Choosing a 529 Plan
529 plans grow in popularity due to the importance of children attending college to increase their professional prospects, all while the total expense of attending college has increased at a rapid rate. Ever since the Economic Growth and Tax Relief Reconciliation Act of 2001 which birthed these plans, the usage of 529 plans has increased due to their ability to grow investments tax free and be used on qualified educational expenses without incurring any taxes for selling those investments. So, the question for most people is how do you chose one?
Prepaid Vs. Savings 529 Plans
Prepaid means that you’re locking in a certain level of tuition rates so that even if the rates increase dramatically between now and when your child goes to school those increases in tuition won’t affect you. This is an attractive option for people who don’t want to worry if they’ll be able to pay for their child’s future tuition. The attractiveness of prepaid plans speaks to those who don’t want to wonder what if and have a guarantee. The state of Florida backs all prepaid plans which means that as long as the state is solvent then your pre-paid plans should hold up their end of the bargain. Unless prices rise extremely quickly it is likely more suitable for people to utilize a savings 529 plan due to the fact that you have more investment flexibility and the ability to use those funds on more than just tuition. Although there are dormitory plans that are now available as well through Florida’s pre-paid plan. The plan can be portable to other states as they will pay the same amount to out of state schools that they would pay to in-state schools. The issue here is that pre-paid plans don’t pay their own schools a very high number, so the plan becomes less effective once used outside of the home state.
Prepaid plan example:
Parents buying their newborn a 4-Year University Pre-paid plan
$186.28 per month over 223 payments = $41,540 (total paid into plan)
The $186 payment is generated by taking today’s general tuition rate and adding a yearly increase of roughly 2.5%.
$41,450/4 = $10,385 Yearly Tuition Average
$6,381 per year tuition rate at UF currently. Applying an annual 2.5% rate over 18 payments yields $9,952 in the freshmen year and $10,717 in their senior year.
If college tuition prices increase more than 2.5% over that time frame then pre-paid saved you the difference. If they increase less than 2.5% then you actually paid more into the plan than you get out by utilizing pre-paid. Over the last 5 years the University of Florida in-state tuition has not changed. If you believe in-state tuition rate increases won’t be in line with national historical averages of 5% before they attend college then a prepaid plan may not be for you.
A savings 529 plan allows you to save money for college at a contribution rate of your choosing. It is not a contractual agreement like a prepaid plan is. If you want to contribute a certain amount one month and a different one the next you can. This can be a negative, in particular for those who aren’t good savers. So if using a savings plan be sure to use a calculator to help you decide how much to put away to stay on track for your end goal. In a 529 savings plan the money that you contribute to the plan then gets invested among different investment choices that your 529 provider will make available to you. You can choose to then invest that money in a high growth/high risk fashion, or in a more conservative/low risk fashion. Generally, it is wise to become more conservative as you get closer to the date in which you student is about to attend college so the value of the account is less at risk when it will be needed most. Then upon time it is needed to draw on the 529 plan you can either transfer funds directly to the school, or via check to you or the student, to use on a whole list of qualified educational expenses. The value of the account will be applicable in-state as well as out of state as long as the school is an accredited institution which allows the plan to keeps it value independent of which school your student attends.
Savings plan example:
Parents buying a newborn a 529 savings plan
Place $186.28 per month into the plan for the next 223 months until their child attends college.
If that 529 plan yields on average a 4% net return then the parent will end up with $61,491 to use for educational expenses.
The savings plan can yield considerably better results than a prepaid plan, but also comes with its own fair share of risk. Be sure to manage the investments appropriately. Also be careful with over funding the plan since withdrawals not related to education are penalized by 10% on top of being charged income tax on any investment gains.
The thing to note though in using a 529 savings plan is that there will be fees for investment managers, account maintenance, etc. so you want to make sure that you pick the right one as there are many choices.
State(Direct) or Broker sold Plan? Which State plan is the best?
Normally 529 plans are sold are from brokerage companies like Blackrock and Merrill Lynch, or sold directly from the states themselves. Generally, it’s cheaper to work through the states directly, but it’s important to look at the complete set of fees when comparing one plan versus the other. A great study comparing fees showcases how the plans sold directly from the states themselves compare to each other.
Being residents of Florida grants plenty of advantages outside of a long summer. The absence of any state taxes gives investors a lack of incentive to use the Florida 529 plans. In many other states the ability to deduct 529 contributions from your taxes pushes people to utilize their home state sponsored 529 plan, but due to no state income taxes here in Florida we can pick from any 529 plan that best fits our needs. If you don’t live in Florida you can look up whether or not your state’s plan gives tax deductions for contributions to your in state plan.
We often push our clients toward using the my529 plan sold by the state of Utah due to their ease of use and low fees imposed by the plan and its investments. This plan year after year has been rated as a top plan among the many choices. By no means though is this the only plan that makes sense for people to use.
Whether it’s a prepaid plan or savings plan, or a combination of both, make sure to have the conversation early as to which is right for you. The prepaid plan is a great way to hedge against rapid tuition increases while savings plans will grant you more investment choices and opportunities of growth. Just be sure to check the fees and such that come along with the savings plans.
Ian is a managing partner of Mellen Money Management, a fee-only, independent financial planning firm locally based in Jacksonville, Florida. In a nutshell, Ian helps clients plan for the financial impact of major life events, so that they are prepared for life's biggest moments. Such an approach has helped his clients live a more fulfilling life. Mellen Money Management’s financial services include investment management and comprehensive financial planning. While their specialty is all things college -- they help families pay less for college and young professionals tackle their student loans. It is their mission to end the student debt crisis one client at a time. To do so they believe the cost of college cannot be solved in a vacuum and that financial trade-offs, like saving for retirement, must be prioritized in a way that one goal doesn't come at the expense of the other.
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