staggering, and it is important to start saving as early as possible to take advantage of the power of compounding. However, a 529 plan is not the best or only solution.  I am a strong  proponent of diversification. I have 529 plans for both of my kids, as well as Roth IRAs for them and a brokerage account earmarked for their college.  I use the 529 plans for money given to them by their grandparents, which makes grandma happy. Fingers crossed there will be some tax free growth to take advantage of but I am not relying on it.